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Practical insights into accounting for certain revenue arrangements

The revenue recognition principles as discussed under Ind AS provide elaborate guidance on various types of arrangements that may be applicable to select class of companies or to most companies in general. In this article, we focus on the guidance provided under appendix B (Customer Loyalty Programmes) and C (Transfer of Assets from Customers) to Ind AS 18 on Revenue, sharing our perspectives on the accounting for the said arrangements.

Customer loyalty programmes
Customer loyalty programmes, comprising loyalty points or ‘award credits’, are offered by a diverse range of businesses, such as supermarkets, retailers, airlines, telecommunication operators, credit card providers and hotels. Award credits may be linked to individual purchases or groups of purchases, or to continued custom over a specified period. The customer can redeem the award credits for free or discounted goods or services.

The structure of loyalty programmes offered by sellers varies, but in general they can be classified into one of the following schemes:

Award credits earned can be redeemed only for goods and services provided by the issuing entity.
Award credits earned can be redeemed for goods and services provided either by the issuing entity or by other entities that participate in the loyalty programme.

For a programme to be accounted as a customer loyalty programme, it needs to contain two essential features:

the entity (seller) grants award credits to a customer as part of a sales transaction; and
subject to meeting any other conditions, the customer can redeem the award credits for free or discounted goods or services in the future.

For instance, a customer receives a complimentary product with every fifth product bought from the entity (seller). As the customer purchases each of the first five products, they are earning the right to receive a free good in the future, i.e., each sales transaction earns the customer credits that go towards free goods in the future.

However, it may be noted that not all types of programmes that provide free or discounted goods are accounted as customer loyalty programmes. For instance, say a purchase of membership of a club entitles a member to purchase certain goods or services at a discounted price. In such case, the substance of such membership needs to be evaluated closely. It may seem that the purchase of membership may not be a separate transaction and the amount received by the club may be against purchase of those discounts themselves.

Accounting for customer loyalty programmes
Deferral of revenue
Under Ind AS, the award credits (i.e., air miles, credit card points, etc.) under customer loyalty programmes are not recognised as sales promotion or any other expense. Instead, they are recognised as a separate component within a multiple element revenue arrangement. As such, the revenue under the sales arrangement is allocated to one or more elements, including the award credit. At the inception of the arrangement, the revenue attributable to the award credit is deferred and is recognised as and when the award credits are redeemed by the customer. The revenue attributed to the award credits takes into account the expected levels of redemption.

Allocation of revenue to award credits
Ind AS requires that the consideration received or receivable from the customer is allocated between the current sales transaction and the award credits by reference to fair values. The Ind ASs do not prescribe a particular allocation method. However, the following two methods provided under IFRS may also be applied under Ind ASs:

relative fair values; or
fair value of the award credits (residual or fair value method).

Using relative fair values, the total consideration is allocated to the different components based on the ratio of the fair values of the components relative to each other. For instance, assume a transaction comprises two components, X and Y. If the fair value of component X is 100 and of component Y is 50, then two-thirds of the total consideration would be allocated to component X. If the total consideration is 120, then revenue of 80 would be allocated to component X and 40 to Y.

Using the residual method, the undelivered components are measured at fair value, and the remainder of the consideration is allocated to the delivered component. For example, assume a transaction consists of two components, X and Y; at the reporting date only component X has been delivered. If the fair value of component Y is 50 and the total consideration is 120, then revenue of 70 would be allocated to component X and 50 to Y.

In estimating fair value, the entity (seller) takes into account:

the amount of the discounts or incentives that would otherwise be offered to customers who have not earned award credits from an initial sale; and
the proportion of award credits expected not to be redeemed, i.e., expected forfeitures.

Other estimation techniques may be available. For example, if an entity (seller) pays a third party to supply the awards, then the fair value of the award credit could be estimated by reference to the amount that the entity pays plus a reasonable profit margin. However, judgment is required to select and apply the estimation technique that is most appropriate in the circumstances.

Accounting for revenue related to award credit The revenue attributable to the award credit (that was deferred at inception) shall be recognised as such in the income statement as and when the awards are redeemed.

Any subsequent change in the estimates of awards expected to be redeemed are trued up for differences between the number of awards expected to be redeemed and the actual number of awards redeemed; the amount of revenue deferred at the time of the original sale is not recalculated.

Steps involved in accounting for customer loyalty programmes
Having discussed the principles of revenue recognition relating to the customer loyalty programmes, the following are the broad steps involved in accounting for the same:
1. Understand the various customer loyalty programmes in effect.

2. Identify the deliverables in the different programmes. Along with the principal goods, the deliverables could be supply of own goods free of cost or at a discounted price in future, supply of promotional gifts based on the level of purchases made by the customer, gift coupons which can be redeemed as a discount on future purchases, award credits, etc.

3. Identify the fair value of the goods sold and the award credit. The fair value of the award credit to be determined based on expected level of redemption, after considering the market price of the award and the amount of the discounts or incentives that would otherwise be offered to customers who have not earned award credits from an initial sale.

4. The appropriate method of allocation of consideration to award credit needs to be chosen. There are mainly two methods to allocate values to the components of a multiple deliverable arrangement: — Relative fair value method — Fair value of the undelivered component.

5. Once the value of the deliverables has been assigned as above, the management then needs to recognise revenue for the delivered goods at its fair value allocated as above and defer revenue equivalent to the allocated fair value of the award credit.

6. Once the fair value allocation is determined as above, the consideration allocated to sale of goods is not subsequently re-assessed based on change in estimates of forfeiture rate. The change in estimates of forfeiture rate only affects the pattern of recognition of revenue relating to the award credits.

7. For the undelivered item (i.e., the award credit) the revenue would have to be deferred till the date of actual redemption. On redemption, the revenue attributable to the award credits is recognised.

Let us understand the above principles with the help of an example:

Company X runs a loyalty scheme rewarding a customer’s spend at its stores. Under this scheme, customers are granted 10 loyalty points (or award credits) for every 100 spent in X’s store. Customers can redeem their points for a discount in the price of a new product in X’s stores. The loyalty points are valid for five years and 50 points entitle a customer to a discount of 50 on the retail price of the product in X’s store.

During 2011, X has sales of 500,000 and grants 50,000 loyalty points to its customers. Based on the expectation that only 40,000 loyalty points will be redeemed, management estimates the fair value of each loyalty point granted to be 0.80. During 2011, 15,000 points were redeemed in exchange for new products, and at the end of the reporting period management still expected a total of 40,000 points to be redeemed, i.e., a further 25,000 points will be redeemed.

X records the following entries in 2011 in relation to the loyalty points granted in 2011:

Particulars

Debit

Credit

Bank

Dr.

500,000

To Revenue

460,000

To Deferred Revenue

40,000

(50,000*0.8)

(Being revenue recognised in relation to sale of goods and deferred
revenue for loyalty points)

At the end of the reporting period, the balance of the deferred revenue is 25,000 [(25,000/40,000) x 40,000]. Therefore, the difference in the deferred revenue balance is recognised as revenue for the year.

Particulars

Debit

Credit

Deferred revenue

Dr.

15,000

To Revenue

15,000

(Being revenue recognised in relation to 15,000 loyalty points
redeemed in 2011)

During 2012, 17,500 points are redeemed, and at the end of the year management expects a total of 42,500 points to be redeemed, i.e., an increase of 2,500 over the original estimate. The fair value of each award credit does not change, but the redemption rate is revised based on the new total expected redemptions. At the end of the year, the balance of deferred revenue for 10,000 loyalty points (i.e., 42,500 — 15,000 — 17,500) is 9,412 [(10,000/42,500) x 40,000]. X records the following entry in 2012 in relation to the loyalty points granted in 2011:

Particulars

Debit

Credit

Deferred revenue

Dr.

15,588

(25,000 – 9,412)

To Revenue

15,588

(Being revenue
recognised in relation to loyalty points redeemed in 2012)

Alternatively, on a cumulative basis 30,588 has been released, which can be calculated as (32,500/ 42,500) x 40,000.

Transfer of assets from customers
Ind AS 18 provides guidance on transfers of property, plant and equipment (or cash to acquire it) for entities that receive such assets from their customers in return for a network connection and/or an ongoing supply of goods or services. As such, the principles contained hereunder do not apply to gratuitous transfers of assets i.e., transfer of assets without consideration. Further, the guidance also cannot be applied to transfers that are in the nature of government grants or those covered under the service concession arrangements.

Concept of control
When the Company receives an item of property, plant and equipment from the customer, it will have to assess if the transferred item meets the definition of the asset from the Company’s perspective. An asset is defined as “an asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity”.

It is important to note that in determining whether an asset exists, the right of ownership is not essential. Therefore, if the customer continues to control the transferred item, the asset definition would not be met despite a transfer of ownership. Hence, the Company must analyse if it has obtained the control of the transferred asset to recognise the same in its books.

Control would imply right to utilise the transferred asset the way Company deems fit. For example, the Company can exchange that asset for other assets, employ it to produce goods or services, charge a price for others to use it, use it to settle liabilities, hold it, or distribute it to owners.

As part of the arrangement for transfer of asset from the customer, the arrangement may require that the Company must use the transferred item of property, plant and equipment to provide one or more service to the customer. However, if the Company has the ability to decide how the transferred item of property, plant and equipment is operated and maintained and when it is replaced, it can be concluded that the Company controls the transferred item of property, plant and equipment.

If based on the above principles, it is concluded that the company has obtained control over the asset transferred by the customer, the company shall recognise (debit) the transferred asset as its own asset (though it may not have the ownership). The corresponding impact of the transfer shall be recognised as either revenue or deferred revenue, depending upon the obligations assumed by the company in lieu of the transferred asset.

Timing of revenue recognition
In determining the timing of revenue recognition, the entity (recipient) considers:

what performance obligations it has as a result of receiving the customer contribution;

whether these performance obligations should be separated for revenue recognition purposes; and

when revenue related to each separately identifiable performance obligation should be recognised.

Comprehensive guidance on how to determine the entity’s performance obligations is not provided under the appendix C. In practice it may be difficult to determine whether the entity only has to connect the customer to a network, or it has to provide ongoing access to a supply of goods and services, or both.

All relevant facts and circumstances should be evaluated when determining whether additional performance obligations arise from the transfer including:

whether or not the customer providing the contribution is charged the same fee for the supply of goods or services as is charged to other customers that are not required to make such customer contributions;

whether customers have the ability to change the supplier of goods or services at their discretion; and

whether a successor customer needs to pay a connection fee when the customer that made the customer contribution discontinues the service, and if so, the amount of such connection fee relative to the fair value of the asset contributed.

In our view, in determining whether a rate charged to a customer includes a discount, the entity should compare rates for ongoing services charged to customers that make a contribution with the rates charged to customers that do not.

If it is determined that some or all of the revenue arising from the customer contribution relates to the ongoing supply of goods or services, then the revenue is recognised as those services are delivered. Typically, such revenue is recognised over the term specified in the agreement with the customer. If, however, no such term is specified, then the period of revenue recognition is limited to the useful life of the transferred asset.

Instead of property, plant and equipment, an entity may receive cash that must be used to construct or acquire an item of property, plant and equipment in order to connect the customer to a network and/or provide the customer with ongoing access to a supply of goods or services. The accounting for such cash contributions depends on whether the item of property, plant and equipment to be acquired or constructed is recognised as an asset of the entity on acquisition/completion.

If the asset is not recognised by the entity, then the cash contribution is accounted for as proceeds for providing the asset to the customer under Ind AS 11 or Ind AS 18, as applicable.

If the asset is recognised by the entity, then the asset is recognised and measured as it is constructed or acquired in accordance with Ind AS 16; the cash contribution is recognised as revenue following the guidance as stated above.

Steps involved in accounting for transfer of assets from customers
Having discussed the principles of revenue recognition relating to the transfer of assets from customers, the following are the broad steps involved in accounting for the same:
(1) Analyse all the relevant agreements to identify arrangements covered within this guidance.

(2) Assess whether the control over the transferred asset is obtain by the company. If the control is transferred to the company, the asset will be recognised in the Company’s balance sheet.

(3) Determine the obligations assumed by Company in lieu of the transfer of control over the transferred asset.

(4) If the above-mentioned obligations are in the nature of ongoing services, then revenue attributable to those obligations is deferred and recognised as the underlying services are rendered and obligations fulfilled.

(5) To the extent the above-mentioned obligations are fulfilled at the inception of the contract, recognise appropriate revenue upfront.

(6) Depreciate the acquired asset over its useful life.

Let us understand the above principles with the help of an example:

Company X has entered into an agreement with Company Y to outsource some of its manufacturing process. As part of the arrangement, Company X will transfer the ownership of its machinery to Company Y.

Based on a report submitted by independent valuer, the fair value of assets transferred is Rs. 90,000. Initially, Company Y must use the equipment to provide the service required by the outsourcing agreement. Company Y is responsible for maintaining the equipment and replacing it when it decides to do so. The useful life of the equipment is 3 years. The outsourcing agreement requires service to be provided for 3 years for a fixed price of Rs.10,000 per year which is lower than the price that Company Y would have charged if the equipment had not been transferred. In such case the fixed price would have been Rs.40,000 per annum.

Pursuant to a detailed analysis, Company Y determines that the control over the equipment is transferred in its favour. Hence, Company Y would have to initially recognise the asset at its fair value in accordance with Ind AS 16. Further, Company Y would also have to recognise the revenue over the period of the services performed i.e., over 3 years.

Company Y shall recognise the following journal entries to recognise the transactions under the arrangement:

Particulars

Yr
1

Yr
2

Yr
3

Asset

Dr.

90,000

15,000

To Deferred

90,000

15,000

Revenue (Being transfer of

assets from customer)

Bank

Dr.

10,000

Deferred Revenue

Dr.

30,000

To Revenue

40,000

(Being revenue recognised

under the arrangement)

Depreciation

Dr.

30,000

To acc. depreciation

30,000

(Being assets transferred

from customer depreciated

over its useful life)

Summary
Overall, the implementation of the above guidance on customer loyalty programmes and transfer of assets from customers will require significant judgment in several respects while preparing the entity’s financial statements.

shailesh.kwebmaker

Redefining the framework for taxation under Ind AS

In the recent past, the corporate sector has seen the much needed refinement of the accounting and tax frameworks, with Notification of several new accounting standards and pronouncements under Indian GAAP, Notification of 35 accounting standards (Ind AS) that are converged with IFRS, and discussions around introduction of the Direct Tax Code (DTC) and the Goods and Services Tax (GST).

While the changes in the accounting and tax frameworks will have a substantial impact on the Indian industry, there was a need for more clarity on the tax implications of the accounting adjustments pursuant to adoption of Ind AS. Further, one of the common criticisms for implementation of Ind AS has been that the differences in recognition and measurement principles between Ind AS and the tax frameworks would potentially lead to additional efforts of maintaining different accounting records — one for accounting purposes and the other for tax purposes.

Background to accounting standards for tax purposes

For the purpose of enabling more clarity on accounting treatment for certain transactions for tax purposes and to standardise the alternative accounting options as contained in the financial accounting standards, the Income-tax Act, 1961 (the Act) permits the Central Government to notify accounting standards that shall be mandatorily applied by the assessees for determining accounting income for income-tax purposes.

Since the introduction of these provisions, two accounting standards relating to disclosure of accounting policies and disclosure of prior period and extraordinary items and changes in accounting policies have been notified.

In 2003, a committee on formulation of accounting standards under the Act submitted its report, recommending that the accounting standards issued by the Institute of Chartered Accountants of India (ICAI) be notified under the Act. The recommendation acknowledged that it would be impractical for the assessee to maintain two sets of books of accounts (i.e., for financial reporting as well as for tax purposes) in case the accounting standards for tax purposes differed significantly from financial accounting standards.

However, the said recommendation could not be effected at that time as new financial accounting standards were evolving and some of the existing standards were under revision. Further, the tax authorities believed that the Notification of the accounting standards issued by ICAI under the Act would require extensive revision to the Act in order to avoid complexity and litigation.

Accounting standard committee

In December 2010, the Central Board of Direct Taxes (CBDT) constituted an Accounting Standard Committee (the Committee) comprising of officers from the Income-tax Department and other professionals. The terms of reference of this Committee were as follows:

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

(b) to suggest method for determination of tax base (book profit) for the purpose of Minimum Alternate Tax (MAT) in case of companies migrating to IFRS (Ind AS) in the initial year of adoption and thereafter; and

(c) to suggest appropriate amendments to the Act in view of transition to IFRS (Ind AS) regime. On 17 October 2011, based on the recommendation of the Committee, the Ministry of Finance issued a Discussion Paper on Tax Accounting Standards. This paper discusses the key recommendations of the Committee on point (a) above.

Main recommendations of the Committee

(a) As the accounting standards to be notified under the Act are required to be in conformity with provisions of the Act, the standards notified by ICAI cannot be adopted without modification. Further, the accounting standards notified under the Act should also eliminate the alternative accounting treatment permitted by the ICAI standards in order to ensure uniformity;

(b) The accounting standards notified under the Act may be termed as Tax Accounting Standards (TAS); such TAS shall be applicable only to those assessees who follow mercantile system of accounting (rather than cash system of accounting);

(c) TAS are intended to be in harmony with the provisions of the Act. As such, in case of conflict, the provisions of the Act shall prevail over TAS;

(d) The starting point for computing the taxable income under the Act would be the income computed based on TAS, instead of net profit as per the financial statements;

(e) The assessee need not maintain separate books of accounts based on TAS. Instead, the assessee should prepare a reconciliation of income computed based on financial accounting standards and TAS.

If the recommendations in the Discussion Paper are eventually accepted and incorporated into the Act, income for tax purposes (to which a set of allowances and disallowances would be adjusted to derive taxable income) would be computed based on provisions of TAS, irrespective of the accounting standards followed for the preparation of the financial statements.

This would partially address the issue relating to the impact of transition of Ind AS on taxation, as taxes payable (other than MAT) would be computed based on TAS, irrespective of whether a company follows the currently applicable accounting standards or Ind AS.

Further, though taxpayers will not be required to maintain separate books of account as per TAS, they would need to maintain and present the reconciliation between the profits per the financial statements and per the provisions of TAS.

So far, the Ministry of Finance has also issued the Draft TAS on Construction Contracts and Government Grants for comments and suggestions. Draft of other TAS will also be issued at a later date.

Draft TAS on construction contracts

Though the draft TAS on construction contracts is substantially similar to Accounting Standard 7 (AS-7) on Construction Contracts, the following modifications merit consideration:

Uncertainty relating to ultimate collection

In line with paragraphs 21 and 22 to AS-7, the revenue from the construction contract cannot be recognised unless it is probable that the ultimate collection of the consideration shall be made from the customer. As such, the revenue recognition in such cases is postponed until such collection is probable.

The draft TAS does not seem to have directly incorporated the above principles, thereby leading to an interpretation that contract revenue to be recognised based on percentage of completion method, even if the ultimate collection is not probable. As such, the company needs to recognise revenue even if at inception the collection does not seem probable, and subsequently write off the receivables as bad debts. This modification may lead to higher income for taxation purposes and may lead to higher income taxes in the initial phase of the contract as compared to the current practice.

Provision for loss-making contracts

AS-7 and Ind AS-11 requires that on construction contracts where the total contract costs exceed the total contract revenue, a provision for such loss should be made immediately. The draft TAS has not incorporated the said requirement of recognising a provision for the said loss immediately. As such, while computing income based on provisions of TAS, such provision for expected losses is not permitted for recognition. Consequently, the income computed based on TAS may be higher than that reported in the financial statements. However, one needs to watch the development of TAS equivalent to Ind AS-37 and AS-29 on Provisions, Contingent Liabilities and Contingent Assets closely, as Ind AS-37 and AS-29 require a provision for onerous contracts for an amount equivalent to lower of the expected loss in case of fulfilment and penalties in case of termination.

Method of computing the stage of completion
AS-7 and Ind AS-11 do not require any particular method for the purpose of computing the stage of completion of the construction contract, but prescribes an illustrative list of the following methods:
(a) the proportion that contract costs incurred for work performed up to the reporting date bear to the estimated total contract costs; or
(b) surveys of work performed; or
(c) completion of a physical proportion of the contract work.

As such, for accounting purposes, the company could follow any of the above methods or any other method if that would lead to more reliable computation of stage of completion.

However, the draft TAS seems to have restricted the alternatives to the ones mentioned above and does not provide flexibility to adopt any other method. As such, modification is more in line with the objective of the committee to eliminate the alternate accounting practices permitted under the financial accounting standards.

Even though TAS permits non-recognition of margins during the early stages of a contract, it prohibits such deferral if the stage of completion exceeds twenty-five percent. Varied practices are currently prevailing on the point of time from which margin is recognised by different companies. This will be aligned under TAS to some extent.

Incidental income to be reduced from costs
AS-7 requires the contract costs be reduced by any incidental income that is not included in contract revenue. The draft TAS clarifies that such incidental income cannot be in the nature of interest, dividends or capital gains.

Need for some more clarity on draft TAS on construction contracts

(A) Combining and segmenting contracts
The draft TAS on construction contracts has retained the guidance on combining and segmenting contracts that requires the assessee, based on the substance of the arrangement, to:

(i) combine two or more contracts, or
(ii) split one contract into multiple components.

Based on the current draft, two specific areas within the combining and segmenting contracts that may require more clarity includes allocation of consideration to identified components within an arrangement and whether the said principles on combining and segmenting contracts shall also extend to accounting for arrangements that are not construction contracts, and commonly referred to as linked transactions and multiple element arrangements.

(a) Allocation of consideration to components
In cases where a single contract is required to be split into components, the draft TAS does not clarify a methodology for such allocation of consideration under a single contract into components.

On adoption of Ind AS, the companies generally allocate the consideration to each component based on either residual method (where the fair value of undelivered components is deferred and residual consideration is allocated to delivered components) or relative fair value method (where the consideration is allocated to each component in the ratio of their fair values). This has not been specifically addressed in TAS.

(b) Extension of principles to arrangements that are not construction contracts

The principles of combining and segmenting contracts are sometimes applied in case of arrangements that may not be a construction contract, but the commercial substance may be established by either combining or segmenting the contract(s) and are commonly referred to as linked transactions or multiple element arrangements, respectively. This may be further clarified in the corresponding TAS of AS-9 or Ind AS-18 on revenue recognition.

As a general principle based on current practices, the taxes are usually levied based on contractually agreed prices for the agreed deliverables and there may not be any need for allocation or aggregation of sale consideration for tax purposes.

(B) Discounting of retention money as per Ind AS

As TAS is based on AS-7, the new concepts in Ind AS that may impact accounting for construction contracts (for example, discounting of retention receivables) have not been incorporated into TAS. Accordingly, companies that transit to Ind AS may need to make certain additional adjustments to comply with TAS.

Draft TAS on government grants

Though TAS is based on Accounting Standard 12, Accounting for Government Grants (AS-12), there are some fundamental modifications to AS-12, which require consideration:

TAS does not permit the capital approach for recording government grants. Accordingly, the current practice of recording grants in the nature of promoters’ contribution or grants related to non-depreciable assets, directly in shareholders’ funds as a capital reserve will not be permitted under TAS;

Under TAS, all grants will either be reduced from the cost of the asset; or recorded over a period as income; or recorded as income immediately; depending on the nature of the grant; and

Unlike AS-12, TAS provides that the initial recognition of the grant cannot be postponed beyond the date of actual receipt. AS-12 specifically provides that mere receipt of a grant is not necessarily conclusive evidence that conditions related to the grant will be fulfilled.

Further, as TAS is derived from AS-12, the new concepts in Ind AS that impact accounting for government grants (for example, recognition of non-monetary grants at fair value) have not been incorporated into the TAS. Accordingly, companies that transition to Ind AS may need to make certain additional adjustments to comply with TAS.

Conclusion
The proposal to issue separate TAS will represent a significant change for taxpayers. Taxpayers would need to evaluate the requirements of the draft TAS proposed from time to time, and determine the specific areas of impact.

The recommendations in the current Discussion Paper will partially address one of the key stated bottlenecks for implementation of Ind AS, by requiring computation of taxable income using a uniform basis. It is likely that recommendations by the Committee on points (ii) and (iii) of their terms of reference will further facilitate the adoption of Ind AS in India.

shailesh.kwebmaker

Joint Ventures: No more proportionate consolidation under IFRS

On 12th May 2011, the International Accounting Standards Board (IASB) issued its new consolidation and related standards, replacing the existing accounting for subsidiaries and joint ventures (now joint arrangements), and making limited amendments in relation to accounting for associates.

In our previous article we had covered IFRS 10, the new standard on consolidated financial statements.

In this article we focus on IFRS 11, Joint Arrangements and IAS 28 (2011), Investments in Associates and Joint Ventures, giving our perspectives on the requirements that are modified and that are expected to have an impact on the preparers and users of IFRS financial statements.

The primary changes introduced under IFRS 11 are:

It carves out from IAS 31 on jointly controlled entities, those cases in which although there is a separate vehicle, that separation is ineffective in certain ways. These arrangements are treated similar to jointly controlled assets/ operations and are now called joint operations; and

Eliminates the free choice of equity accounting or proportionate consolidation for accounting for investments in joint ventures. These must now be accounted always using the equity method.

Identifying joint arrangements

A joint arrangement is an arrangement over which two or more parties have a joint control, being contractually agreed sharing of control i.e., unanimous consent is required for decisions about the relevant activities.

In order to identify a joint arrangement, IFRS 11 requires a two-step analysis to be performed: (1) assess whether collective control exists of an arrangement; and (2) then assess whether the contractual arrangement gives two or more parties joint control over the arrangement.

What is the meaning of control?

IFRS 11 does not define the term ‘control’. As such, reference may be had to the definition of ‘control’ under IFRS 10. As discussed in detail in our last article on IFRS 10, the assessment of control may undergo a change under IFRS 10 as compared to IAS 27 (2008). For instance, only substantive rights held by the investor and others are considered in assessing control. To be substantive, rights need to be exercisable when decisions about the relevant activities need to be made, and their holders need to have a practical ability to exercise the rights. It may be noted that the ‘rights that need to be exercisable when decisions about the relevant activities need to be made’ is different from the current requirement under IAS 27 (2008) of ‘rights that are currently exercisable’.

De facto control in case of joint arrangements

Joint control exists only when it is contractually agreed that decisions about relevant activities require the unanimous consent of the parties that control the arrangement collectively. When, for instance, the parties can demonstrate past experience of voting together in the absence of a contractual agreement to do so, this will not satisfy that requirement. However, it is possible to establish a joint de facto control i.e., control is based on de facto circumstances and the parties sharing control have contractually agreed to share that control.

For instance, A and B hold 24.5% each in Company C, while the remaining 51% shares are held by numerous shareholders, none of them holding more than 1% shares each and do not have any shareholder agreement amongst them. If A and B contractually agree that on decisions relating to the relevant activities of Company C, the casting of their combined voting power of 49% requires their unanimous consent; it may be concluded that A and B have joint control over Company C on a de facto basis.

Key differences from IAS 31

IFRS 11 does not modify the overall definition of an arrangement subject to joint control, although in a few cases, the joint control evaluation may undergo a change on account of application of control definition under IFRS 10.

Classifying joint arrangements

After determining that joint control exists, joint arrangements are divided into two types, each having its own accounting model, defined as follows:

A joint operation is one whereby the jointly controlling parties, known as the joint operators, have rights to the assets and obligations for the liabilities, relating to the arrangement;

A joint venture is one whereby the jointly controlling parties, known as the joint venturers, have rights to the net assets of the arrangement.

The key to determining the type of arrangement, and therefore the subsequent accounting, is the rights and obligations of the parties to the arrangement. For instance, two parties set up a separate entity, whereby the main feature of its legal form is that the parties (and not the entity) have rights to the assets and obligations for the liabilities of the entity, and the contractual arrangement between the parties establishes the parties’ rights to the assets, responsibility for all operational or financial obligations and the sharing of profit or loss. Though the arrangement is structured through a separate entity, as the legal form of the separate vehicle does not confer separation between the parties and the vehicle, the joint arrangement is a joint operation.

An entity determines the type of joint arrangement by considering the structure, the legal form, the contractual arrangement and other facts and circumstances.

Structure of joint arrangements

A joint arrangement not structured through a separate vehicle can be classified only as a joint operation. A separate vehicle is a separately identifiable financial structure, including separate legal entities or entities recognised by statutes, regardless of whether those entities have a legal personality.

A joint arrangement structured through a separate vehicle can be either a joint venture or a joint operation. As such, a separate vehicle is necessary but not a sufficient condition for a joint venture. If there is a separate vehicle, then the remaining tests are applied.

Legal form of the arrangement

If the legal form of the separate vehicle does not confer separation between the parties and the separate vehicle i.e., the assets and liabilities placed in the separate vehicle are the parties’ assets and liabilities, then the joint arrangement is a joint operation.

Contractual arrangement

When the contractual arrangement specifies that the parties have rights to the assets and obligations for the liabilities relating to the arrangement, then the arrangement is a joint operation.

It may be noted that in relation to ‘obligations for the liabilities’, it seems that the contractual obligation for liabilities is something that needs to reflect a primary obligation, rather than a secondary one; and something that represents a non-contingent, ongoing obligation, rather than an obligation that will be settled if and when a certain event occurs (say, a default in case of guarantees issued or calling of uncalled capital).

Other facts and circumstances

The test at this step of the analysis is to identify whether, despite the legal form and contractual arrangements indicating that the arrangement is a joint venture, other facts and circumstances give the parties rights to substantially all of the economic benefits relating to the arrangement and cause the arrangement to depend on the parties on a continuous basis for settling its liabilities, and therefore the arrangement is a joint operation.

In practice, most joint arrangements in India, which are structured as separate companies, may meet the separation criteria and hence qualify as a joint venture and not as a joint operation.

Financial statements of joint venturers

IFRS 11 prescribes accounting treatment for joint operators, whereas IAS 28 (2011) prescribes the accounting treatment for joint venturers.

In its consolidated financial statements, a joint venturer accounts for its interest in the joint venture using the equity method in accordance with IAS 28 (2011), unless under IAS 28 (2011), the entity is exempted from applying the equity method.

Under the equity method, the investment in a joint venture is recognised initially at cost, and subsequently adjusted for the post- acquisition changes in the share of the joint venture’s net assets. The joint venturer’s share of profit or loss and other comprehensive income of the joint venture are included in its profit or loss and other comprehensive income, respectively.

In its separate financial statements, a joint venturer accounts for its interest in the joint venture in accordance with IAS 27 (2011) Separate financial statements i.e., at cost or in accordance with IFRS 9/IAS 39. Such a choice is available even if the joint venturer is exempted from preparing consolidated financial statements. This requirement is in line with the existing requirements.

Key differences from IAS 31

IAS 31 provides an accounting policy choice for a joint controller’s interest in a jointly controlled entity, whereby either the equity method or pro-portionate consolidation can be used. In future, only the equity method shall be permitted. As such, the joint co ntroller’s share of net income and net assets that are adjusted against the individual items of income/expenses/assets/liabilities shall now be presented as a single line item in the statement of financial position and statement of comprehensive income. In other words, a single line ‘Investment in Joint Venture’ and a single line ‘equity profit pick-up’ adjustment on such investments will be recorded.

Financial statements of joint operators

In both its consolidated and separate financial statements, a joint operator recognises its assets, liabilities and transactions, including its share of those incurred jointly. These assets, liabilities and transactions are accounted for in accordance with the relevant IFRS.

Transactions between a joint operator and a joint operation

When a joint operator sells or contributes assets to a joint operation, such transactions are in effect transactions with other parties to the joint operation. The joint operator recognises gains and losses from such transactions only to the extent of the other parties’ interests in the joint operation. The full amount of any loss is recognised immediately by the joint operator, to the extent that these transactions provide evidence of impairment of any assets to be sold or contributed.

When a joint operator purchases assets from a joint operation, it does not recognise its share of the gains or losses until those assets have been sold to a third party. The joint operator’s share of any losses is recognised immediately, to the extent that these transactions provide evidence of impairment of those assets.

Other parties to the joint arrangement
Other parties to the joint venture

For the purpose of consolidated financial statements, the other parties to the joint venture first determine whether they exercise significant influence. If significant influence exists, then the interest is recognised in accordance with IAS 28 (2011); else it is recognised in accordance with IAS 39/IFRS 9.

For separate financial statements, other parties to a joint venture account for their interest in the joint venture in accordance with IAS 39/IFRS 9. If significant influence exists, then the interest may also be recognised at cost.

Other parties a joint operation

The other party to a joint operation accounts for its investment in the same way as a joint operator if it has rights to the assets and obligations for the liabilities. If such a party does not have such rights and obligations, then it accounts for its interest in accordance with the IFRS applicable to that interest for instance IAS 28 (2011) or IAS 39/IFRS 9 as the case may be.

Summary

Overall, the implementation of IFRS 11 will require significant judgment in several respects, while the requirement to apply equity method of accounting to account for interests in joint ventures may have a significant impact on the entity’s financial statements. While the standard is not mandatorily effective until periods beginning on or after 1 January 2013, it is expected that preparers will want to begin evaluating their involvement with joint arrangements sooner than that, as the changes under the new standard generally will call for retrospective application.

At this moment, it is unclear by when the corresponding changes will be introduced under the Ind-AS framework. However, it is advisable for Indian companies to evaluate the impact of this new standard, as it is inevitable that Ind-AS will ultimately incorporate the changes due to the new standard.

shailesh.kwebmaker

IFRS introduces framework for measuring fair values

On 12 May 2011, the International Accounting Standards Board (IASB) issued IFRS 13 Fair Value Measurement that is intended to replace the fair value measurement guidance contained under various standards with a single authoritative pronouncement on fair value measurement.

In this article we focus on the guidance provided under IFRS 13 in relation to the definition of fair value, the framework for measuring the fair value and certain disclosure requirements, giving our perspectives on the requirements that are modified and that are expected to have an impact on the preparers and users of IFRS financial statements.

IFRS 13 provides elaborate guidance on how to measure the fair value when required or permitted under IFRS. It neither introduces new requirements to measure assets or liabilities at fair value, nor does it eliminate the exceptions to fair value measurements on the grounds of practicality in line with guidance contained under certain standards.

Scope of IFRS 13

The IFRS 13 guidance shall be applied to items of assets, liabilities and equity that are permitted or required to be measured at fair value. However, the guidance contained therein does not apply to the measurement and disclosure requirements in certain cases, such as:

share-based payment transactions within the scope of IFRS 2 Share-based Payment;
leasing transactions within the scope of IAS 17 Leases; and
measurements that have some similarities to fair value but are not fair value, such as net realisable value in IAS 2 Inventories or value in use in IAS 36 Impairment of Assets.

Further, the fair value measurement guidance also does not apply to the disclosure requirements in certain cases, such as:

plan assets measured at fair value in accordance with IAS 19 Employee Benefits;
retirement benefit plan investments measured at fair value in accordance with IAS 26 Accounting and Reporting by Retirement Benefit Plans; and
assets for which recoverable amount is fair value less costs of disposal in accordance with IAS 36.

Measurement principles
Definition of fair value

IFRS 13 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

Measurement of asset or liability

A fair value measurement of an asset or liability considers the characteristics of that asset or liability (e.g., the condition and location of the asset and restrictions, if any, on its sale or use), if market participants would consider those characteristics when determining the price of the asset or liability at the measurement date.

The transaction

A fair value measurement assumes that the asset or liability is exchanged in an orderly transaction between market participants to sell the asset or transfer the liability at the measurement date under current market conditions. The hypothetical transaction is considered from the perspective of a market participant that holds the asset or owes the liability, i.e., it does not consider entityspecific factors that might influence an actual transaction. Therefore, the entity need not have the intention or ability to enter into a transaction on that date. An orderly transaction is a transaction that assumes exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities i.e. it is not a forced transaction, e.g., a forced liquidation or distress sale.

Principal or most advantageous market

The hypothetical transaction to sell the asset or transfer the liability is assumed to take place in the principal market. This is the market with the greatest volume and level of activity for the asset or liability.

In the absence of a principal market, the transaction is assumed to take place in the most advantageous market. This is the market that maximises the amount that would be received to sell the asset or minimises the amount that would be paid to transfer the liability, after considering transaction costs and transport costs. Because different entities may have access to different markets, the principal or most advantageous market for the same asset or liability may vary from one entity to another.

Market participants

Fair value measurement uses assumptions that market participants would use in pricing the asset or liability. Market participants are buyers and sellers in the principal (or most advantageous) market who are independent of each other, knowledgeable about the asset or liability, and willing and able to enter into a transaction for the asset or liability.

Price

Fair value is the price that would apply in a transaction between market participants whether it is observable in an active market or estimated using a valuation technique.

Transaction cost and transportation cost

Although transaction costs are taken into account in identifying the most advantageous market, the price used to measure the fair value of an asset or a liability is not adjusted for transaction costs. This is because they are not a characteristic of the asset or liability and are instead characteristic of a transaction. However, if location is a characteristic of an asset e.g., crude oil held in the Arctic Circle, then the price in the principal or most advantageous market is adjusted for the costs that would be incurred to transport the asset to that market, e.g., costs to transport the crude oil from Arctic Circle to the appropriate market.

Application to non-financial assets — highest and best use and valuation premise

A fair value measurement considers a market participant’s ability to generate economic benefit by using the asset or by selling it to another market participant who will use the asset in its highest and best use. Highest and best use refers to the use of an asset that would maximise the value of the asset, considering uses of the asset that are physically possible, legally permissible and financially feasible. Highest and best use is determined from the perspective of market participants, even if the reporting entity intends a different use. However, an entity need not perform an exhaustive search for other potential uses if there is no evidence to suggest that the current use of an asset is not its highest and best use. The concept of highest and best use is relevant only to the valuation of non-financial assets and does not apply to the valuation of financial assets or liabilities.

Liabilities and equity instruments

The fair value of a liability or an entity’s own equity instrument is measured using quoted prices for the transfer of identical instruments. When such prices are not available, an entity measures fair value from the perspective of a market participant holding the identical item as an asset. If quoted prices in an active market for the corresponding asset are also not available, then other observable inputs are used, such as prices in an inactive market for the asset. Otherwise, an entity uses another valuation technique(s), such as a present value measurement or the pricing of a similar liability or instrument. IFRS 13 retains the principle in IAS 39 that the fair value of a financial liability with a demand feature is not less than the present value of the amount payable on demand.

Fair value at initial recognition

The price paid in a transaction to acquire an asset or received to assume a liability, often referred to as the ‘entry price’, may or may not equal the fair value of that asset or liability based on an exit price. If an IFRS requires or permits an entity to measure an asset or liability initially at fair value and the transaction price differs from fair value, then the entity recognises the resulting gain or loss in profit or loss unless the specific IFRS requires otherwise. Therefore, the recognition of a ‘day one’ gain or loss when the transaction price differs from the fair value will be determined by the particular standard that prescribes the accounting for the asset or liability.

Valuation techniques

The objective of using a valuation technique is to determine the price at which an orderly transaction would take place between market participants at the measurement date. An entity uses valuation techniques that are appropriate in the circumstances and for which sufficient data are available, maximising the use of relevant observable inputs and minimising the use of unobservable inputs. IFRS 13 identifies three valuation approaches: income, market and cost.

Fair value hierarchy

IFRS 13 establishes a fair value hierarchy based on the inputs to valuation technique used to measure fair value to increase consistency and comparability. The inputs are categorised into three levels, with the highest priority given to unadjusted quoted price in active markets for identical assets or liabilities and lowest priority given to unobservable inputs.

The level into which a fair value measurement is classified in its entirety is determined by reference to the observability and significance of the inputs used in the valuation model. The valuation technique often incorporate both observable and unobservable inputs, however the fair value measurement is classified in its entirety into either level 2 or level 3, based on the lowest level input that is significant to the fair value measurement.

The availability of relevant inputs and their relative subjectivity might affect the selection of appropriate valuation techniques. However, the fair value hierarchy prioritises the inputs to valuation techniques, not the valuation techniques used to measure fair value. For example, a fair value measurement developed using a present value technique might be categorised within level 2 or level 3, depending on the inputs that are significant to the entire measurement and the level of the fair value hierarchy within which those inputs are categorised.

Level 1 Inputs

Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date. A quoted price in an active market provides the most reliable evidence of fair value and shall be used without adjustment to measure fair value.

An active market is a market in which transactions for the asset or liability takes place with sufficient frequency and volume for pricing information to be provided on an ongoing basis.

Level 2 Inputs

The determination of whether a fair value measurement is categorised into level 2 or level 3 depends on whether the inputs used in the valuation techniques are observable or unobservable and their significance to the fair value measurement.

Level 2 inputs are inputs other than quoted prices included within level 1 that are observable for the asset or liability, either directly or indirectly.

Observable inputs are inputs that are developed using market data, such as publicly available information about actual events or transactions, and that reflect the assumptions that market participants would use when pricing the asset or liability.

Level 3 Inputs

Level 3 inputs are unobservable inputs for the asset or liability. Unobservable inputs are inputs for which market data are not available and that are developed using the best information available about the assumptions that market participants would use when pricing the asset or liability.

Inputs into valuation techniques

When selecting the inputs into a valuation technique, an entity selects inputs that are consistent with the characteristics that market participants would take into account in a transaction. A premium or discount, such as a control premium or a discount for lack of control, may be appropriate if it would be considered by market participants in pricing the asset or liability based on the unit of account.

Using quoted prices provided by third parties

IFRS 13 does not preclude the use of quoted prices provided by third parties, such as brokers or pricing services, provided that the prices are developed in accordance with IFRS 13.

Markets that are not active and transactions that are not orderly

IFRS 13 describes factors that may indicate that a market has seen a decrease in the volume or level of activity. An entity evaluates the significance and relevance of factors to determine whether, based on the evidence available, there has been a significant decrease in the volume or level of activity; however, the standard stresses that even if a market is not active, it is not appropriate to conclude that all transactions in that market are not orderly, i.e., are forced or distress sales.

Quoted prices derived from a market that is not active may not be determinative of fair value. In such circumstances, further analysis of the transactions or quoted prices is needed, and a significant adjustment to the transaction or quoted prices may be necessary to measure fair value.

Disclosures
The objective of the disclosures is to provide information that enables financial statement users to assess the methods and inputs used to develop fair value measurements and, for recurring fair value measurements that use significant unobservable inputs (level 3), the effect of the measurements on profit or loss or other comprehensive income.

To meet this objective, an entity provides certain minimum disclosures for each class of assets and liabilities. For non-financial assets and non-financial liabilities that are measured at or based on fair value in the statement of financial position, IFRS 13 requires fair value disclosures that are similar to existing fair value disclosures for financial assets and financial liabilities in IFRS 7. This disclosure is also required for non-recurring fair value measurements (e.g., an asset held for sale). The requirement to disclose a fair value hierarchy and information on valuation techniques is also extended to assets and liabilities which are not measured at fair value in the statement of financial position, but for which fair value is disclosed pursuant to another standard.

In addition, a description of the valuation processes used by the entity for level 3 measurements is required to be disclosed. This includes, for example, how an entity decides its valuation policies and procedures and analyses changes in fair value measurements from period to period. An entity should disclose a narrative description of the sensitivity of level 3 measurements to changes in unobservable inputs, including the effect of any interrelationships between unobservable inputs, as well as quantitative information on significant unobservable inputs used in measuring fair value.

Effective date and transition

An entity should apply IFRS 13 prospectively for annual periods beginning on or after 1 January 2013. Earlier application is permitted with disclosure of that fact.

The disclosure requirements of IFRS 13 need not be applied in comparative information for periods before initial application.

Summary
Overall, the implementation of IFRS 13 will require significant judgment while preparing the entity’s financial statements. The standard is neither mandatorily effective until periods beginning on or after 1st January 2013, nor does it require retrospective application. As such, the comparative disclosures and measurements are not required in line with IFRS 13 in the first period of application.

At this moment, it is unclear by when the corresponding changes will be introduced under the Ind AS framework. However, it is advisable for Indian companies to evaluate the impact of this new standard, as it is inevitable that Ind AS will ultimately incorporate the changes due to the new standard.

shailesh.kwebmaker

IFRS introduces a single control model for asesing control over investes

On 12th May 2011, the IASB issued its new suite of consolidation and related standards, replacing the existing accounting for subsidiaries and joint ventures (now joint arrangements), and making limited amendments in relation to associates. In this article we focus on IFRS 10 Consolidated Financial Statements

and IAS 27 (2011) Separate Financial Statements, giving our perspectives on the requirements that are modified and that are expected to have an impact on the preparers and users of IFRS financial statements.

New suite of standards

Key

IFRS 10 Consolidated Financial Statements ? IFRS 11 Joint Arrangements

IFRS 12 Disclosure of Interests in Other Entities

IAS 27 (2011) Separate Financial Statements

IAS 28 (2011) Investments in Associates and Joint Ventures

IFRS 10 supersedes IAS 27 Consolidated and Separate Financial Statements and SIC-12 Consolidation — Special Purpose Entities; while the requirements of IAS 27 (2008) relating to the separate financial statements are retained in IAS 27 (2011).

Change in control criteria In a nutshell, IFRS 10 provides similar guidance in relation to the exemptions from preparing consolidated financial statements and the consolidated procedures as contained in IAS 27 (2008); the major change introduced by IFRS 10 is in relation to the definition of control over the investee.

The definition of a subsidiary under IAS 27 (2008) focusses on the concept of control and has two parts, both of which need to be met in order to conclude that one entity controls another, i.e., (a) the power to govern the financial and operating policies of an entity, and (b) to obtain benefits from its activities.

Under IFRS 10, an investor controls an investee when it is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee. Thus, an investor controls an investee if the investor has all the following:

(a) power over the investee;
(b) exposure, or rights, to variable returns from its involvement with the investee; and
(c) the ability to use its power over the investee to affect the amount of the nvestor’s returns.

The exposure to risks and rewards of an investee does not on its own, determine that the investor has control over an investee; it is one of the factors of the control analysis.

Control is assessed on a continuous basis, i.e., it is reassessed as facts and circumstances change. A change in market conditions does not trigger a reassessment of the control conclusion unless it changes one or more of the elements of control (e.g., whether potential voting rights are substantive).

In assessing control over an investee, the investor considers the purpose and design of the investee so as to identify the investee’s relevant activities, how decisions about such activities are made, who has the current ability to direct those activities and who receives returns therefrom.

New single control model

To assess control over the investee under the new single control model under IFRS 10, the following factors may be considered:

(1) Identify the investee;
(2) Identify the relevant activities of the investee;
(3) Indentify how decisions about the relevant activities are made;
(4) Assess whether the investor has power over the relevant activities;
(5) Assess whether the investor is exposed to variability in returns;
(6) Assess whether there a link between power and returns.

The investor considers all relevant facts and circumstances when assessing control over the investee. The approach comprises a collection of indicators of control, but no hierarchy is provided in the approach. In cases where the investor has majority of the voting rights over the investee, the assessment of control may be straightforward; while in certain other cases, a more detailed analysis of all facts and circumstances of the case needs to be made before concluding on the investor’s control over the investee.

Let us understand each of the above-mentioned six factors of the new control model:

Identify the investee

IFRS 10 requires the investor to assess control over the investee, which is a separate legal entity. However, in certain cases, the investor may acquire control over specified assets and liabilities of an entity, such that those specified assets and liabilities may be considered as a deemed separate entity. Such deemed entities are referred to as ‘Silo’ for the purpose of applying the consolidation standard. Specified assets and liabilities qualify as ‘Silo’ if:

In substance, the assets, liabilities and equity of the silo are separate from the overall entity such that none of those assets can be used to pay other obligations of the entity and those assets are the only source of payment for specified liabilities of the silo; and

Parties other than those with the specified liability, have no rights or obligations related to the specified assets or residual cash flows from those assets.

Where one party controls a silo, the other parties exclude the silo when assessing control over the separate legal entity.

Key changes from IAS 27 (2008)

Under IAS 27 (2008), control under is assessed at the level of the separate legal entity; whereas under IFRS 10, the control may also be assessed at the level of silo.

Identify the relevant activities of the investee

For the purpose of IFRS 10, the term ‘relevant activities’ imply activities of the investee that significantly affect the investee’s returns.

Range of activities

For many investees, a range of operating and financing activities significantly affect their returns such as (a) selling and purchasing of goods or services; (b) managing financial assets during their life (including upon default); (c) selecting, acquiring or disposing of assets; (d) researching and developing new products or processes; and (e) determining a funding structure or obtaining funding.

In such cases, the decisions affecting the returns may be linked to decisions such as establishing operating and capital decisions of the investee, including budgets; and appointing and remunerating an investee’s key management personnel or service providers and terminating their services or employment.

Relevant activities occur only when particular circumstances arise or events occur

There can also be investees for which relevant activities occur only when particular circumstances arise or events occur, as the direction of activities is predetermined until this date. In such cases, only the decisions about the investee’s activities when those circumstances or events occur can significantly affect its returns and thus be relevant activities.

As can be noted above, determination of activities that significantly affect the returns of an investee will be highly judgmental in some cases.

Key difference from IAS 27 (2008)

Unlike IFRS 10, IAS 27 (2008) does not include any guidance on the relevant activities of an investee for the purpose of assessing control.

Identify how decisions about the relevant activities are made

To determine control over the investee, IFRS 10 requires the investor to assess whether the investee is controlled by means of voting instruments or is controlled by means of other rights. Depending on the means of control, a different analysis is per-formed to assess which Investor has control over the Investee.

Assess whether the investor has power over the relevant activities

An investor has power over an investee when the investor has existing rights that give it the current ability to direct the activities that significantly affect the investee’s returns. As the definition of power is based on ability, power does not need to be exercised.

In assessing whether the rights held by an investor give it power, the following are considered:

Substantive rights

Only substantive rights held by the investor and oth-ers are considered. To be substantive, rights need to be exercisable when decisions about the relevant activities need to be made, and their holders need to have a practical ability to exercise the rights.

It may be noted that the ‘rights that need to be exercisable when decisions about the relevant activities need to be made’ is different from the current requirement under IAS 27 (2008) of ‘rights that are currently exercisable’. For instance, Entity A has an option to acquire a majority stake in Entity B and the option, which is deep in the money, is exercisable in 25 days’ time. Any shareholder of Entity B can call for a general meeting of the Company by giving a notice of 30 days. Thus in the given case, by the time the general meeting will be held, Entity A would have obtained the majority stake in Entity B and thereby the control (presuming the voting rights are considered relevant). This is different from IAS 27 (2008) where the control would be established only when the option becomes exercisable i.e., after 25 days. Thus, the revised control model may change the date of obtaining control over an investee.

Under IAS 27 (2008), the management’s intentions with respect to the exercise of potential voting rights are ignored in assessing control, because these intentions do not affect the existence of the ability to exercise power. Further, the exercise price of potential voting rights and the financial capability of the holder to exercise them also are ignored. As such, the intent of the parties is not considered when determining whether the rights are currently exercis-able. It seems that IFRS 10 would require the intent of the party who writes or purchases the potential voting rights would be taken into account when assessing whether the rights are substantive.

Protective rights are related to fundamental changes in the activities of an investee or apply only in exceptional circumstances. They cannot give their holders power or prevent others from having power.

IFRS 10 provides guidance on the rights of other parties, and in particular on protective rights. IAS 27 (2008) does not provide any such guidance and as such, guidance is mainly drawn from US GAAP.

Voting rights

An investor can have power over an investee when the investee’s relevant activities are directed through voting rights in the following situations:

? the investor holds the majority of the voting rights, and these rights are substantive; or
? the investor holds less than half of the voting rights but: (1) has an agreement with other shareholders; (2) holds rights arising from other contractual arrangements; (3) holds substan-tive potential voting rights; (4) holds rights sufficient to unilaterally direct the relevant activities of the investee (de facto power); or

(5) holds a combination of those.

The above guidance on voting rights under IFRS 10 is similar to that prescribed by IAS 27 (2008).

De facto control
The investor had de facto control over the investee, because its rights are sufficient to give it power as it has the practical ability to direct the relevant activities unilaterally.

Assessing whether an investor de facto has power over an investee is a two-step process:

? In the first step, the investor considers all facts and circumstances, including the size of its holding of voting rights relative to the size and dispersion of the holdings of other shareholders.

As a result, if the investor holds significantly more rights than any other shareholder and the other shareholdings are widely dispersed, then the investor may have sufficient information to conclude that it has power over the investee. In other cases, it may be clear that the investor does not control the investee. If the first step is not conclusive, then additional facts and circumstances are analysed in the second step.

? In the second step, the investor considers whether the other shareholders are passive in nature as demonstrated by voting patterns at previous shareholders’ meetings. Assessing the voting patterns at previous shareholders’ meeting may require consideration of the number of shareholders that typically come to the meeting to vote i.e., the usual quorum in shareholder’s meeting, and not how other shareholders vote i.e., whether they usually vote the same way as the investor.

If, after this second step, the conclusion is not clear, then the investor does not control the investee.

Assessing de facto control involves exercise of man-agement judgment. The areas involving higher level of management judgment includes:

? Determining whether the current shareholding in the Investee is sufficient;

? Determining whether the other shareholding is sufficiently dispersed; and

? Determining the exact date when the de facto control is obtained. It may be noted that the investor may not have any evidence of de facto control as at the date of acquiring investments. The evidence of de facto control may be obtained only after the initial stages of holding of an investment in the investee.

IAS 27 (2008) does not provide guidance on control whether it should be based on only the power to govern; or in addition to power to govern, the evaluation of control take into account the de facto circumstances. In practice, the reporting entities have an accounting policy choice whether to assess control based on power to govern or, based on de facto circumstances in addition to power to govern. IFRS 10 requires consideration of de facto circumstances as part of the control analysis, and as such eliminates the said accounting policy choice.

Rights other than voting

When holders of voting rights as a group do not have the ability to significantly affect the investee’s returns, the investor considers the purpose and design of the investee and the following three factors:

?   evidence that the investor has the practical ability to direct the relevant activities unilater-ally;
?   indications that the investor has a special relationship with the investee;
?   whether the investor has a large exposure to variability in returns.

The first of these three factors is given the greatest weight in the analysis.

Assess whether the investor is exposed to variability in returns

The investor also should consider whether it is exposed, or has rights, to variability in returns from its involvement with the investee. Returns are defined broadly, and include distributions of economic benefits and changes in the value of the investment, as well as fees, remunerations, tax benefits, economies of scale, cost savings and other synergies.

Assess whether there a link between power and returns

Delegated power

In order to have control, an investor needs to have the ability to use its power over the investee to affect returns for the investor’s own benefit, i.e., there needs to be a link between power and returns.

An investor that has decision-making power over an investee determines whether it acts as an agent or as a principal when assessing whether it controls an investee. If the decision-maker is an agent, then the link between power and returns is absent and the decision maker’s delegated power is deemed to be held by its principal(s).

To determine whether it is an agent, the decision-maker considers:

(1) whether a single party holds substantive rights to remove the decision-maker without cause; if this the case, then the decision maker is an agent;

(2) whether its remuneration is on an arm’s-length terms; if this is not the case, then the decision-maker is a principal;

(3) the overall relationship between itself and other parties through a series of factors if neither (1) nor (2) is conclusive. These factors include:

?   the scope of its decision-making authority over the investee;
?   substantive rights held by other parties;
?   the decision-maker’s remuneration (level of linkage with the investee’s performance); and
?   its exposure to variability of returns because of other interests that it holds in the investee.

Different weightage is applied to each of the factors depending on particular facts and circumstances. The last two factors, i.e., remuneration and other interests held, are sometimes considered in aggregate in IFRS 10 and referred to as the decision-maker’s ‘economic interests’. The greater the magnitude of and variability associated with its economic interests, the more likely it is that the decision-maker is a principal.

Relationship with other parties

The investor determines whether other parties that have an interest in the investee are acting on behalf of the investor. When this is the case, the investor considers the decision-making rights held by these parties together with its own rights to assess whether it controls the investee.

Consolidation procedures

The consolidation procedures under IFRS 10 are similar to the consolidation procedures prescribed under IAS 27 (2008). This also includes accounting for loss of control over an investee.

Separate financial statements

The requirements of IAS 27 (2008) relating to separate financial statements have been retained in IAS 27 (2011).

Effective date and transitional requirements

Effective date
IFRS 10 and IAS 27 (2011) are effective for annual periods beginning on or after 1st January 2013. Early adoption is permitted provided that the entire consolidation suite is adopted at the same time.

Summary

Overall, the implementation of IFRS 10 will require significant judgment in several respects. While the standard is not mandatorily effective until periods beginning on or after 1 January 2013, it is expected that preparers will want to begin evaluating their involvement with investees under the new consolidation standard sooner than that, as the changes in the consolidation conclusion under the new standard generally will call for retrospective application.

At this moment, it is unclear by when the corresponding changes will be introduced under Ind AS framework. However, it is advisable for the companies to continue the process of estimating the impact of the convergence on their business, especially in the light of continuous changes to IFRS.

shailesh.kwebmaker

Carve-outs Under IND-AS

With its press release dated 25th February 2011, the Ministry of Corporate Affairs (MCA) notified 35 Indian Accounting Standards converged with IFRS (Ind-AS), thereby eliminating the speculation on the contents of the final standards. However, the press release does not contain the date of implementation of the converged standards. The MCA has clarified that the date of implementation shall be notified at a later date after various issues, including tax-related ones, are resolved.

The final standards notified by the MCA are substantially similar to the current IFRS standards. However, there are certain changes made to the Ind-AS standards as part of the convergence (rather than adoption) process to suit more appropriately to the Indian environment. These changes can be classified into the following categories:

Mandatory differences as compared to IFRS
Removal of accounting policy choices available under IFRS
Additional accounting policy options provided, which are not in compliance with IFRS requirements
Certain IFRS guidance to be adopted with separate (deferred) implementation dates.

This article attempts to explain the first category of carve-outs i.e., mandatory differences with IFRS and their impact on the financial statements. We will cover the other categories of carve-outs in our subsequent articles.

Foreign currency convertible bonds (FCCB):

Position under IFRS:
FCCB involve an exchange of a fixed number of shares for a fixed consideration that is denominated in foreign currency. Since the cash flows of the issuer entity in its own functional currency (i.e., in rupees) is variable due to changes in exchange rates, FCCB do not meet the definition of an equity instrument under IFRS. Thus, under IFRS, FCCB are classified as hybrid instruments and are initially split between the conversion option (embedded derivative) and the loan liability.

Conversion option: The conversion option is treated like a derivative and is initially recorded at its fair value. Like all derivatives, the conversion option is subsequently marked-to-market (MTM) at every reporting date and the impact is recognised in the income statement.

Loan liability: The loan liability is initially recorded as the difference between the proceeds and the amount allocated to the conversion option. Interest is thereafter recorded based on imputed interest rates. Further, the loan is adjusted for exchange rate movements that are recognised in the income statement.

Position under Ind-AS:
The Ind-AS has modified the definition of financial liabilities under Ind-AS 32 (vis-à-vis IAS 32) to exclude from its definition, the option to convert the foreign currency denominated borrowings into a fixed number of shares at a fixed exercise price (in any currency). Thus, these instruments will be split initially into the loan liability and the conversion option (as discussed above), but the conversion option will be recognised as equity (as against a derivative under IFRS) and therefore will not remeasured subsequently i.e., no subsequent MTM.

Key implications of the carve-out:
The key implication of this is that the conversion option is not subsequently MTM under Ind-AS, while such MTM is required under IFRS.

Under IFRS, the changes in the fair value of the conversion option may have a significant impact and result in volatility in profits. Further, the impact on the profits for the year is inversely related to the movement in the underlying share price; i.e., if the fair value of the underlying shares rises, MTM of the conversion option would lead to losses to be recognised in the income statement and vice-versa.

Under Ind-AS, since the conversion option is recognised as equity and is not remeasured subsequently, the carve-out eliminates the volatility in profits on account of the changes in the underlying share prices of the company.

Let us understand the impact of the carve-out with the help of an example:

On 1st April 2012, Company A (INR functional currency) issued 10,000 convertible bonds of USD 100 each with a coupon rate of 4% p.a. (interest payable annually in arrears). The total proceeds collected aggregated to USD 1 million. Each USD 100 bond is convertible, at the holder’s discretion, at any time prior to maturity on 31st March 2017, into 1,000 ordinary shares of Rs.10 each. For simplicity, transaction costs and deferred taxes are ignored. The following information on the exchange rate (spot) and fair value of conversion option (option) may be relevant:

Under IFRS, proceeds collected would be required to be split into loan liability and the conversion option. The total proceeds from the issue of USD 1 million aggregates to Rs.45 million based on a conversion rate of USD 1 = Rs.45. On initial recognition, the conversion option would be recognised at its fair value (i.e., Rs.4.5 million or 0.1 million USD) and the remaining proceeds (i.e., Rs.40.5 million or 0.9 million USD) would be recognised as loan liability.

The Company shall compute an effective interest rate based on the loan principal received (i.e., 0.9 million USD), loan principal on maturity (USD 1 million) and payments to be made for interest costs @ 4% p.a. on the loan principal of USD 1 million. The effective interest rate in this case works out to 6.4% p.a. The interest cost p.a. shall be computed based on outstanding loan principal (in foreign currency) and the effective interest rate of 6.4% p.a. converted at average exchange rates during the year. Further, the loan liability shall be translated at exchange rate as at the reporting date, with the exchange differences recognised in the income statement.

The conversion option on initial recognition aggregated to Rs.4.5 million, while the fair value of the conversion option as at the end of the year aggregates to Rs.9.2 million i.e., an increase by Rs.4.7 million. IFRS requires such a change in the fair value of conversion option to be recognised in the income statement.

Let us consider the movements in the carrying values of the conversion option and the loan liability:

Under IFRS

There are three costs recognised in the income statement i.e., interest cost on the loan, the exchange differences on the loan and the MTM gains/losses on the conversion option.

Under Ind-AS, the accounting for the loan liability is same as under IFRS. However, the conversion option is to be recognised as equity. As stated above, for simplicity we have ignored the transaction costs and deferred taxes. On initial recognition, the fair value of the conversion option (i.e., Rs.4.5 million) shall be recognised as equity. As at the end of the first year i.e., 31st March 2013, there is no further adjustment required on account of the fair value movements of the conversion option.

The costs to the company on account of FCCB under Ind-AS will be the interest cost and exchange gains/losses on the loan components of the instrument, with the conversion option not being remeasured for changes in its fair value.

Under Ind-AS

Agreements for sale of real estate (IFRIC 15):
Position under IFRS:

IFRIC 15 focusses on the accounting for revenue recognition by entities that undertake the construction of real estate. IFRIC 15 provides guidance on determining whether revenue from the construction of real estate should be accounted for in accordance with IAS 11 (Construction contract) or IAS 18 (Sale of goods), and the timing of revenue recognition.

IFRIC 15 clarifies that IAS 11 is applied to agreements for the construction of real estate that meet the definitio

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Need for optimal choice of accounting policies under Ind-AS

The final standards notified by the MCA are substantially similar to the current IFRS standards. However, there are certain changes made to the Ind-AS standards as part of the convergence (rather than adoption) process to make them suitable to the Indian environment. These changes can be classified into the following categories:

Mandatory differences as compared to IFRS;
Removal of accounting policy choices available under IFRS;
Additional accounting policy options provided, which are not in compliance with IFRS requirements;
Certain IFRS guidance to be adopted with separate (deferred) implementation dates.

Our previous article explained the first category of carve-outs i.e., mandatory differences with IFRS and their impact on the financial statements. This article attempts to cover the other categories of carve-outs, whose primary focus is on accounting policies.

I. Removal of accounting policy choices available under IFRS:

This category of carve-outs pertain to several areas where IFRS offers multiple policy choices while Ind- AS restricts these policy choices.

This category of carve-outs do not result in deviations from IFRS, as they represent permitted policy choices. However, while following the policies prescribed under Ind AS will result in conformity with IFRS, these carve-outs could pose a challenge for Indian companies, if global peers follow other alternative policies (such as fair value model for investment property); if such companies are a part of a global group that follows other alternative policies; or if the Indian company has previously followed other alternative policies for IFRS reporting to overseas stakeholders.

Presentation of profit and loss account based on single statement or two-statement approach:

Position under IFRS:

IFRS provides entities with an accounting policy choice in relation to the presentation of income statement. The reporting entity can present comprehensive income as:

a single statement of comprehensive income (which includes all components of profit or loss and other comprehensive income); or
in the form of two statements i.e., an income statement (which displays components of profit or loss) followed immediately by a separate ‘statement of comprehensive income’ (which begins with profit or loss as reported in the income statement and discloses components of other comprehensive income aggregating to total comprehensive income for the period).

Position under Ind-AS:

Ind-AS requires entities to present the profit and loss account based on the single-statement approach. The two-statement approach is not permitted under Ind-AS.

Presentation of expenses based on nature or function:

Position under IFRS:
Expenses in the profit and loss account are classified according to their nature or function.

When expenses are classified according to function, expenses are generally allocated to cost of sales, selling, administrative or any other functions of the reporting entity.

There is no guidance in IFRS on how specific expenses are allocated to functions. An entity establishes its own definitions of functions such as cost of sales, selling and administrative activities, and applies these definitions consistently. Additional information based on the nature of expenses (e.g., depreciation, amortisation and staff costs) is disclosed in the notes to the financial statements.

When classification by nature is used, expenses are aggregated according to their nature (e.g., purchases of materials, transport costs, depreciation and amortisation, staff costs and advertising costs).

Position under Ind-AS:

Ind-AS permits presentation of expenses based on the nature of expenses only. As such, presentation of expenses based on function is not permitted.

Presentation of dividend/interest received and paid in the cash flow statement:

Position under IFRS:

Interest paid/received and dividends received are usually classified as operating cash flows for a financial institution. For other entities, IFRS provides entities with an accounting policy choice whereby:

Interest paid and interest and dividends received may be classified as operating cash flows, because they enter into the determination of profit or loss.
Alternatively, interest paid and interest and dividends received may be classified as financing cash flows and investing cash flows, respectively, because they are costs of obtaining financial resources or returns on investments.

Position under Ind-AS:

Ind-AS requires interest paid and interest and dividends received to be classified as financing cash flows and investing cash flows, respectively.

Investment property: Cost model and fair value model:

Position under IFRS:

All investment properties are initially measured at cost. Subsequent to initial recognition, an entity chooses an accounting policy to be applied consistently, either to:

measure all investment property using the fair value model; or
measure all investment property using the cost model.

Where an entity has adopted a fair value model, all changes in fair value subsequent to initial recognition are recognised in the profit and loss account.

Position under Ind-AS:

Ind-AS prohibits use of fair value model for investment property.

Actuarial gains and losses:

Position under IFRS:

Under IFRS, actuarial gains and losses on defined benefit plans can be recognised using various acceptable policy choices. Thus, such actuarial gains or losses can either be recognised in other comprehensive income; or recognised immediately in the profit and loss account; or amortised into the profit and loss account using the corridor approach (or any other systematic method which results in faster recognition than the corridor approach).

Position under Ind-AS:

Ind-AS does not permit immediate recognition of actuarial gains or losses in the profit and loss account or amortisation through the profit and loss account. It requires actuarial gains or losses to be recognised directly in other comprehensive income.

Presentation of government grants related to assets:

Position under IFRS: Two methods of presentation in financial statements of grants related to assets are regarded as acceptable alternatives:

grants presented as deferred income and recognised in profit or loss on a systematic basis over the useful life of the asset.
grants adjusted against the carrying value of the asset. The grant is recognised in profit or loss over the life of a depreciable asset as a reduced depreciation expense.

Position under Ind-AS:

Ind-AS requires government grants related to assets to be presented in the balance sheet by setting up the grant as deferred income. Recognition as a reduction from the asset is not permitted.

Measurement of non-monetary grants:

Position under IFRS:

A government grant may take the form of a transfer of a non-monetary asset, such as land or other resources, for the use of the entity. If a government grant is in the form of a non-monetary asset, then an entity chooses an accounting policy, to be applied consistently, to recognise the asset and grant at either the fair value of the non-monetary asset or at the nominal amount paid.

Position under Ind-AS:

In case of non-monetary grants, the fair value of the non-monetary asset is assessed and both the grant and the asset are accounted for at that fair value.

II. Additional accounting policy choices:

This category of carve-outs represent an area where a company can either elect to follow policies aligned to IFRS, or alternate policies that diverge from IFRS.

This category of carve-outs represents an area where each individual company needs to apply careful thought and consideration. Thus, if companies want to achieve full compliance with IFRS, they would need to elect accounting policies that are aligned to IFRS. On the other hand, if compliance with IFRS is not relevant for the company, it may elect other policies that are divergent with IFRS. While assessing these policy choices, companies need to evaluate not just their current environment, but future plans (for instance, plans for a future overseas listing or fund-raising).

Such carve-outs include the following:

Exchange differences on long-term foreign currency monetary items:

Position under IFRS:

Foreign exchange gains and losses generally are recognised in the profit or loss.

Position under Ind-AS:

Ind-AS has retained the above position under IFRS. Additionally, it has provided an option to recognise unrealised exchange differences on long-term monetary assets and liabilities to be recognised directly in equity and accumulated in a separate component of equity. The amount so accumulated shall be transferred to profit or loss over the period of maturity of such long-term monetary items in an appropriate manner.

Deemed cost exemption for Property, Plant and Equipment (PPE):

Position under IFRS:

On transition to IFRS, an entity has the following choices with respect to PPE for computing deemed cost under IFRS:

Revalue individual, some or all items of PPE to its fair value as at the transition date.

In case assets are revalued under the previous GAAP, then those revalued amounts can be considered as a deemed cost, provided that that revalued amounts are broadly comparable (i) to the fair values as at the date of revaluation, or (ii) cost or depreciated cost in accordance with IFRS adjusted to reflect, for instance, the changes in the general or specific price index.

Event-driven (such as on account of IPO or Privatisation) fair values may be considered as deemed cost.

Position under Ind-AS:

Apart from the options provided under IFRS, Ind-AS provides an additional option to continue Indian GAAP carrying values of all items of PPE as at the transition date without any modification, except for recognising asset retirement obligations. This exemption, if exercised, is required to be applied to all items of PPE without exception.

III. Certain guidance to be adopted with separate (deferred) implementation dates:

The Ind-AS standards currently notified defer the application of guidance on accounting for embedded lease arrangements and service concession arrangements. It is expected that such guidance will become mandatory at a later date.

Similarly, the Ind-AS on accounting for exploration and evaluation of mineral resources shall be notified at a later date.

Summary:

While Ind-AS financial statements presented for the first transition period cannot be fully compliant with IFRS (since comparatives would not be presented), Ind-AS financial statements for subsequent years can be made fully compliant with IFRS, if a company chooses optimal accounting policies and does not adopt the diluted alternatives available under Ind-AS. This is assuming that a company is not impacted by the mandatory deviations.

It is advisable for the companies to continue the process of estimating the exact impact of the convergence on their business, especially in the light of mandatory carve-outs and other non-mandatory differences with IFRS that are now clear on account of the notification of the final standards. Companies that otherwise need to fully comply with IFRS issued by the IASB (for example, because their securities are listed in overseas markets that require IFRS) need to carefully evaluate the impact of such carve-outs.

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Introduction to the New Revenue Recognition Standard Issued by IASB

The IASB issued the first exposure draft of the new revenue recognition standard in June 2010. This new standard is a joint project of the IASB and FASB to clarify the principles for recognising revenue from contracts with customers. It intends to provide a single revenue recognition model which integrates the numerous revenue recognition guidances under US GAAP and the broader principles provided under IFRS to improve comparability over a range of industries, companies and geographical boundaries. The revenue recognition model under this exposure draft is a step-by-step analysis of contracts focussing on control i.e.,

identify the contract with the customer;

identify separate performance obligations in the contract;

determine and allocate the transaction price; and

recognise revenue when or as each performance obligation is satisfied by transferring control of a good or service to the customer.

Nearly thousand comment letters were received in response to this exposure draft. Considering the representations, the IASB issued a revised exposure draft in November 2011. One of the principles that the revised draft clarifies is on distinguishing when control of a good or service is transferred over a period of time or at a point in time. This article focusses on this aspect of the revised exposure draft in relation to its implications on revenue recognition for real estate companies.

Implications of IASB’s revised revenue recognition exposure draft for real estate companies

One of the most debated matter in India’s convergence with IFRS was point of revenue recognition from sale of real estate, more commonly known as the application of IFRIC 15 principles. The assessment of IASB’s IFRIC 15 principles which deals with agreements for the construction of Real Estate would lead to most real estate companies in India accounting for sale of apartments/flats as sale of goods and recognising revenue on completion of the contract i.e., transfer of physical possession of the units to the customer as opposed to accounting for these as construction contracts using the percentage completion method. This would have a major impact on the performance measures of real estate companies. Consequently, when Ind AS were issued in February 2011, the Ind AS on construction contracts had a carve-out from the IASB principles to include development of real estate as a construction contract and accrue revenues using the percentage completion method.

IFRIC 15 principles have been debated internationally. Malaysia and Philippines had also deferred applicability of IFRIC 15 when they adopted IFRS while Singapore decided to issue a modified IFRIC 15 providing specific guidance in the context of legal situations prevailing in that country. The issue under debate was that IFRIC 15 principles were leading to a completed contract method of accounting sometimes due to the legal framework of a country for instance, continuous transfer of legal title of the work in progress was legally not allowed in many jurisdictions and hence leading to a completed contract method of accounting although that was not the substance of these transactions. In that case, the profit and loss account of the developers will not truly reflect the performance of the business, as during the years the real estate project development continues, no revenue will be recognised and all revenue will be recognised in the year when possession is given.

IFRIC 15 principles were incorporated in the original exposure draft of revenue recognition standard. However, based on the representations and comment letters received, the IASB in its revised exposure draft has changed criterion for determining whether performance obligations are being satisfied over a period of time impacting the timing of revenue recognition from the sale of real estate.

The earlier principles of IFRIC 15 allowed the percentage completion method when either the unit is based on a customer-specific design or it could be demonstrated that there is a continuous transfer of units while construction progresses which is evidenced:

— if construction activity takes place on land owned by the buyer;
— the buyer cannot put the incomplete property back to the developer;
— on premature termination the buyer retains the work in progress and the developer has the right to be paid for the work performed; or
— the agreement gives the buyer the right to take over the work in progress during construction.

These criterions have been changed significantly under the revised exposure draft. Under the revised exposure draft, performance obligations of the company can be met over a period of time if the entity:

(a) creates or enhances an asset (for example, work in progress) that the customer controls as the asset is created or enhanced. Or

(b) does not create an asset with an alternative use to the entity and at least one of the following criteria is met:

(i) the customer simultaneously receives and consumes the benefits of the entity’s performance as the entity performs or

(ii) another entity would not need to substantially re-perform the work the entity has completed to date if that other entity were to fulfil the remaining obligation to the customer, or

(iii) the entity has a right to payment for performance completed to date and it expects to fulfil the contract as promised.

Most typical Indian real estate contracts for sale of apartments are for specific unit sales to customers, require progress payments based on completion of work and are intended to be fulfilled which would fall under the above criterion of satisfying performance obligations over time.

The following example illustrates the above criterion:

Example 1:

Company Z is developing residential real estate and starts marketing individual units (apartments). Z has entered into the minimum number of contracts that are needed to begin construction. A customer enters into a binding sales contract for a specified unit that is not yet ready for occupancy. As per the contract, the customer pays a non-refundable deposit at inception of the contract and agrees to make progress payments throughout the contract. Those payments are intended to at least compensate Z for performance completed to date and are refundable only if Z fails to deliver the completed unit.

Z receives the final payment on delivery of possession of the unit to the customer. To finance the payments, the customer borrows from a financial institution that makes the payments directly to Z on behalf of the customer. The lender has full recourse against the customer. The customer can sell his or her interest in the partially completed unit, which would require approval of the lender but not Z. The customer is able to specify minor variations to the basic design, but cannot specify or alter major structural elements of the unit’s design. The contract precludes Z from transferring the specified unit to another customer.

The apartment created by the Z’s performance does not have an alternative use to Z, because it would lead to breach of contract with the customer. Z concludes that it has a right to payment for performance completed to date, because the customer is obliged to compensate Z for its performance rather than only a loss of profit if the contract is terminated. In addition, Z expects to fulfil the contract as promised. Hence, Z has a performance obligation that it satisfies over time.

The new rules are more pragmatic and will enable percentage completion method for real estate where the criterions are met. This essentially means that Indian real estate companies need to reassess the implications of revenue recognition under the revised exposure draft to understand whether their contracts would meet the conditions of satisfying performance obligations over time. It is important to analyse in which exact cases the new principles would allow percentage completion method. This would also then eliminate the need for a carve-out under Ind AS. Comment period for this exposure draft is open until 13 March 2012. This should be regarded as an opportunity to voice out any concerns or clarifications to the IASB so that the standard achieves global acceptance.

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Revenue Recognition

Revenue has been defined as income that arises in
the ordinary course of activities of the entity i.e., from sale of goods
or services. Ind AS 18 on Revenue Recognition prescribes certain
general principles for revenue recognition from transactions involving
sale of goods, rendering of services and the use of entity’s assets that
generate fees such as royalties, dividend and interest. Revenue is
recognised when it is probable that economic benefits of the transaction
will flow to an entity and costs are identifiable and can be measured
reliably. In this article, we aim to understand certain key principles
of revenue recognition prescribed under Ind AS 18 in case of multiple
element arrangements, customer loyalty programmes, transfer of assets
from customers and sale on extended credit terms by way of examples.
Multiple deliverable contracts:

Companies at times offer a broad range
of products and services to its customers. These arrangements are
sometimes negotiated with the customer through a single contract which
contains multiple deliverables that are separately identifiable and have
stand-alone value to the customer, for example an automobile company
sells vehicles to a customer along with an optional extended warranty of
three years for a composite price. In accounting for revenue in case of
multiple deliverable arrangements the company should identify
‘separately identifiable components’ for which revenue is recognised at
varied points of time as per the contract. The consideration for these
separate elements should be allocated on a fair value basis using either
the ‘Fair value method’ or the ‘Relative fair value method’. Under the
fair value method, the revenue equivalent to the fair value of all
undelivered contract is deferred, and the difference between total
contract price and deferred revenue is recognised as revenue on
delivered components. Under the relative fair value method, the total
contract price is allocated to each contract deliverable in the ratio of
their fair values as a percentage to the aggregate fair values of all
individual contract deliverables.

Let us consider the concept of
multiple deliverable arrangements by way of an example — Example 1:
Multiple deliverables A company sells a vehicle along with a contract
for an optional three-year extended warranty bundled along with it for a
contract value of INR 570,000. The fair value of the extended warranty
services is INR 60,000. The fair value of the vehicle without the
extended warranty services is INR 540,000. The entire consideration is
required to be paid upfront.
Relative fair value method

Step 1: The above contract can be broken into the following identifiable components:

Step 2: Allocation of revenue based on their relative fair values — Contract value: INR 570,000

It
may be noted here that the aggregate fair value of delivered components
is INR 600,000 while the aggregate contract price is INR 570,000. As
such, there is a discount of 5% (i.e., 30,000/ 600,000) on the overall
contract as compared to its market price. Under the relative fair value
method, this discount of 5% is applied to each deliverable for revenue
recognition purposes. As such, the consideration allocated to vehicle is
INR 513,000 (i.e., 95% of INR 540,000) and that allocated to extended
warranty is INR 57,000 (i.e., 95% of INR 60,000).

Fair value method

It
may be noted here that under the fair value method, the consideration
allocated to the undelivered component is its entire fair value and the
remaining contract price is allocated to the delivered component. As
such, the consideration allocated to the extended warranty (i.e.,
undelivered component) shall be INR 60,000 while the remaining
consideration of INR 510,000 (i.e., INR 570,000 — INR 60,000) shall be
allocated to the sale of vehicle.

Customer loyalty programmes:

A
range of businesses, such as supermarkets, retailers, airlines,
telecommunication operators, credit card providers and hotels offer
customer loyalty programmes, which comprise of loyalty points or ‘award
credits’. Such award credits or loyalty points may be linked to
individual purchases or groups of purchases, or to continued custom over
a specified period. The customer usually redeems these award credits
for free or discounted goods or services.

For a programme to be accounted as a customer loyalty programme, it needs to contain two essential features:

— the entity (seller) grants award credits to a customer as part of a sales transaction; and

—
subject to meeting any other conditions, the customer can redeem the
award credits for free or discounted goods or services in the future.

For
instance, a customer receives a complimentary product with every tenth
product bought from the entity (seller). As the customer purchases each
of the first ten products, they are earning the right to receive a free
good in the future, i.e., each sales transaction earns the customer
credits that go towards free goods in the future.

In accounting
for customer loyalty programmes the company estimates the fair value of
the award credits, generated through its loyalty programmes. The
consideration (for goods sold on which award credits are issued) is
allocated to the award credits based on either the fair value method or
the relative fair value method (as discussed above). Revenue is
recognised for the delivered goods based on the sale consideration
allocated to the goods sold while the sale consideration allocated to
the award credits are recognised when the award credits are redeemed.

Let us understand the above principles with the help of an example —

Example
2: Customer loyalty programmes Company Q runs a loyalty scheme that
rewards customers’ spend at its stores. As per the scheme, customers are
granted 10 award credits for every INR 100 spent in Q’s store.
Customers can redeem their accumulated points towards a discount on the
price of a new product in Q’s stores. The loyalty points are valid for
three years.

During 2012, Q had sales of INR 1,000,000 and
accordingly granted 100,000 loyalty points to its customers. The
management expected only 80,000 loyalty points to be redeemed and that
the cost per point redeemed would be INR 0.8 per point. The management
has adopted fair value method for allocation of consideration to the
multiple deliverables i.e., initial sale of goods and award credits. Q
records the following entries in 2012 in relation to the loyalty points
granted in 2012:

Redemption of award credits in Year 1

During
2012, 30,000 points were redeemed, and at the end of the reporting
period, management still expected a total of 80,000 points to be
redeemed, i.e., a further 50,000 points will be redeemed over the next
two years.

At the end of the reporting period, the balance of
the deferred revenue is INR 40,000 [(50,000/ 80,000) x 64,000].
Therefore, the difference in the deferred revenue balance is recognised
as revenue for the year.

Redemption in year 2: change in estimates

During 2013, 35,000 points are redeemed, and at the end of the year management expects a total of 85,000 points to be redeemed, i.e., an increase of 5,000 over the original estimate. The redemption rate is revised based on the new total expected redemptions. As such, at the end of year 2, 20,000 award credits would remain outstanding i.e., 85,000 – 30,000 – 35,000, after considering the revised total award credits to be utilised and actual redemption of award credits.

At the end of the year, the balance of deferred revenue for 20,000 loyalty points shall be INR 15,059 [(20,000/85,000) x 64,000] which shall represent the closing balance in deferred revenue account. The differential amount in deferred rev-enue account of INR 24,941 (i.e., 64,000 – 24,000 – 15,059) shall be transferred to revenue. Q records the following entry in 2013 in relation to the loyalty points granted in 2012:

Alternatively, on a cumulative basis INR 48,941 is released from deferred revenue account to revenue, which can be calculated as (65,000/85,000) x 64,000.

The remaining balance in deferred revenue account of INR 15,059 shall be recognised as revenue in the year 2014.

Transfer of assets from customers:

Ind AS 18 provides guidance on transfer of property, plant and equipment (or cash for its acquisition) for entities that receive such assets from their customers in return for ongoing supply of goods or services. As such, the principles contained hereunder do not apply to gratuitous transfers of assets i.e., transfer of assets without consideration. Further, the guidance also cannot be applied to transfers that are in the nature of government grants or those covered under the service concession arrangements.

If it is concluded that the company has obtained control over the asset transferred by the customer, the company should recognise (debit) the transferred asset as its own asset (though it may not have the ownership). The corresponding impact of the transfer should be recognised as either revenue or deferred revenue, depending upon the obligations assumed by the company in lieu of the transferred asset.

Timing of revenue recognition

In determining the timing of revenue recognition, the entity (recipient) considers:

what performance obligations it has as a result of receiving the customer contribution;

whether these performance obligations should be separated for revenue recognition purposes; and

when revenue related to each separately identifiable performance obligation should be recognised.

The accounting for transfer of assets from customers involves an analysis whether the control over the transferred asset is obtained by the company and if the control is transferred the asset will be recognised in the company’s balance sheet. The company is required to determine the obligations assumed by the company in lieu of the transfer of control over the transferred asset and if the above-mentioned obligations are in the nature of ongoing services, then revenue attributable to those obligations is deferred and recognised as the underlying services are rendered and obligations fulfilled where as to the extent that the obligations are fulfilled at the inception of the contract, revenue shall be recognised upfront. The assets transferred by the customer shall be depreciated over the useful life of the asset.

Let us understand the above principles with the help of an example

Example 3: Transfer of assets from customers

Company M enters into an agreement with Company N to outsource some of its manufacturing process. As part of the arrangement, Company M will transfer its machinery to Company N.

Based on a report submitted by independent valuer, the fair value of assets transferred is INR 100,000. Initially, Company N must use the equipment to provide the service required by the outsourcing agreement. Company N is responsible for maintaining the equipment and replacing it when it decides to do so. The useful life of the equipment is 5 years. The outsourcing agreement requires service to be provided for 5 years for a fixed price of INR 30,000 per year, which is lower than the price that Company N would have charged if the equipment had not been transferred. In such case the fixed price would have been INR 50,000 per annum.

Pursuant to a detailed analysis, Company N determines that the control over the equipment is transferred in its favour. Hence, Company N would have to initially recognise the asset at its fair value in accordance with Ind AS 16. Further, Company N would also have to recognise the revenue over the period of the services performed i.e., over 5 years. (Refer Table 1)

Table 1: Recognition of Revenue over Period
of Service Performed

INR

Particulars

Year 1

Year 2

Year 3

Year 4

Year
5

Asset A/c

Dr.

100,000

To Deferred Revenue A/c

(100,000)

(Being transfer of control over the assets from
customer in lieu of rendering ongoing services)

Bank A/c

Dr.

30,000

Deferred Revenue A/c

Dr.

20,000

(100,000/5)

To Revenue

(50,000)

(Being revenue recognised)

Depreciation A/c

Dr.

20,000

To Accumulated Depreciation

(20,000)

(Being depreciation provided over 5 years)

Extended credit terms:
When payment for goods sold or services rendered is deferred beyond the normal credit terms, and the company does not charge a market interest rate, the arrangement effectively constitutes a sale with financing arrangement and revenue should be recognised at the current cash price. The length of normal credit terms depends on the industry and economic environment in which the company operates.

Example 4: Sale on extended credit terms

Company K sells equipment to Company L for a total consideration of INR 1,000,000. The payment for this sale is deferred over a period of five years with regular payments of INR 200,000 each year to be made by Company L to Company K. No interest is charged by Company K to Company L and the normal credit terms of Company K are four months from the date of sale. The current cash price for the goods sold is INR 758,157. Considering the current cash price and the five annual payments of INR 200,000, the effective interest rate on the transaction works out to 10% p.a.

The sale by Company K to Company L is on deferred payment basis and beyond its normal credit terms. The total consideration under the terms of the arrangement is INR 1,000,000. However, revenue should be recognised at the current cash price i.e., the price at which the goods will be sold without such extended credit terms. The difference between the current cash price and the total consideration should be recognised as finance income over the extended credit period.

Accordingly, the revenue on the date of the transaction shall be recognised at its current cash price of INR 758,157. The difference INR 241,843 (i.e., INR 1,000,000 – INR 758,157) will be recognised as finance income over the period of the contract using the effective interest rate method.

The recognition of finance income based on effective interest rate of 10% is computed as shown in Table 2

Table 2: Recognition of Finance Income based on Effective Interest

Year

Opening Value

Interest

Payments

Closing Value

(A)

(B) = (A * 10%)

(C)

(D)=(A+B+C)

Year 1

7,58,157

75,816

-2,00,000

6,33,973

Year 2

6,33,973

63,397

-2,00,000

4,97,370

Year 3

4,97,370

49,737

-2,00,000

3,47,107

Year 4

3,47,107

34,711

-2,00,000

1,81,818

Year 5

1,81,818

18,182

-2,00,000

Total interest

241,843

Journal entries

INR

Particulars

Year 1

Year 2

Year 3

Year 4

Year 5

Debtors A/c

Dr.

758,157

To Sales A/c

(758,157)

(Being revenue recognised)

Debtor A/c

Dr.

75,816

63,397

49,737

34,711

18,182

To Finance Income

(75,816)

(63,397)

(49,737)

(34,711)

(18,182)

(Being finance income
recognised over the extended credit period)

Bank A/c

Dr.

200,000

To Debtor A/c

(200,000)

(Being amount collected from debtors)

Summary:

Revenue recognition principles prescribed under Ind AS 18 and discussed in this article vary significantly from the currently applicable AS 9 – Revenue Recognition. The application of these principles will require significant judgment in several aspects while preparing an entity’s financial statement.

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Revenue Recognition by Real Estate Developers — An Important carve-out in Ind-AS

Revenue recognition for real estate developers is one of the most critical carve-outs considered by standard-setters when framing Ind-AS, in accordance with the plan to converge with IFRS. Ind AS requires real estate developers to recognise revenue on a percentage completion method in accordance with ‘construction contract’ accounting principles, as against IFRS, which would require accounting on completion similar to ‘sale of goods’ in most cases depending on the contracts with customers. Further, the Institute of Chartered Accountants of India (ICAI) on 13th December 2011 issued an exposure draft of the Guidance Note (GN) on Recognition of Revenue by Real Estate Developers. This GN seeks to supersede the existing GN of ICAI of June 2006. Currently, the accounting practices followed by real estate companies for revenue recognition are very diverse and this GN seeks to align the current practices by giving bright-lines for determining the eligibility of real estate transactions for revenue recognition.

The GN should be applied to all transactions in real estate commencing or entered into on or after 1st April 2012. The GN also gives an early adoption option, provided that it is applied to all transactions commencing on or were entered into on or after the earlier adoption date.

This GN mandates the application of POC method [as defined in Accounting Standard (AS) 7, Construction Contracts] in respect of real estate transactions where the economic substance is similar to construction-type contracts. It gives the following indicators for determining if the economic substance of the transactions is similar to construction type contracts:

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

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

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

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

The GN also specifies that the POC method is applied only when all the following conditions are fulfilled:

(a) All critical approvals necessary for commencement of the project have been obtained;

(b) When the stage of completion reaches a reasonable level of development. Rebuttable presumption — reasonable level is not achieved if the expenditure incurred on project costs is less than 25% of the construction and development costs;

(d) At least 10% of the total revenue as per the agreements of sale or any other legally enforceable documents are realised at the reporting date.

Therefore, companies need to assess the eligibility of individual project based on the above parameters at each reporting period before any revenue can be recognised from them. Unless and until all the above conditions are met, revenue cannot be recognised from a project. In the calculation of stage of completion of 25% for point (b) above, only actual construction costs can be included and other costs (i.e., cost of land and development rights and borrowing costs) are excluded. Hence, the GN focusses on actual physical construction activities rather than costs. However, this calculation of stage of completion is only for determining if the project is an eligible project for revenue recognition. Once it is determined that a particular project is an eligible project, revenue can be recognised based on a POC calculation that is different from the calculation done for deciding eligibility. Put differently, revenue recognition can be based on a higher POC, calculated by taking total actual costs including cost of land and development rights. While this is not explicitly mentioned in the GN it is coming out from the illustration appended to the GN.

The GN also puts an additional overall restriction on recognition of revenue when there are outstanding defaults in payment by customers. It says that the recognition of revenue by reference to POC should not at any point exceed the estimated total revenue from eligible contracts. Eligible contracts for this purpose are those meeting the above four POC criteria plus where there are no outstanding defaults of the payment terms. The GN does not define ‘outstanding default’ and hence, a question arises if the ‘outstanding default’ to be determined as at the period ends only or post balance sheet payments should also be considered? For example, there was a default in payment by a customer before the period end, but the customer has paid and regularised the account post the period end before the financial statements approved. It is not clear from the GN whether this will be considered as an ‘outstanding default’ as at the period end.

Example
ABC Limited is in the business of real estate development and sale. On 1st April 2010, ABC started a project to construct and sell 100 flats of 1,000 sq.ft. each. Cost of construction, including directly attributable costs is Rs.3,000 per sq.ft. Cost of land and development right is Rs.30 crore. Actual figures for the year ended 31st March 2011 are given in Table 1:

Rs. in crores

Sales — 30 flats at
an average sales price of Rs.7,000 per sq.ft.

21.00

Collection from
customers — 40%

8.40

Actual construction
costs, including direct and indirect overheads

15.00

Total revised
estimated balance costs to complete

17.00

POC for determining
if the project is eligible for revenue recognition (actual construction

costs/total estimated
construction costs)

46.88%

POC for recognition
of revenue (cost of land and development rights + actual construction

costs/Total revised
estimated costs including land and development costs)

72.58%

Since the project meets all revenue recognition preconditions as per the GN (i.e., actual construction costs exceed 25% of the total estimated construction costs, 25% of the total revenue secured by sale con-tracts and 10% collection), revenue can be recognised from the project for the year ended 31st March 2011. The Table 2 shows the calculation of revenue, costs and work in progress to be recognised in the financial statements for the year ended 31st March 2011:

Rs. in crores

Revenue to be
recognised

(30 x 7,000 x 1,000 x
72.58%)

15.24

Project costs [(30 +
15) x 30,000

sq.ft./100,000
sq.ft.)]

13.50

Work in progress (30
+ 15 – 13.50)

31.50

In case there were defaults in payment by 10 flat holders out of the total 30, the additional computation shown in Table 3 is to be done to determine if the revenue recognition of Rs.15.24 crore is appropriate.

Rs. in crores

Revenue to be
recognised

(as above)

15.24

Estimated total
revenue from

eligible contracts

(20 flats x 1,000
sq.ft. x Rs.7,000

per sq.ft.)

14.00

Work in progress (30 + 15 – 13.50)

31.50

Since the revenue as per the POC workings of Rs.15.24 crore is higher than the estimated total revenue from eligible contracts of Rs.14 crore, revenue recognition should be restricted to Rs.14 crore and correspondingly cost of projects to be recognised in the profit and loss should also be adjusted.

This guidance note will enhance consistency in the accounting practices of real estate developers and in particular the application of the percentage completion method. This however remains a very important ‘carve-out’ and will have a significant impact on companies who wish to prepare and report their financial statements under IFRS.

Editor’s Note: It is understood that the Guidance Note on Recognition of Revenue by Real Estate Developers has been finalised and is expected to be issued shortly.

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

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

Computation of deferred taxes using the balance-sheet approach

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

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

Summary of accounting for deferred tax

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

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

Case study

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

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

Note 1: Land

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

Note 2: Plant and equipment

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

Note 3: Dividend receivable

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

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

Note 4: Trade receivables

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

Note 5: Interest receivable

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

Note 6: Loan

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

Note 7: Business loss

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

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

Effective tax rate reconciliation

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

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

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

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

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Changes in ownership — Approach under Ind AS

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

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

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

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

Example 1

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

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

The amounts are based on the following calculation:

Example 2

Disposal of shares in an existing subsidiary without losing control

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

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

The amounts are based on the following calculation:

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

Example 3

Subsidiary issues new shares — Control retained but ownership interest changes

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

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

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

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

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

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

In such step acquisitions

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

Example 4:

Associate becomes subsidiary

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

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

The transaction would be accounted for as follows:

Note 1

Calculation of goodwill

Note 2

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

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

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

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

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

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

Example 5

Subsidiary becomes associate

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

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

Debit

Credit

Cash
(fair value of consideration

received)

700

Equity
(non-controlling interest)

800

Investment
in Entity B

(at
fair value)

700

Net
assets of Entity B

(including
goodwill)

2000

Gain
on disposal

200

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

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

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Tax Accounting Standards: A New Framework for Computing Taxable Income

Background

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

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

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

2 To suggest a method for determination of tax
base (book profit) for the purpose of Minimum Alternate Tax (MAT) in
case of companies migrating to IFRS (Ind AS) in the initial year of
adoption and thereafter; and

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

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

Approach for Formulation of Tax Accounting Standards

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

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

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

Following are various other considerations and recommendations by the Committee:

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

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

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

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

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

The Committee recommended that:

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

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

TAS to remove alternatives, to the extent possible;

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

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

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

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

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

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

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

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

Accounting policies

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

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

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

Valuation of inventories

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

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

Events occurring after the end of the previous year

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

Prior period expense

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

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

Construction contracts

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

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

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

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

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

Revenue recognition

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

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

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

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

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

Tangible fixed assets

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

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

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

Conclusion

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

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

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

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

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

shailesh.kwebmaker

Property, Plant and Equipment – Changes under Ind AS

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

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

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

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

General and Administrative Overheads:

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

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

Foreign Exchange Differences:

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

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

Asset Retirement Obligations:

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

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

Let us understand this concept through the following example:

Example 1:

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

– Initial measurement

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

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

– Subsequent measurement

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

Table 2 – Deprication (Rs. in lakh)

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

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

Accounting entry:

*Every year

Income statement a/c (imputed interest) Dr.

To Provision for restoration costs Cr.

At the end of year 5

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

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

Deferred Payment Terms:

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

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

Example 2:

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

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

Table 4 – Accounting for Retention Money in Asset Purchase

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

Borrowing Costs:

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

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

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

Depreciation:

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

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

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

Example 3

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

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

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

Particulars

Remarks

Year
1

Year
2

Year
3

Year
4

Year
5

Year
6

Total

Cost

100

(10)

(30)

(10)

Replacement of Compo-

nents

Depreciation

Component A

Useful life –

(10)

(60)

6
years

Component B

Useful life –

(10)

(30)

3
years

Component B (replaced)

Useful life –

(10)

(30)

3
years

Component C

Useful life –

(5)

(10)

2
years

Component C (replaced)

Useful life –

(5)

(20)

2
years

Depreciation
charge for

(25)

(150)

the year

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

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

Particulars

Dr/

Amount

Derecognition
of

Component B at end

of year 3

Accumulated Deprecia-

Dr.

tion A/c

To Asset A/c (Compo-

Cr.

nent B)

(Being: De-recognition

of Component B at

the expiry of its
use-

ful life)

Recognition
of new

Component B in year

Asset A/c (Component

Dr.

To Bank A/c

Similar entries will need to be considered for Component C.

Example 4

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

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

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

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

Particulars

Year 1

Year 2

Year 3

Year 4-15

Total

Cost

4,000,000

Dry Docking

800,000

(Component

Balance

3,200,000

Component

Deprecia-

tion

Compo-

266,667

266,666

800,000

nent A

(800,000/3)

Compo-

213,334

213,333

2,560,0000

3,200,000

nent B

Conclusion:

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

shailesh.kwebmaker

Debt v. Equity — Case studies

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

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

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

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

Classification as equity or financial liability:

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

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

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

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

Preference shares:

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

They are not redeemable on a specific date

They are not redeemable at the option of the holder

Dividend payments are discretionary.

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

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

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

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

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

Compound financial instruments:

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

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

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

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

Accounting under Ind AS 32

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

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

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

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

Example 6: Compulsorily Convertible Bond

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

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

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

Example 7: Foreign Currency Convertible Bond

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

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

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

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

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

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

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

shailesh.kwebmaker

Accounting for fair value hedge s and hedge s of net in vestment in foreign operations

In our previous
article, we discussed the need for hedge accounting by companies as well
as the basic principles of hedge accounting and criteria required to
qualify for hedge accounting. We gave an example of a cash flow hedge of
a highly probable forecast purchase transaction and illustrated the
impact of hedge accounting on a companies’ profit or loss account
through the term of the hedging instrument. In this article, we shall
elucidate the accounting using fair value hedges and the hedge of a net
investment in a foreign operation and illustrate the accounting
treatment through examples.

Fair value hedges:

A fair value hedge is a
hedge of changes in the fair value of a recognised asset or liability,
an unrecognised firm commitment, or an identified portion of such an
asset, liability or firm commitment, that is attributable to a
particular risk and could affect profit or loss. The following are
examples of fair value hedges: a hedge of interest rate risk associated
with a fixed rate interest-bearing asset or liability (e.g. converting a
fixed rate instrument to a floating rate instrument using an interest
rate swap); a hedge of a firm commitment to purchase an asset or to
incur a liability; or a hedge of interest rate risk on a portfolio basis
(a portfolio fair value hedge).

Accounting for a fair value hedge:

l
Hedging instruments that are derivatives – Fair value changes are
recognised in the profit or loss account.
Hedging instruments that are
non derivatives – Foreign currency components of their carrying amounts
measured in accordance with Ind-AS 21 are recognised in the profit or
loss account.
Hedged item otherwise measured at amortised cost (Eg.
fixed rate borrowing) or through other comprehensive income (Eg.
available for sale financial asset) – Adjustment to the carrying amount
of the hedged item related to the hedged risk are recognised in the
profit or loss account.
The categorisation of the fair value hedge
adjustment as either a monetary or a non-monetary item, under Ind-AS 21,
should be consistent with the categorisation of the hedged item under
Ind-AS 21.
In a fair value hedge, any ineffectiveness automatically is
reported in profit or loss through the accounting process, unlike in a
cash flow hedge, in which the ineffectiveness has to be calculated and
recognised separately.

If the fair value hedge is fully effective, the
gain or loss on the hedging instrument would fully offset the gain or
loss on the hedged item attributable to the risk being hedged.
Accordingly, there would be no net impact to the profit or loss account.

The qualifying criteria for hedge accounting remain the same across
types of hedges, i.e. cash flow hedges, fair value hedges or net
investment in foreign operation.

Let us look into fair value hedges in
more detail by way of the following example.

Example 1: Fair Value
Hedges

RV International Limited (RVIL) is a manufacturer with an Indian
Rupees (Rs.) functional currency with trade transactions with several
countries. The company has the maximum number of trade transactions with
companies in the United States of America. RVIL’s reporting dates are
30th September and 31st March.

On 15th July 20X1, RVIL enters into a
contract to sell its manufactured units to a company in the United
States. As per the contract, RVIL is committed to deliver 1,000 units at
a price of INRNaN per unit on 30th June 20X2. The contract contains
several specifications of the units to be delivered and also contains a
penalty clause that states that if RVIL fails to adhere to its time and
quality commitment, as per the specifications of the contracts, it shall
be liable to a penalty of INRNaN million. The invoice is payable on
31st August 20X2. RVIL expects that is shall incur costs of Rs. 67.5
million in manufacturing and packing the units. All such costs are
denominated in its functional currency, Rs.

On the date that RVIL enters
into the contract of sale, its management decides to hedge the
resulting foreign currency risk and enters into a forward contract to
sell INRNaN million against Rs. The terms of the sale transactions and
of the forward contract are as shown in Table 1 and Table 2

RVIL
accordingly adopts a risk management strategy to hedge its firm
commitment denominated in $ as a fair value hedge. The management of the
company designates the spot component of the forward contract as a
hedge of the change in the fair value of the contracted firm commitment
attributable to movements in spot rates. All critical terms of the
hedged item and hedging instruments match, on the date of inception –
15th July 20X1. The hedge is determined to be 100% effective on a
prospective basis considering that all the critical terms match. The
fair value of the forward contract (hedging instrument) is Nil as on the
date of inception. Fair value is calculated as the difference between
the discounted fair value of the forward contract at the forward rate on
inception (18,000,000 * 45.9420 * discount factor at 10.6500% = Rs.
749,959,475) with the discounted fair value of the forward contract on
testing date (18,000,000 *45.9420 * discount factor at 10.6500% = Rs.
749,959,475). On 30th September the fair value shall be Rs. 37,707,866
[(18,000,000 * discount factor at 10.8600 * (48.2040 – 45.9420)]. Hedge
accounting principles also require retrospective effectiveness testing
at each date which is determined to be 100% in this example for each
testing date.

In this example, the designated hedged risk is the spot
component i.e. hedge effectiveness is measured on the basis of changes
in spot component of the forward rates. The change in the fair value of
the derivative attributable to the forward points is excluded from the
hedge relationship. This forward points component does not therefore
give rise to any ineffectiveness. It is recognised in profit or loss as
‘other operating income and expense’. Alternatively, the forward points
can be recognised as ‘interest income and expense’.

Also important to
note is that in a fair value hedge, the full fair value of the hedging
instrument is recognised in the profit and loss account. Hence,
ineffectiveness is not measured separately. The journal entries for the
transaction are as shown in Table 3.

Hence the revenue is recognised, at
a net amount of Rs. 810,000,000, which is equivalent to the value at
the hedged rate i.e. the spot rate on the date of inception (18,000,000 *
45.000).

Net Investment in a Foreign Operation: Ind-AS 39 does
not override the principles of Ind- AS 21, but it does provide the hedge
accounting model for hedging an entity’s foreign exchange exposure
arising from net investments in foreign operations.

A net investment
hedge is a hedge of the foreign currency exposure, arising from a net
investment in a foreign operation, using a derivative and/or a
non-derivative monetary item as the hedging instrument.

The hedged risk is the foreign currency exposure arising from a net investment in a foreign operation when the net assets of that foreign operation are included in the financial statements. The application of hedge accounting for a net investment in foreign operation is relevant only for the consolidated financial statements of a group of companies.

Accounting for net investment hedges:

If the hedging instrument in a net investment hedge is a derivative, then it is measured at fair value. The effective portion of the change in fair value of the hedging instrument is computed by reference to the functional currency of the parent entity against whose functional currency the hedged risk is measured.

This effective portion is recognised in other comprehensive income and presented within equity in the foreign currency translation reserve. The ineffective portion of the gain or loss on the hedging instrument is immediately recognised in profit or loss.

If the hedging instrument is a non-derivative, e.g. a foreign currency borrowing, then the effective portion of the foreign exchange gain or loss, arising on translation of the hedging instrument into the functional currency of the hedging entity, is recognised in Foreign Currency Translation Reserve.

The effective portion is computed by reference to the functional currency of the parent entity, against whose functional currency the hedged risk is measured. Effectiveness is usually achieved if currency matches and notional amount of invest-ment is unlikely to go below notional amount of derivative, for e.g., due to losses incurred.

Hence, cumulative amounts are recognised in the other comprehensive income – changes on foreign currency translation of the foreign operation and effective portion of the gains or loss on the hedging instrument.

When a net investment in a foreign operation is disposed of, the cumulative amounts recognised previously in other comprehensive income, are re-classified to profit or loss. However, it is necessary for an entity to keep track of the amount recognised in other comprehensive income separately in respect of each foreign operation, in order to identify the amounts to be reclassified to profit or loss on disposal or partial disposal.

Let us look into net investment in foreign operations hedges in more detail by way of the following example.

Example 2: Hedges of net investment in a foreign operation

Company P is an Indian company with an Rs. functional currency. It has a subsidiary in the US, Company S, whose functional currency is $. The net investment of Company P in Company S is $ 10 million. The reporting dates of Company P for its consolidated financial statements are 30th September and 31st March. The group’s presentation currency is Rs.

On 1st April 20×1, Company P takes a two-year $ 10 million floating rate (Six month LIBOR) loan. Interest payment dates are 30th September and 31st March of the respective years. The loan matures on 31st March 20X3. It is assumed that no transaction costs are incurred relating to the loan issuance.

The management of Company P has decided to hedge its net investment in Company S by designating the $ denominated loan, in order to reduce the volatility in its consolidated balance sheet on account of foreign currency translation of its net investment in Company S. The net investment of Company P is not expected to fall below $ 10 million as company S is a profitable entity and has a profit forecast for future years as approved by the board of directors of Company P. However, on 30th September 20X2, the net investment of Company P in Company S decreases to $ 9.8 million on account of unexpected losses incurred by Company S.

As per hedge effectiveness testing, the hedge is 100% effective upto the time when losses are incurred by Company S which leads to a certain amount of ineffectiveness. Relevant details of the exchange and interest rates are as shown in Table 4 and Table 5 on page 90.

The journal entries for the transaction are as under:

At each period, following the process of consolidation of a foreign subsidiary’s net assets, Company P records a Foreign Currency Translation Reserve (FCTR) which is presented in Column C above. Journal entries relating to the loan are given in Table 6:

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Hedge accounting in a volatile environment

Entities generally enter into certain derivative transactions to protect or hedge themselves from risk of fluctuation in certain key variables (such as currency exchange rates, interest rates or commodity prices) that may have a detrimental impact on their profit and loss accounts. In a hedging transaction, there is usually a hedged item and a hedging instrument such that the hedging instrument protects an entity from fluctuations in the value of the hedged item. In order to reflect the impact of hedging activities in the profit or loss account, an entity may elect to apply the hedge accounting principles under IFRS (or Ind AS). These principles provide guidance on designating hedge relationships by identifying qualifying hedged items, hedging instruments and hedged risks.

Qualifying hedged items can be recognised assets, liabilities, unrecognised firm commitments, highly probable forecast transactions or net investments in foreign operations. In general, only derivative instruments entered into with an external party qualify as hedging instruments. However, for hedges of foreign exchange risk only, non-derivative financial instruments (for example, loans) may qualify as hedging instruments.

Hedge accounting allows an entity to either :
• measure assets, liabilities and firm commitments selectively on a basis different from that otherwise stipulated in IFRS or Ind AS (“fair value hegde accounting model”); or

• defer the recognition in profit or loss of gains or losses on derivatives (“cash flow hedge accounting model” or “net investment hedging”).

Hedge accounting is voluntary; however, it is permitted only when strict documentation and effectiveness requirements, as stated in IAS 39 are met. The Ind AS criteria are similar to the IFRS criteria. These criteria are:

• There is formal designation and written documentation at the inception of the hedge.

• The effectiveness of the hedging relationship can be measured reliably. This requires the fair value of the hedging instrument, and the fair value (or cash flows) of the hedged item with respect to the risk being hedged, to be reliably measurable.

• The hedge is expected to be highly effective in achieving fair value or cash flow offsets in accordance with the original documented risk management strategy.

• The hedge is assessed and determined to be highly effective on an ongoing basis throughout the hedge relationship. A hedge is highly effective if changes in the fair value of the hedging instrument, and changes in the fair value or expected cash flows of the hedged item attributable to the hedged risk, offset within the range of 80-125 percent.

• For a cash flow hedge of a forecast transaction, the transaction is highly probable and creates an exposure to variability in cash flows that ultimately could affect profit or loss.

One of the more common hedging transactions entered into by entities is a hedge of highly probable forecast transactions (purchases or sales), considered a cash flow hedge. A cash flow hedge is a hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with a recognised asset or liability, or a highly probable forecast transaction that could affect profit or loss. In the case of hedges of highly probable forecast purchase or sale transactions in foreign currency, the hedged risk would be currency risk, the hedged items are the forecast purchases/sales and the hedging instruments typically used are currency forwards.

Given below is an example of applying hedge accounting to the cash flow hedge of a highly probable forecast purchase.

Example:
Company R is an Indian company with Indian Rupees (INR) as the functional currency. The reporting dates of Company R are 30th June and 31st December.

On 1st January 20X0, Company R expects to purchase a significant amount of raw materials in future for its production activities. A Company based in the US will supply the raw materials. Company R’s management forecasts 100,000 units of raw material will be received and invoiced on 31st July 20X1 at a price of USD 75 per unit. For convenience, it is assumed that the invoice will also be paid on 31st July 20X1.

The Company’s management decides to hedge the foreign currency risk arising from this highly probable forecast purchase. R enters into a forward contract to buy USD and sell INR. The negotiations with the US Company are in advanced stages and the board of Company R has approved the transaction.

On 1st January 20X0, the Company enters into a US Dollar forward contract, to purchase USD 7,500,000 at a forward rate of INR/USD 46.245, by selling an equivalent INR sum of INR 346,837,500 on 31st July 20X1.

Exchange Rates on various dates are as shown in Table 1 :

Annualised interest rates applicable for discounting cash flows on 31 July 20X1 at various dates of the hedge are as shown in Table 2:

The fair value of the foreign currency forward contract at each measurement date is computed as the present value of the expected settlement amount, which is the difference between the contractually set forward rate and the actual forward rate on the date of measurement, multiplied by the discount factor.

On 1st January 20X0, which is the start date of the forward contract, the fair value of the derivative will be nil, as the difference between the contractually set forward rate and the actual forward rate (7,500,000 * (46.2450 – 46.2450)) is Nil.

On 30th June 20X0, the actual forward rate is 45.9732 and discount factor of 0.9138. Accordingly, the fair value of the currency forward contract is Rs. (1,862,774) i.e. [(7,500,000 * (45.9732 – 46.2450)) * 0.9138].

The fair value of the currency forward contract at each measurement date is computed in the same manner. Accordingly, the fair values at each measurement date are shown in Table 3.

The company designates this hedge relationship on 1st January 20X0.

Hedge effectiveness testing needs to be performed on a prospective as well as on a retrospective basis. A common way to measure hedge effectiveness is the cumulative dollar offset method which is a quantitative method that consists of comparing the change in fair value or cash flows of the hedging instrument with the change in fair value or cash flows of the hedged item attributable to the hedged risk.

Prospective testing will consider the expected variability in cash flows based on possible movements in exchange rates using dollar offset/hypothetical derivative method. Retrospective testing will consider actual variability in value/cash flows based on actual changes in forward rates.

In the given case, hedge effectiveness has been assessed prospectively and retrospectively using the cumulative dollar offset method and a hypothetical derivative for the notional amount of hedged purchases to demonstrate a relationship between the change in fair value of the hedging instrument and the change in fair value of the hedged item. The hypothetical derivative method is used to measure hedge effectiveness and ineffectiveness and is based on the comparison of the change in the fair value of the actual contracts designated as the hedging instrument and the change in the fair value of a hypothetical hedging instrument for purchases in the month of payment (considering that payment is the designated hedged item). In the given case, the hypothetical derivative that models the hedged cash flows would be a forward contract to pay $ 7,500,000 in return for INR.

The effectiveness of the relationship will be demonstrated by the following ratio:
Cumulative change in the fair value of the forward contract(s) by designated expiry.

Cumulative change in the fair value of the Hypo-thetical Derivative.

If the ratio of the change is within the range of 80% to 125%, the hedge will be determined to both continue to be, and to have been highly effective.

In this example, using the cumulative dollar offset method and a hypothetical derivative, the hedge effectiveness has been assessed as 100% effective at each measurement date. This is primarily because the date of maturity of the currency forward contract and date of the forecasted purchase payment, and the notional amount being hedged is the same. Hence, the ratio of fair value of the forward contract undertaken (hedging instrument) and the hypothetical derivative is 100% in each case. In practice, ineffectiveness often arises due to any changes in the expected timing of the purchase/ collection and the maturity date of the derivative. For example, though the derivative matures at the end of the month, the payment may occur at any time during the month.

Journal Entries (ignoring the impact of taxes) for the transaction using hedge accounting:

Date

Particulars

Dr/ Cr

Amount

(INR)

1-Jan-X0

No entry as the fair value of the currency
forward contract is nil

30-Jun-X0

Hedging reserve (OCI)W

1,862,774

To Derivative (liability)

1,862,774

(Being, change in the effective portion of
the fair value of the cur-

rency forward
contract)

31-Dec-X0

Derivative (asset)

2,141,046

Derivative (liability)

1,862,774

To Hedging reserve (OCI)

4,003,820

(Being, change in the effective portion of
the fair value of the cur-

rency forward
contract – difference between the fair value between

measurement dates 31
December 20X0 and 30 June 20X0 (-1,862,774

– 2,141,046))

30-Jun-X1

Derivative (asset)

2,519,448

To Hedging reserve (OCI)

2,519,448

(Being, change in the effective portion of
the fair value of the currency

forward contract –
(4,446,495 – 2,141,046))

31-Jul-X1

Derivative (asset)

4,002,005

To Hedging reserve (OCI)

4,002,005

(Being, change in the effective portion of
the fair value of the cur-

rency forward
contract)

31-Jul-X1

Inventory

355,500,000

To Trade Payable

355,500,000

(Being,
recognition of purchase
of inventory at
spot rates

i.e.7,500,000*47.4)

31-Jul-X1

Hedging reserve (OCI)

8,662,500

To Inventory

8,662,500

(Being, recognition of gains recognised in
equity into the carrying

amount of the
inventory acquired by Company R. The
net impact

of this adjustment is
that the inventory is ultimately recognised at

the forward rate of
46.245; alternatively this could have been carried

in OCI and released
to the P&L account directly when the inventory

would have been
booked in the P&L account)

31-Jul-X1

Cash

8,662,500

To Derivative (asset)

8,662,500

(Being, settlement of derivative in cash)

31-Jul-X1

Trade Payable

355,500,000

To Cash

355,500,000

(Being, settlement of trade payable)

In this example, since the hedge is 100% effective. the fair value of the currency forward contract has been taken to Hedging Reserve at each period end.

Conclusion:

By adopting hedge accounting, a company is able to align its risk management policy with its accounting treatment and better represent the transaction in its financial statements. It also reduces the volatility in the profit and loss account by deferring the unrealised gains or losses on the hedging instruments to other comprehensive income. In the future articles, we shall discuss examples on the other two type of hedges i.e. fair value hedge and hedge of a net investment in a foreign operations.

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Ind-AS impact on retail industry and summary of the carve-outs

The final Indian Accounting Standards (Ind-ASs) have been notified by the Ministry of Corporate Affairs (MCA) vide its announcement dated 25th February 2011. With the announcement, the final position of Ind-ASs, including key carveouts, has become clear. However, the MCA announcement does not convey the effective dates for the application of the Ind-ASs, giving an impression to industry that the implementation of Ind-AS is deferred. However, such an interpretation may be made with caution, as the final notified date of transition may not be too far.

The adoption of Ind-AS will have an impact on financial reporting of many entities, some of which are sector-specific, while some may be entityspecific. This article attempts to analyse some of the key impact areas on transition to Ind-AS for the retail industry and summarises the carve-outs vis-à-vis the IFRS.

Revenue recognition:
Principal v. Agent: Many a time, the retailer permits another entity to operate from its retail outlet. Under such cases, the retailer should closely evaluate its risks emanating from the arrangement to determine whether the retailer is ultimately selling the goods to the customer in his own capacity or the retailer is only facilitating the sale of goods in his capacity as an agent.

Under the current practice, a retailer invariably recognises the gross value of sales proceeds as revenue in the absence of clear guidance in distinguishing a principal from an agent.

Ind-AS provides more elaborate guidance on classification between a principal and an agent. It clarifies that if the retailer carries significant risks (such as inventory risk and price risk) and determines the price of goods, it is considered a principal, or else an agent. If the retailer is acting as the agent, then only the commission earned should be booked as revenues.

Customer loyalty programmes: Most retailers use consumer promotional schemes to increase business opportunities. These promotions typically include offers such as award credits or points through a loyalty scheme or the provision of a future discount through vouchers or coupons. Award credits may be linked to individual purchases or group of purchases. The customer may redeem the award credits for free or discounted goods or services.

Under current practice, there is no specific guidance on accounting for customer loyalty programmes. Certain entities recognise the cost of discounted/ free goods along with cost of sales, while certain entities present such costs as sales promotion expense. Further certain entities recognise the cost upfront based on estimates, while certain entities recognise the cost on incurrence.

Under Ind-AS, the revenue transactions under customer loyalty programmes are considered to have multiple elements, where the revenue attributable to the sale of goods either free of cost or at discounted price in future is recognised separately from the current sale transaction. The principles of recognition of customer loyalty programmes are as under:

An entity recognises the award credits as a separately identifiable component of revenue and defers the recognition of revenue related to the award credits until its utilisation.

The revenue attributed to the award credits takes into account the expected level of redemption.

The consideration received or receivable from the customer is allocated between the current sales transaction and the award credits by reference to their fair values.

The fair value is determined based on relative fair value method (where the benefit under the award is charged proportionately to each component).

The above guidance shall lead to initial deferral of revenue attributable to the award credits.

Product warranties: In the retail industry, the retailers often provide warranty on sale of products of its own brand. Currently such warranty obligations are accounted for through full recognition of revenue and an accrual of estimated costs, irrespective of the duration of the warranty period. Under Ind-AS, where the normal warranty offered by entities is for a duration of more than a year, the warranty provision would be recognised at its discounted value. The provisions would accrete over the expected term of the provision leading to an interest expense.

Thus the warranty costs to the extent of time value of money would be recognised as interest cost.

Leases:
Often the lease arrangements involve an initial fit-out period before commencement of the retail store’s operation, during which the retailer may be offered a rent-free right to use the leased premise. The rent would commence on the commencement of the operations. In the absence of elaborate guidance on such arrangements, currently the lease rent is usually recognised based on the commencement of the lease payments.

The Ind-ASs provide specific guidance on treatment of such lease incentives as part of the net consideration agreed for the use of the leased asset, irrespective of the incentive’s nature or form or timing of payments. As such, the retailer (lessee) shall recognise the incentives as a reduction of rental expense over the lease term on a straightline basis, unless another systematic basis is representative of the time pattern of the lessee’s benefit from the use of the leased asset.

Thus, the lease rent shall be recognised even for the period when there were no lease rentals payable, leading to a higher lease rental during the initial rent-free period. However, the subsequent lease rental charge would decline on account of the lease incentives being recognised as a reduction of lease rent expense over the lease term.

Interest-free lease deposits: The retail outlets are invariably taken on a noncancellable operating lease with an interest-free lease deposit. Under the current practice, the interest-free deposits are recognised as such at their transaction values.

Under the Ind-ASs, such interest-free deposits are classified as financial assets, which are required to be recognised at its fair value on initial recognition and at its amortised cost subsequently. These interest-free deposits are recognised at their discounted values and the difference between the contractual amount and discounted values represent the prepaid lease rent. The lease deposits would accrete over the lease term to match the undiscounted amount, leading to interest income, while the prepaid lease rent would be amortised as lease rent over the lease term on a straight-line basis.

As such, the accounting treatment under Ind- AS would lead to grossing up of lease rent and interest income. However, as the lease rents would be charged on straight-line basis and the interest income on effective interest rate basis, the higher lease rents may not exactly offset the interest income for the intervening reporting periods, though they would exactly offset when the entire lease term is considered together.

Asset retirement obligations: The retailers that acquire their stores on lease invariably are obligated to return the leased premises to the lessor on completion of the lease term on an ‘as-is’ basis. The retailer is obligated to remove its fixed assets, especially the leasehold improvements, on completion of the lease term.

Ind-ASs, in line with the current practice, require the creation of a provision for asset retirement obligations when there is an obligation for outflow of economic resources that is probable and can is reliably measurable. However, it is not common to find entities, other than exploration companies, that recognise the asset retirement obligations under the current practice on account of lack of elaborate guidance under the current GAAP.

Ind-AS requires a provision (and a corresponding asset) to be created at the initial stage by discounting the eventual estimated liability to its present value. The discount is unwound by way of recognising an interest expense over the life of the asset. Further, the provision is required to be re-estimated every reporting date. Apart from re-estimating the amount and timing of the outflow of economic resources, even the discounting factor is also re-estimated at each reporting period and is accounted as a change of estimates.

Application of Ind-AS will lead to an increase in the depreciation charge related to the cost capitalised and higher finance costs on account of unwinding the discount over the life of the asset.

Key carve-outs:

The final Ind AS includes several ‘carve-outs’ (deviations) from IFRS as issued by the International Accounting Standards Board (IASB). The Indian standard-setters have examined individual IFRS and modified the requirements where deemed necessary to suit Indian conditions. ‘Carve-outs’ are generally perceived as non-desirable, since they would dilute the key purpose of converging with IFRS (i.e., to have a common set of accounting standards across countries; provide seamless access to international capital markets; provide comfort to investors).

An analysis of the Ind AS carve-outs reveal that while some of the carve-outs are mandatory and represent clear deviations from IFRS, several of the carve-outs represent removal of policy choices under IFRS in certain areas or conversely provide alternate policy choices under Ind AS for certain other areas.

Let us start with the first category of carve-outs (mandatory deviations). The significant mandatory deviations from IFRS that an Indian company cannot avoid are a handful. These include revenue recognition for real estate sales on the basis of percentage completion method (IFRS requires revenue recognition when the final possession is given to the customer) and accounting for the equity conversion option of a foreign currency convertible bond (FCCB) as an equity component (IFRS requires the equity conversion option to be periodically marked-to-market). Our experience indicates that these carve-outs are not expected to impact a wide cross-section of companies. There are some other, less substantive, mandatory deviations (for example, use of a government bond rate for discounting employee benefit obligations as opposed to corporate bond rates required by IFRS or excluding own credit risk in fair valuation of certain financial liabilities).

Let us now examine the second category of carve-outs (removal of policy choices). There are several areas where IFRS offers multiple policy choices, while Ind AS prescribes one of these policy choices. Such carve-outs include (1) Single statement presentation of the income statement (IFRS permits the statement of comprehensive income to be presented separately) (2) Classification of expenses in the profit and loss account by their nature (IFRS permits classification by function) (3) Classification of interest and dividend as financing/ investing cash flows (IFRS permits operating classification) (4) No choice to carry investment property at fair value (IFRS permits this) (5) Recognition of actuarial gains and losses directly in reserves (IFRS permits alternatives including recognition in the profit and loss account) and Recomputation of borrowing costs capitalisable (IFRS permits prospective application).

This category of carve -outs does not result in deviations from IFRS, as they represent permitted policy choices. These could pose a challenge for Indian companies, if global peers follow other alternative policies; if such companies are a part of a global group that follows other alternative policies; or if the Indian company has previously followed other alternative policies for IFRS reporting to overseas stakeholders.

The third category of carve-outs (additional policy choices) represent an area where a company can either elect to follow policies aligned to IFRS, or alternate policies that diverge from IFRS. Such carve-outs include (1) Choice to defer exchange differences on long-term foreign currency assets and liabilities, and recognise such differences over the period of the underlying asset/liability (IFRS requires all such differences to be immediately charged to the profit and loss account) (2) Choice to consider Indian GAAP carrying values as ‘deemed cost’ for fixed assets acquired prior to transition date (IFRS offers no such choice on transition — retrospective IFRS values or ‘fair values’ are the two choices on transition; Ind-AS offers a third choice). This category of carve-outs represents an area where each individual company needs to apply careful thought and consideration. While assessing these policy choices, companies need to evaluate not just their current environment, but future plans (for example, plans for a future overseas listing).

The notified converged standards have also deferred the applicability of guidance on accounting for embedded leases and service concession arrangements.

These carve-outs could have been avoided, but the Government has adopted a practical approach to implement a significant and complex change in the accounting framework. It is now up to each company to choose whether they want to fully converge with IFRS (subject to the mandatory deviations discussed above) or take a simpler way out to manage the transition.

Ind-AS financial statements for subsequent periods can be made compliant with IFRS if a company chooses optimal accounting policies and does not adopt the prescribed alternatives available under Ind AS (other than those impacted by mandatory deviations).

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Ind AS 102 – Share Based Payments

Background

Currently, the accounting guidance under Indian GAAP for Employee Share Based Payment Plans (ESOPs) is contained in the Guidance Note on Accounting for Employee Share-based Payments. In the case of listed companies, guidance is also provided in the Securities and Exchange Board of India (Employee Stock Option Scheme and Employee Stock Purchase Scheme) Guidelines, 1999. There is no specific guidance currently under Indian GAAP for options granted to non-employees (for example, vendors or customers). Ind AS 102 deals with all types of share based payments, including share based payments made to non-employees.

Objective, scope and definitions

Ind AS 102 provides guidance with respect to the financial reporting by an entity, when it undertakes a share-based payment transaction. Ind AS 102 specifically excludes the below-mentioned share-based payment transactions from its scope, as the relevant guidance relating to these transactions are covered under other accounting standards:

• Share-based consideration paid in a business combination (Ind AS 103 – Business Combination)

• Certain contracts falling within the scope of Ind AS 32 “Financial Instruments: Presentation” or Ind AS 39 “Financial Instruments: Recognition and Measurement”.

Type of share based payment transactions

Under Ind AS 102, share based payment transactions are classified as follows:

Equity-settled share-based payment transactions. Under this the entity receives goods or services as Jamil Khatri Akeel Master Chartered Accountants IFRS consideration for equity instruments of the entity or another group entity. Cash-settled share-based payment transactions. Under this the entity acquires goods or services by incurring liabilities to the supplier of those goods or services for amounts that are based on the price (or value) of the entity’s shares or other equity instruments of the entity. Transactions with cash alternatives. Under this the entity receives or acquires goods or services and the terms of the arrangement, provide either the entity or the supplier of those goods or services with a choice of whether the entity settles the transaction in cash (or other assets) or by issuing equity instruments.

Measurement

Equity settled share based payment transactions Equity settled share based payment transactions are measured with reference to the fair value at the grant date (where options are granted to employees) or with reference to the fair value at the date at which the entity obtains the goods or receives the services (where options are granted to non-employees).

The measurement is at the fair value of the goods or services received, unless that fair value cannot be estimated reliably. If the fair value of the goods or services received cannot be estimated reliably, the entity shall measure the fair value by reference to the fair value of the equity instruments granted.

Typically, in the case of employees, fair value of equity instrument is considered since it is not possible to estimate reliably the fair value of the services received. However, in case of transactions with parties other than employees, there is a rebuttable presumption that the fair value of the goods or services can be estimated reliably.

The fair value of the instruments granted can generally be measured using the market prices (if available) or using a valuation technique (for example, option pricing models).

Example

Entity P grants 100 share options to each of its 200 employees which are conditional upon completing three years of service. Estimated fair value of each option on grant date is INR 10.

Year 1
Cumulative expense (100* 200* 10*1/3) = Rs. 66,667 Expense for the current period = Rs. 66,667 Entry – Expense Dr 66,667 To Equity 66,667

Year 2
Cumulative expense (100* 200* 10*2/3) = Rs. 133,333 Expense for the current period = Rs. 66,667 (133,333 – 66,667) Entry – Expense Dr 66,667 To Equity 66,667

Year 3

Cumulative expense (100* 200* 10*3/3) = Rs. 200,000 Expense for the current period = Rs. 66,667 (200,000-133,333) Entry – Expense Dr 66,667 To Equity 66,667

Cash settled transactions

Cash-settled share-based payment transactions are measured at the fair value of the liability. Further, at each reporting date, and ultimately at the settlement date, the fair value of the recognised liability is remeasured with any changes in the fair value recognised in the profit or loss account. It is to be noted that equity settled share based payment transactions are not required to be remeasured.

Example

Entity A granted 60 Share Appreciation Rights (SAR) to each of its 200 employees with three years service condition. The SAR will be ultimately settled by Entity A making cash payments to the employees based on the value of the SAR. Fair value of options at the end of: Year 1 – Rs. 15 Year 2 – Rs. 20 Year 3 – Rs. 22

At the end of Year 1

Cumulative expense (60* 200* 15*1/3) = Rs. 60,000 Expense for the current period = Rs. 60,000 Entry – Expense Dr 60,000 To Liability 60,000

At the end of Year 2

Cumulative expense (60* 200* 20*2/3) = Rs. 160,000 Expense for the current period = Rs. 100,000 (160,000 – 60,000) Entry – Expense Dr 100,000 To Liability 100,000

At the end of Year 3

Cumulative expense (60 * 200* 22 *3/3) = Rs. 264,000

Expense for the current period = Rs. 104,000 (264,000-160,000)

Entry – Expense Dr 104,000

To Liability 104,000

Conditions affecting the recognition and fair value

Conditions that determine whether the counterparty receives the share-based payment are separated into vesting conditions and non-vesting conditions.

Service conditions are those conditions which require counterparty to complete specified period of service, whereas performance conditions require the counterparty to meet specified performance targets in addition to service conditions. Performance conditions could either be market conditions where vesting is related to the market price of entity’s equity instruments or nonmarket performance conditions where vesting is related to specific performance targets unrelated to market price (for example, specified increase in sales, net profit or EPS).

Service conditions and non-market performance conditions are not reflected in the grant date fair valuation and a true up is required for failure to satisfy such condition. Market conditions and non-vesting conditions are reflected in grant date fair valuation and no true up is required subsequently for failure to satisfy such conditions.

Accordingly, no charge is recognised for goods or services received if the equity instruments granted do not vest because of failure to satisfy a service condition/non-market performance condition. On the other hand, in the case of grants of equity instruments with market conditions, the entity shall recognise the charge for goods or services received from a counterparty who satisfies all other vesting conditions (for example, services received from an employee who remains in service for the specified period of service), irrespective of whether that market condition is satisfied.

In other words, market conditions are reflected as an adjustment to the initial estimate of fair value at grant date of the instrument to be received and no adjustments are made as a result of differences between estimated and actual vesting due to market conditions.

Non-vesting conditions

Non-vesting conditions are similar to market conditions and are reflected in measuring the grant-date fair value of the share-based payment. No adjustment is made for any differences between expected and actual outcome of non-vesting conditions.

Therefore, if all service and non-market performance conditions are met, then the entity will recognise the share-based payment as a cost even if the counter-party does not receive the share-based payment due to a failure to meet a non-vesting condition.

In practice, most Indian ESOP plans have service vesting conditions, while some plans may contain performance conditions. Non-vesting conditions are rare.

Forfeiture

A grant is forfeited when the vesting conditions are not satisfied.

The amount recognised for goods or services received during the vesting period shall be based on the number of share options expected to vest considering options estimated to be forfeited.

When the goods or services received are recognised with a corresponding increase in equity, then entity shall not make any adjustment to total equity after the vesting date. An entity shall not subsequently reverse the amount recognised for services received from an employee if the vested equity instruments are later forfeited or, in the case of share options, the options are not exercised.

Estimated share-based payment cost is trued up for forfeitures or estimated forfeitures on account of an employee failing to provide the required service.

Group share-based payment arrangements

A share-based payment in which the receiving entity and the settling entity are in the same group from the perspective of the ultimate parent and which is settled either by an entity in that group or by an external shareholder of any entity in that group is a group share-based payment transaction from the perspective of the receiving and the settling entities.

In a group share -based payment transaction in which the parent grants a share-based payment to the employees of its subsidiary, the share-based payment is recognised in the consolidated financial statements of the parent, in the separate financial statements of the parent and in the financial statements of the subsidiary.

Examples

Parent P grants its own equity instruments or a cash payment based on its own equity instruments to the employees of Subsidiary S as a consideration for the services provided to S, wherein P has an obligation towards the employees of S; or

Subsidiary S grants equity instruments of Parent P or a cash payment based on the equity instruments to its own employees as a consideration for the services provided to S. Here S has an obligation towards its employees.

Let us understand the accounting treatment in case of group share based payment.

Accounting by subsidiary, when parent grants shares to the employees/counter party of its subsidiary

Here a subsidiary has no obligation to settle the transaction with the counterparty. However, subsidiary is receiving service/goods and hence recognises an expense/asset and an increase in its equity for the contribution received from the parent.

Accounting by a subsidiary who grants rights to equity instruments of its parent to its employees

The subsidiary shall account for the transaction with its employees as cash-settled. This requirement applies irrespective of how the subsidiary obtains the equity instruments to satisfy its obligations to its employees.

Accounting by parent that settles the share-based payment directly

When a parent grants rights to its equity instruments to employees of a subsidiary, the parent receives goods or services indirectly through the subsidiary in the form of an increased investment in the subsidiary, i.e. the subsidiary receives services from employees that are paid for by the parent, thereby increasing the value of the subsidiary.

Therefore, the parent should recognise in equity the equity-settled share-based payment with a correspond-ing increase in its investment in the subsidiary in its financial statements. The amount recognised as an additional investment is based on the grant-date fair value of the share-based payment. An increase in investment and corresponding increase in equity for the equity-settled share-based payment should be recognised by the parent over the vesting period of the share-based payment.

In consolidated financial statements, the investment in the subsidiary mentioned above would be eliminated against equity contribution recognised by subsidiary in its standalone financial statements and accordingly, employee compensation expense would be recognised with corresponding credit to either equity or liability.

Treasury shares

Under Ind AS, a trust formed for administering an employee stock option plan generally meets the definition of a Special Purpose Entity, and hence is consolidated with the entity. Under this approach, cost will be recognised for all grants through the trust; shares held by the Trust will be considered as treasury shares of the company; and any loan given by the company to the trust will be eliminated on consolidation. As a result of this accounting treatment, cost of any shares bought by the Trust from the open market will be reduced from the reserves of the company. Any subsequent sales by b the trust (either to the employee or third parties) will result in an increase in the reserves.

Exit Mechanism

Sometimes, an award requires an exit event (e.g. sale of the business) as either a vesting or exercise condition. The requirement for an exit event affects share-based payments in different ways, depending on how the condition is expressed. If the condition is required to occur during the service period, then it would be a performance condition.

For example, a grant of share options has a three-year service condition. However, the options cannot be exercised until an IPO occurs.

If employees leaving the entity after the service period but before the IPO retain the options, then the condition of an IPO is a non-vesting condition.

If employees leaving the entity before an exit event are required to surrender the ‘vested’ options (or sell them back at a nominal amount) then the exit condition is in substance a vesting condition.

Let us take another example. If the options do not vest until an IPO occurs and employees leaving before the IPO forfeit the options, then this is an award that contains both a service condition and a non-market performance condition, assuming that there is no minimum IPO price. Such an arrangement should be accounted for as a grant with a variable vesting period (i.e. the length of the vesting period) varies depending on when a performance condition is satisfied, based on a non-market performance condition. Because the IPO has no minimum price and therefore is not a market condition, the condition would not be reflected in the grant-date measurement of fair value and the cost would be recognised over the expected vesting period and trued up to the actual vesting period and the actual number of equity instruments granted.

Conclusion

The accounting for share based payment under Ind AS 102 is much wider in scope as compared to the existing guidance. The guidance on accounting for group share based payment should be carefully evaluated to determine the appropriate accounting treatment for group entities. Ind AS 102 provides guidance on accounting for share based payments and mandates use of fair value for recognition of share based payments (intrinsic method is permitted only in very rare circumstances). This is likely to impact the employee compensation expense of many Indian companies who have issued stock options to employees and currently use intrinsic value method to account for these options. The use of fair value method to recognise share based payment would provide a more accurate picture to all stakeholders with respect to the true compensation cost. However, this will also bring in challenges since compensation cost will be recorded, based on a calculated ‘fair value’ of the option on the grant date, which in most situations will be significantly different from the actual gain (or no gain) for the employee at the time of the vesting/exercise.

Nirav Shah

Ind AS 105 – Non-current assets held for sale and Discontinued Operations

Background

Current Indian GAAP does not prescribe comprehensive guidance on Non-current assets held for sale and discontinued operations. Under Indian Accounting Standards (Ind AS) that are converged to International Financial Reporting Standards (IFRS), Ind AS 105 has been aligned with IFRS 5 and there are no major differences between Ind AS and IFRS. Ind AS 105 also covers in an appendix the requirements specified in IFRIC 17 – Distribution of non-current assets to owners.

Scope and Definitions

Ind AS 105 provides guidance with respect to classification, measurement and presentation of all noncurrent assets/disposal groups held for sale and assets classified as held for distribution. The standard also covers classification and presentation requirements of Discontinued Operations.

Definitions

Non-current assets are assets which do not meet the definition of current assets as defined in Ind AS 1. In practical terms, non-current assets are assets which are not expected to be realised within a period of twelve months from the reporting period.

Disposal Group is a group of assets to be disposed of, by sale or otherwise, together as a group in a single transaction, and liabilities directly associated with those assets that will be transferred in the transaction. Thus, disposal group may contain assets or liabilities which are current in nature or assets which do not fall within the purview of this standard. Here, when an entity applies the measurement requirements of this standard it has to consider the Disposal group as a whole.

Discontinued Operation is a component of an entity that either has been disposed of or is classified as held for sale and:
• represents a separate major line of business or geographical area of operations;
• is part of a single co-ordinated plan to dispose of a separate major line of business or geographical area of operations; or
• is a subsidiary acquired exclusively with a view to resale.

Criteria for Classification as “Held for sale”

Under Ind AS 105, an entity shall classify a non-current asset (or disposal group) as held for sale if its carrying amount will be recovered principally through a sale transaction rather than through continuing use.

There are mainly two conditions which must be satisfied for an asset (or disposal group) to be classified as “Held for sale”.

1) An Asset must be Available for Immediate Sale in the Present Condition Subject to Terms that are Usual and Customary i.e. Common Practices which Exist for Sales of such Assets (or disposal groups) For example, an entity intends to sell second hand machinery and there is demand for second hand machinery in the market, however there are very few users of this particular machinery and usually it takes three to six months of time to close the sale transaction. In this case, the asset can be said to be available for immediate sale and can be considered as “held for sale” if other criteria is met.

2) Sale must be Highly Probable:

The Standard provides detailed guidance on this second condition about when can sale be said to be highly probable. The standard specified that for the sale to be highly probable:

• Appropriate level of management must be committed to a plan to sell the asset (or disposal group) and active programme to locate a buyer and complete the plan has been initiated.

• Assets (or disposal group) under consideration must be marketed at a price that is reasonable to its current fair value.

• The sale should be expected to qualify for recognition as a completed sale within one year from the date of such classification i.e. an entity expects to complete the sale transaction within one year from the date on which theses assets are classified as held for sale.

Measurement Principles

There are mainly three stages of measurement of assets (or disposal group) held for sale:

• Before initial classification as held for sale – Assets (or disposal group) held for sale before such classification are measured according to applicable Indian accounting standard e.g. Plant and machinery as per Ind AS 16.

• At the time of initial classification – Non-current asset (or disposal group) classified as held for sale is measured at the lower of its carrying amount and fair value less costs to sell.

• Subsequent measurement – After the classification of assets (or disposal group) as held for sale during subsequent reporting period, these assets (or disposal group) as a whole is measured at the lower of carrying amount and fair value less costs to sell.

Ind AS 105 also provides guidance on impairment testing of assets (or disposal group) classified as held for sale. Impairment testing is carried out on initial classification as well as during the subsequent measurement period. Write down of assets to fair value less cost to sell that has not been recognised as per the above mentioned criteria is recognised as impairment loss. For example, if carrying amount of non-current asset held for sale is 1,000 and fair value less cost to sell is 900, 100 will be included in profit and loss account as impairment loss.

Also, at the time of subsequent measurement, if there is any gain due to increase in fair value less cost to sell of an asset the same should be recognised to the extent of cumulative impairment loss recognised previously. For example, continuing above if there is gain of 120 based on re-measurement of non-current asset, gain to the extent of only 100 i.e. to the extent of impairment loss recognised earlier will recognised as gain in profit and loss.

Disposal group may contain assets or liabilities that are not non-current in nature or not within the scope of Ind AS 105. At the time of initial classification or during subsequent measurement, these assets or liabilities are measured or remeasured as per the standard applicable to such assets or liabilities. The measurement criteria i.e. amount lower of carrying amount and fair value less costs to sell is applied to disposal group as a whole i.e. for the disposal group itself.

For example, Disposal group contains PP&E (non-current asset) and also has inventories (current asset – not covered under Ind AS 105). Based on the individual assessment of assets applying relevant accounting standard value of disposal group let’s say is 20,000. If after applying the measurement criteria of Ind AS 105 to this disposal group as a whole value comes to 18,000 then 2,000 will be recognised as impairment loss. However, as per the standard this loss of 2,000 will be proportionately allocated only to non-current assets within the disposal group. Another important aspect that merits consideration is that the non-current assets held for sale shall not be depreciated (or amortised) individually or as a part of disposal group.

Changes to a Plan of Sale

If non-current asset (or disposal group) classified as held for sale, no longer meet the criteria specified, then such assets cease to be classified as held for sale.

In such a case, non-current asset (or disposal group) is measured at lower of:

• its carrying amount before the asset (or disposal group) was classified as held for sale, adjusted for any depreciation, amortisation or revaluations that would have been recognised had the asset (or disposal group) not been classified as held for sale, and

• its recoverable amount at the date of the subsequent decision not to sell.

The impact of the above change is recognised in profit and loss account.

There can be a case where some of the non-current assets of disposal group still meet the criteria of held for sale’ whereas disposal group as a whole does not meet the requirement. In such cases, these non-current assets shall be measured as per the measurement criteria of this standard in their individual capacity.

Disclosure in Financial Statements

There are mainly two disclosure requirements as per Ind AS 105 viz. disclosure requirements for:

• Non-current assets (or disposal group)
These are presented separately from other assets and liabilities (which are part of disposal group).

Also, an entity should not offset such assets and liabilities.
• Discontinued operations
There are mainly two disclosure required with respect to discontinued operations. These include (a) post-tax profit or loss and post-tax gain or loss recognised on the measurement to fair value less costs to sell or disposal group constituting discontinued operations. Both these can be presented as a single amount in the statement of profit or loss. (b) related income tax expenses as per Ind AS 12 on above.
Similarly, cash flows from discontinued operations will also form part of disclosure in cash flow statement. An entity has a choice of presenting above either in statement of profit or loss/cash flow or in notes to accounts.

Apart from above there are certain additional disclosures required by Ind AS 105 which mainly includes description of non-current assets (or disposal group), facts and circumstances leading to sale or disposal etc.

Distribution of Non-current Assets to Owners

The essence of the above guidance is that distribution of non-current assets to owners is akin to dividend distribution and hence should be accounted as such.

Appendix C of Ind AS 105 and Appendix A of Ind AS 10 contain this guidance.

This part of the standard mainly covers two types of transactions:

• Distribution of non-cash assets; and
• Distribution that give owners a choice of receiving either non-cash assets or a cash alternative.

The standard does not cover transactions where non-cash assets distributed are controlled by the same party or parties who controlled such assets before distribution or transactions where entity distributes ownership in a subsidiary but retains control.

Measurement and Presentation Requirements

As per the standard, when a company declares to distribute assets to its owners, the company should recognise liability for dividend payable when dividend is appropriately authorised and is not at the discretion of the entity.

Dividend payable liability will be measured by an entity at the fair value of the assets to be distributed where non-cash assets are distributed as dividend. Further, the standard specifies that when an entity settles the dividend payable, it shall recognise the difference, if any, between the carrying amounts of the assets distributed and the carrying amount of the dividend payable in profit or loss. The same is disclosed as a separate line item in profit or loss account.

An entity shall disclose carrying amount of the dividend payable at the beginning and end of the period and any changes in carrying amount of such liability due to changes in fair value which is reviewed at the end of each reporting period and necessary adjustments are made.

Conclusion

This accounting standard provides specific guidance on measurement and classification of Non-current assets held for sale, which does not exist under current Indian GAAP. The guidance requires measurement of such assets at lower of carrying amount and fair value less costs to sell.

Further, the standard also lays down criteria to be met for an operation to be classified as discontinuing operation.

The guidance on distribution of non-cash assets to owners requires accounting for such transactions as dividend.

The above guidance would change the accounting and disclosure requirements for the above transactions/events as compared to existing Indian GAAP.

Nirav Shah

Related parties under Ind AS: Enhanced scope and disclosure requirements

Related party relationships and transactions with such parties are an integral part of day-to-day business for many groups. Users of financial statements are likely to be interested in the existence of these relationships and in transactions, along with their potential impact, between such parties when they assess the operations, financial performance and financial position of an entity.

The accounting definition of a related party under AS-18, which is a part of the present Indian GAAP, is not as far reaching in its scope as the international practice.

As part of convergence to IFRS, the Ind AS attempts to address the above and introduces certain additional disclosure requirements to enhance the quality of financial information to the users of financial statements.

In this article we shall consider some of the key differences in the identification of related parties for financial reporting purposes between Indian GAAP and Ind AS.

Definition of related party

AS-18 defines a related party as follows — ‘Parties are considered to be related if at any time during the reporting period one party has the ability to control the other party or exercise significant influence over the other party in making financial and/ or operating decisions’. It clarifies that AS-18 applies only to related party relationships described in the standard, which are as under:

(a) enterprises that directly, or indirectly through one or more intermediaries, control, or are controlled by, or are under common control with, the reporting enterprise (this includes holding companies, subsidiaries and fellow subsidiaries);

(b) associates and joint ventures of the reporting enterprise and the investing party or venturer in respect of which the reporting enterprise is an associate or a joint venture;

(c) individuals owning, directly or indirectly, an interest in the voting power of the reporting enterprise that gives them control or significant influence over the enterprise, and relatives of any such individual;

(d) key management personnel and relatives of such personnel; and

(e) enterprises over which any person described in (c) or (d) is able to exercise significant influence. This includes enterprises owned by directors or major shareholders of the reporting enterprise and enterprises that have a member of key management in common with the reporting enterprise.

Ind AS 24 states that a related party is a person or entity that is related to the entity that is preparing its financial statements referred to as the ‘reporting entity’.

(a) A person or a close member of that person’s family is related to a reporting entity if that person:

(i) has control or joint control over the reporting entity;

(ii) has significant influence over the reporting entity; or

(iii) is a member of the key management personnel of the reporting entity or of a parent of the reporting entity.

(b) An entity would be a related party if any of the following conditions apply:

(i) The entity and the reporting entity are members of the same group (which means that each parent, subsidiary and fellow subsidiary is related to the others).

(ii) One entity is an associate or joint venture of the other entity (or an associate or joint venture of a member of a group of which the other entity is a member).

(iii) Both entities are joint ventures of the same third party.

(iv) One entity is a joint venture of a third entity and the other entity is an associate of the third entity.

(v) The entity is a post-employment benefit plan for the benefit of employees of either the reporting entity or an entity related to the reporting entity. If the reporting entity is itself such a plan, the sponsoring employers are also related to the reporting entity.

(vi) The entity is controlled or jointly controlled by a person identified in (a). (vii) A person identified in (a) (i) has significant influence over the entity or is a member of the key management personnel of the entity (or of a parent of the entity).

Related party relationships included and excluded

For the purpose of this section, we shall analyse these relationships from the perspective of Reporting Entity (RE), and reference to Parent, Associates and Joint Ventures of the reporting enterprise shall be denoted as P, A and J, respectively. Further, to highlight indirect relations within a group structure, for instance, Parent company’s investment in its Joint venture is referred to as P-J, where the ‘P’ denotes RE’s Parent Company and the ‘J’ that follows ‘P’ denotes to another Joint venture of the Parent Company.

Parent’s investment in Joint Venture (i.e., P-J) and associates (i.e., P-A)

Under the present Indian GAAP, parent’s investment in another subsidiary (i.e., P-S) is a related party, as that subsidiary is reporting entity’s fellow subsidiary. However, from the drafting of the relationships stated above, the parent’s investment in its joint venture (i.e., P-J) is not considered as related party under current Indian GAAP. Similarly, the parent’s investment in its associate (i.e., P-A) is also not considered as a related party to RE.

Under Ind AS, two entities are related if one entity is an associate or joint venture of the other entity (or an associate or joint venture of a member of a group of which the other entity is a member). Since the group is defined to include the parent company and each of entities under its direct and indirect control, the parent’s investment in its joint venture (i.e., P-J) is a related party to RE. Similarly, the parent’s investment in its associates (i.e., P-A) is also considered to be related party to RE.

Subsidiaries of joint ventures (i.e., J-S) and associates (i.e., A-S)

The present Indian GAAP does not specifically clarify whether a reference to the associates and joint ventures in AS-18 should be interpreted as those stand-alone entities or their entire group. As such, it is a common practice of not considering the subsidiaries of associates and joint ventures as related parties.

Under Ind AS, it is specifically stated that an associate includes subsidiaries of the associate and a joint venture includes subsidiaries of the joint venture. As such, for instance, an associate’s subsidiary (i.e., A-S) and the investor (i.e., RE) that has significant influence over the associate (A) are related to each other. Similarly, J-S is also considered to be a related party under Ind AS.

Key managerial personnel (KMP)

Under present Indian GAAP, a non-executive director of a company is not considered as a KMP by virtue of merely his being a director unless he has the authority and responsibility for planning, directing and controlling the activities of the reporting enterprise.

Under Ind AS, KMP are those persons having authority and responsibility for planning, directing and controlling the activities of the entity, directly or indirectly, including any director (whether executive or otherwise) of that entity.

Classification of investees as subsidiaries, joint ventures and associates

It may be noted that the reference to the terms subsidiaries, joint ventures and associates as stated above are required from the perspective of the Ind AS principles in assessing control, joint control and significant influence, considering the rights to participate in the financial and operating policies of the investee. As such, unlike present Indian GAAP, the percentage ownership of the investee’s capital may not be the determinative factor in assessing the relationship with the investee.

As such, the related party relationships may undergo a change not only on account of changes to the identified related party relationships in the standard, but also on account of change in classification of the investees based on the degree to which the company can influence the operations of the investee.

State-controlled enterprise/Government-related entities

The present Indian GAAP defines a state-controlled enterprise as an enterprise which is under the control of the Central Government and/or any State Government(s). Under the definition of state-controlled enterprises, those enterprises that are under joint control or under significant influence of the Central and/or State Government(s) are not considered as state-controlled enterprises. As such, the disclosure exemptions provided under AS-18 do not extend to such enterprises under joint control/ significant influence of the government.

Under Ind AS, a government-related entity is an entity that is controlled, jointly controlled or significantly influenced by a government. As such, disclosure exemptions provided under Ind AS 24 extend to enterprises under joint control/significant influence of the same government. Further, it follows that the differences stated above (such as subsidiaries of associates i.e., A-S) may additionally be considered for this purpose.

Disclosure requirements
Duties of confidentiality

Like the present Indian GAAP, the Ind AS states that the related party disclosure requirements as laid down under Ind AS 24 do not apply in circumstances where providing such disclosures would conflict with the reporting entity’s duties of confidentiality as specifically required in terms of a statute or by any regulator or similar competent authority.

However, this is a departure from the IFRS as issued by IASB (commonly referred to as a carve-out). As such, IFRS does not prescribe any such exemption from disclosure requirements prescribed under IAS 24 on account of duties of confidentiality as specifically required in terms of a statute or by any regulator or similar competent authority.

Compensation to KMP

Under the present Indian GAAP, the employee compensation provided to KMP is required to be disclosed. However, there is no specific requirement to disclose the breakup of such compensation.

Under Ind AS, the employee compensation to KMP is required to be disclosed, along with its breakup into short-term employee benefits, post-employment benefits, other long-term benefits, termination benefits and share-based payments.

Disclosure of terms and conditions of transaction

The present Indian GAAP requires disclosure of, amongst other things, name of related party, description of related party relationship and the description of the transaction.

Ind AS additionally requires disclosure of terms and conditions of the related party transactions, including whether they are secured, and the nature of the consideration to be provided in settlement; and details of any guarantees given or received.

Disclosure exemptions for government-related entities

As per AS-18, no disclosure is required in the financial statements of state-controlled enterprises as regards related party relationships with other state-controlled enterprises and transactions with such enterprises.

As per Ind AS 24, the reporting entity is exempt from the disclosure requirements in relation to related party transactions and outstanding balances, including commitments, with:

a) a government that has control, joint control or significant influence over the reporting entity; and
b) another entity that is a related party because the same government has control, joint control or significant influence over both the reporting entity and the other entity.

If a reporting entity applies the exemption as stated above, it shall disclose the following about the transactions and related outstanding balances:

a) the name of the government and the nature of its relationship with the reporting entity (i.e., control, joint control or significant influence);

b) the following information in sufficient detail to enable users of the entity’s financial statements to understand the effect of related party transactions on its financial statements:

i) the nature and amount of each individually significant transaction; and
ii) for other transactions that are collectively, but not individually, significant, a qualitative or quantitative indication of their extent.

Summary
One of the key GAAP differences between present Indian GAAP and Ind AS is that of indirect relationships, whereby Ind AS considers the all group entities of an entity (instead of that separate legal entity) to be related if that entity is related to the reporting entity. Accordingly, for instance, if an entity is related to a reporting entity in the capacity of an associate or joint venture, all entities controlled by such associates and joint ventures are considered as related parties under Ind AS. Similar is the case with the associates and joint ventures of the reporting entity’s parent company.

Overall, the implementation of Ind AS will require identifying the additional related party relationships covered within the scope of the standard. Further, the related party relationships need to be identified after appropriately classifying all the entities concerned as subsidiaries, associates and joint ventures, in accordance with Ind AS (that could be different from its classification under present Indian GAAP) from the perspective of the investor i.e., the reporting entity or its investee within its group or its associates/joint ventures as the case may be. It may particularly be difficult at times to assess the appropriate classification of the investees of an associate into subsidiary/ associates/joint venture, on account of associate company not reporting under Ind AS and limited access to the financial information of the associate.

While the Ind AS is not mandatory as yet, it is expected that preparers will want to evaluate their involvement with related parties under the new standard soon, as the changes in the group structure from an accounting perspective under Ind AS will have additional implications.

Nirav Shah

Tax Accounting Standards: A new way of computing taxable income

In our previous article, we had covered the approach for formulation of the Tax Accounting Standards by the CBDT Committee (the Committee), final recommendations of the Committee and some of the important implications of the TAS around areas such as accounting policies, inventories, prior period expenses, construction contracts, revenue recognition and fixed assets. In this article, we will cover some other important areas which would be impacted and lead to different taxable incomes under the proposed TAS regime.

The effects of changes in foreign exchange rates

• Unlike AS 11, under TAS all foreign currency transactions will have to be recorded at the exchange rate prevalent on the date of the transactions. TAS eliminates the option for entities to recognise foreign currency transactions at an average rate for a week or month when the exchange rate does not fluctuate significantly. This may lead to practical challenges with no significant benefits in reporting.

• Unlike AS 11 wherein exchange differences on translation of non-integral foreign operations are required to be recorded in reserves i.e. foreign currency translation reserve account, TAS requires these exchange differences to be recognised in the profit and loss account as income or expense. This treatment appears to be based on the analysis that the Income Tax Act, 1961 (‘the Act’) does not distinguish between the tax treatment of incorporating the results of branches that may qualify as non-integral from those that qualify as integral. However, as per TAS, there is a measurement difference in quantification of impact of exchange differences between integral and non-integral foreign operation.

For instance, fixed assets and other non-monetary assets of non-integral foreign operations are measured at closing rates whereas such assets are not re-measured in case of integral operations. Prior to the TAS, where the foreign currency exposures on existing monetary items were hedged through options, any exchange loss on the foreign currency monetary item was claimed as a deduction, but any corresponding unrecognised gain on the option contract may have been ignored, if the company determined that such contracts were not directly covered by AS 11.

However, the TAS now includes foreign currency option contracts and other similar contracts within the ambit of forward exchange contracts. When these contracts are entered into for hedging recognised assets or liabilities, the premium or discount is amortised over the life of the contract and the spot exchange differences are recognised in the computation of taxable income. Although this treatment may not be in line with current accounting and tax practices, it brings in uniformity in the treatment of foreign currency options and forward contracts to the extent that they seek to hedge a recognised asset or liability.

• The premium, discount or exchange differences on all foreign currency derivatives that are intended for trading or speculation purposes or that are entered into to hedge the foreign currency risk of a firm commitment or a highly probable forecast transaction are to be recognised only at the time of settlement of the contract. This is consistent with other provisions of the TAS to not recognise unrealised gains and losses.

• As per TAS, exchange differences on foreign currency borrowings, other than those specifically covered u/s. 43 A will be allowed as a deduction or will be taxed based on translation at the year-end spot rate.

Government grants

• As per AS 12, grants in the nature of promoters’ contribution are recorded directly in shareholders’ funds as a capital reserve. However, TAS does not permit the above capital approach for recording government grants.

• Under the TAS, all grants will either be reduced from the cost of the asset, or recorded over a period as income, or recorded as income immediately, depending on the nature of the grant.

• Under the TAS, grants related to non-depreciable assets such as land, shall be recognised as income over the same period over which the costs of meeting any underlying obligations are charged to income.

• AS 12 specifically provides that mere receipt of a grant is not necessarily conclusive evidence that conditions related to the grant will be fulfilled. Unlike AS 12, the TAS provides that the initial recognition of the grant cannot be postponed beyond the date of actual receipt.

Securities

• Unlike AS 13, the TAS covers securities held as stock–in-trade, but does not cover other securities.

• TAS provides that where an asset is acquired in exchange for another asset, shares or securities, its actual cost shall be the lower of the fair market value of the securities acquired or the assets/securities given up/issued. Unlike TAS, AS 13 requires that the actual cost in such cases shall be determined generally by reference to the fair market value of the consideration given.

• The TAS requires the comparison of cost and net realisable value for securities held as stock-in-trade to be assessed category-wise and not for each individual security. This may represent a significant change in practice for entities that currently do this comparison for each individual security.

• The TAS also provides that securities that are not quoted or are quoted irregularly shall be valued at cost. This could also represent a change in practice for some entities.

• Unlike AS 13 which allows the weighted average cost method for determination of cost for securities sold, TAS provides that the determination of such costs shall be made using the First in First Out method.

Borrowing costs

• Unlike AS 16, TAS requires capitalisation of borrowing costs for all covered assets irrespective of the period of construction. The only exception to this rule is for inventories, where the TAS requires capitalisation of borrowing costs to inventories that require more than 12 months to complete. In comparison, AS 16 defines a qualifying asset as an asset that necessarily takes a substantial period of time (generally understood as 12 months) to be ready for its intended use or sale. This could result in significant practical challenges to compute capitalisation of borrowing costs in all such cases. Under the TAS, the actual overall borrowing cost (other than borrowing costs on loans taken specifically for a qualifying asset) is allocated to qualifying asset (other than those funded through specific borrowings) based on the ratio of their average carrying value to the average total assets of the company. It should be noted that, while this allocation approach may be simple to apply, it may result in unintended consequences.

For example, assume that construction on a qualifying asset commences on 2nd April and the asset is put to use on 30th March of a previous year. Under the proposed approach, since the qualifying asset is not under construction either on the first day or the last day of the previous year, the average cost may be determined to be Nil. This could result in no allocation of borrowing costs to such an asset.

• Under TAS, in the case of loans borrowed specifically for acquisition of qualifying asset, capitalisation of borrowing costs commences from the date on which the funds are borrowed. Whereas under AS 16, capitalisation of borrowing cost commences only if all three conditions are satisfied (a) expenditure on qualifying asset is being incurred (b) borrowing costs are being incurred and (c) activities that are necessary to prepare the asset for its intended use or sale are in progress.

• Currently, there is inconsistency in treatment of income from temporary deployment of unutilised funds from specific loans (to be considered as an adjustment to borrowing costs incurred or considered as a separate income). The TAS now provides that in case of specific loans, any income from temporary deployment of unutilised funds shall be treated as income. Along with the provision relating to capitalisation of borrowing costs on specific loans even in period prior to the construction activity, this may have a significant impact on the practices currently followed.

• TAS requires capitalisation of borrowing costs even if the active development is interrupted. Under AS 16, the capitalisation of borrowing cost is suspended during extended periods in which active development is interrupted. However, this provision in the TAS seems to clarify the requirements that already exist in the Act.

Leases

• Under the TAS, the lessor would not be entitled to depreciation on assets that are given on finance lease. TAS now provides that assets covered by a finance lease shall be capitalised and depreciated by the lessee like any other owned asset. Presently, the Act permits depreciation only on those assets that are owned by the assessee. As such, for a finance lease arrangement, it is generally the lessor that is entitled to the depreciation deduction and the lease rentals are taxed as income in the hands of the lessor. Since the Act overrides the TAS, suitable amendments may be required to the Act to facilitate this provision of the TAS.

• Similarly, assets given on finance lease by the manufacturer lessor would be considered as sold by lessor with a corresponding recognition of revenues and profits. The finance income component of the lease rental would be recognised as income over the lease term.

• The consequential impact of the above changes under various other provisions such as Tax Deduction at Source and benefits under Double Taxation Avoidance Agreements would need to be considered prior to implementation of the TAS.

• Under the TAS, same lease classification shall be made by the lessor and lessee for the lease transaction. A joint confirmation to that extent will have to be executed in a timely manner, in the absence of which the lessee would not be entitled to a depreciation deduction on such assets. It is currently unclear on whether the lessor would be eligible for a depreciation deduction in such cases.

• AS 19 requires a lease to be classified as a finance lease, if there is a transfer of substantial risks and rewards relating to the ownership of the leased asset. AS 19 accordingly provides several indicators for finance lease classification that have to be considered in totality based on the substance of the arrangement. These indicators do not necessarily individually result in classification as a finance lease. However, the TAS considers the existence of any one of the specified indicators as sufficient evidence for finance lease classification. This may result in a change in lease classification as compared to current practice, with a greater number of lease arrangements meeting the finance lease classification criteria.

• Under the TAS, the definition of minimum lease payment does not include residual value guaranteed by any party other than the lessee. This is to ensure that there is a uniform lease classification. Whereas under AS 19, in case of a lessor, the definition of minimum lease payment (which affects the lease classification into operating or finance lease) includes residual value guaranteed by the lessee or any other party. However, in case of the lessee, the definition of minimum lease payment includes only the residual value guaranteed by the lessee. This difference may at times result in different lease classification for lessor and lessee under AS 19.

• Unlike AS 19 where initial direct costs incurred in negotiating and arranging a lease can be recognised upfront or over time, under TAS the upfront recognition of initial direct cost for the lessor is not permitted. Prior to TAS, in the absence of specific guidance under the Act, the tax treatment was in line with the requirements of the accounting standards.

Intangible assets

• TAS excludes goodwill from its scope, whereas AS 26 includes goodwill arising on acquisition of a group of assets that constitute a business (for example, slump sale). In the absence of specific provisions in the TAS, the current practice in this area (that has emerged based on judicial pronouncements) may prevail.

• For internally developed intangible assets, TAS does not provide any guidance on scenarios, where the development phase of a project cannot be distinguished from the research phase. Hence, the assessee would need to establish clearly whether the costs relate to the research phase or the development phase. Unlike TAS, AS 26 provides that in case the development phase of a project cannot be distinguished from the research phase, then the entire costs are recognised as part of research phase and consequently charged as expense.

• Under the TAS, development costs cannot be expensed merely on grounds of uncertainty around the commercial feasibility. If other criteria for capitalisation are met, the same should be capitalised. Unlike TAS, AS 26 requires companies to establish commercial feasibility of the project for determining capitalisation of development costs.

• Under the TAS, in the case of acquisition of an intangible asset in exchange for another asset, shares or other securities, the actual cost shall be the lower of the fair market value of the asset acquired or the fair value of the asset given up/securities issued. Unlike TAS, AS 26 provides that in such cases, the fair value of the asset/securities given up or fair value of the asset acquired, whichever is more clearly evident, should be recorded as actual cost.

Provisions, contingent liabilities and contingent assets

• AS 29 provides for recognising losses on onerous executory contracts, when the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it. TAS excludes all executory contracts, including onerous contracts, from its scope. Accordingly, such unavoidable future losses cannot be currently recognised under the TAS. This is consistent with the general provisions under the TAS, which preclude recognition of unrealised gains and losses.

• Under the TAS, provision is required to be recognised if its existence is reasonably certain. In comparison, AS 29 requires the recognition of a provision if its existence is considered probable (more likely than not). This change from ‘probable’ to ‘reasonably certain’ may result in new interpretation issues.

• Under AS 29, contingent assets are not recognised unless the virtual certainty criteria is met. This is a very high threshold and generally such assets are not recognised until realised. However, under TAS, contingent assets are recognised when it is reasonably certain that an inflow of economic benefits will arise. Thus, the provisions of the TAS may accelerate the recognition of contingent assets and related income. This provision seems to have been inserted to bring in parity between the treatment of provisions for contingencies and treatment of contingent assets.

Summary

The final report of the Committee along with the draft TAS, represents a significant move towards providing a uniform basis for computation of tax-able income. Many of the differences between the TAS and the AS are intended to harmonise the basis for computation of taxable profits with the existing provisions of the Act. Companies would therefore have a comprehensive framework based on which adjustments may be made each year to their accounting profits to determine taxable income.

Some of the provisions of the TAS also represent a significant change or clarification in the tax position as compared to currently prevailing practices. These are broadly intended to cover aspects that have historically been a subject matter of litigation and diversity. Depending on the practices currently followed, a company may be affected significantly by these changes.

The report also indicates that additional guidance would be provided through TAS where there is currently no guidance, including areas such as real estate accounting, service concessions, financial instruments, share based payments and exploration activities. This will further strengthen the TAS framework in the future.

The draft TAS will also remove one of the significant impediments to adoption of Ind AS, since the TAS provides an independent framework for computation of taxable income, regardless of the accounting framework adopted by companies (Indian GAAP or Ind AS). However, an important consideration for adoption of Ind AS is the impact it will have on computation of the Minimum Alternate Tax (MAT), which is based on the accounting profits. The Committee did not address this issue in its Final Report. The main reasons cited were the uncertainty around the implementation date for Ind AS as well as the forthcoming changes in IFRS. The Committee has recommended that transition to Ind AS should be closely monitored and appropriate amendments relating to MAT should be considered in the future based on these developments.

The real benefit of providing a uniform framework for computing taxable income will only be achieved through a uniform and impartial implementation of TAS by the tax authorities and the judiciary. The tax authorities may consider issuance of internal implementation guidelines and training to ensure that the TAS are correctly applied and implemented at the field level.

Nirav Shah

Determination of Control- Now a Critical Judgement Area under IFRS

IFRS 10 – Consolidated Financial Statements is effective for annual periods beginning on or after 1st January 2013. It builds on the control guidance that existed in IAS 27 and SIC 12 and adds additional context, explanations and application guidance that is consistent with the definition of control. IFRS 10 applies a single control model to determine whether an investee should be consolidated. De-facto control is explicitly included in the model.

IFRS 10 states that ‘an investor controls an investee when it is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee’. IFRS 10 requires an investor to assess whether it has power over the relevant activities of the investee. Only substantive rights of the investor are relevant for this purpose and voting and other rights needs to be considered for this assessment. There are additional considerations for assessment of power in the instance of the investor holding less than a majority of the voting rights.

De-facto control is one such consideration. De-facto control is said to exist when an investor’s current voting rights may be sufficient to give it power even though it has less than half of the voting rights. Assessing whether an investor has de-facto control over an investee is a two-step process:

• In the first step, the investor considers all facts and circumstances including the size of its holding of voting rights relative to the size and dispersion of the holdings of other vote holders. Even without potential voting rights or other contractual rights, when the investor holds significantly more voting rights than any other vote holder or organised group of vote holders, this may be sufficient evidence ofpower. In other situations, these factors may provide sufficient evidence that the investor does not have power – e.g. when there is a concentration of other voting interests among a small group of vote holders. In some cases, these factors may not be conclusive and the investor needs to proceed to the second step

• In the second step, the investor considers whether the other shareholders are passive in nature as demonstrated by voting patterns at previous shareholders’ meetings. The investor also considers the factors normally used to assess power when the investee is controlled by rights other than voting rights.

An investor with less than a majority of the voting rights has rights that are sufficient to give it power when the investor has the practical ability to direct the relevant activities unilaterally. When assessing whether an investor’s voting rights are sufficient to give it power, an investor considers all facts and circumstances, including:

a) the size of the investor’s holding of voting rights relative to the size and dispersion of holdings of the other vote holders, noting that:

• the more voting rights an investor holds, the more likely the investor is to have existing rights that give it the current ability to direct the relevant activities;

• the more voting rights an investor holds relative to other vote holders, the more likely the investor is to have existing rights that give it the current ability to direct the relevant activities;

• the more parties that would need to act together to outvote the investor, the more likely the investor is to have existing rights that give it the current ability to direct the relevant activities;

b) potential voting rights held by the investor, other vote holders or other parties

c) rights arising from other contractual arrangements; and

d) any additional facts and circumstances that indicate the investor has, or does not have, the current ability to direct the relevant activities at the time that decisions need to be made, including voting patterns at previous shareholders’ meetings.

When the direction of relevant activities is determined by majority vote and an investor holds significantly more voting rights than any other vote holder or organised group of vote holders, and the other shareholdings are widely dispersed, it may be clear, after considering the factors listed above, that the investor has power over the investee.

Determining whether an investor has de-facto control over an investee is usually highly judgmental: it includes determining the point at which an investor’s shareholding in an investee is sufficient and the point at which other shareholdings’ interests are sufficiently dispersed. It would also be difficult for a dominant shareholder to know whether a voting agreement amongst other shareholders exists.

Applying the above principles poses various challenges. There may be situations in which the dominant shareholder does not know whether arrangements exist among other shareholders, or whether it is easy for other shareholders to consult with each other. The investor should have processes in place to allow it to capture publicly available information about other shareholder concentrations and agreements.

The smaller the size of the investor’s holding of voting rights and the less the dispersion of the holding of other vote holders, the more reliance is placed on the additional factors in Step 2 of the analysis; within these, a greater weighting is placed on the evidence of power.

The ‘voting patterns at previous shareholders’ meetings’ requires consideration of the number of shareholders that typically come to the meetings to vote (i.e. the usual quorum in shareholders’ meetings) and not how the other shareholders vote (i.e. whether they usually vote the same way as the investor). However, how far back should one look for assessing the past trend is a question of judgment. Also, for start-up companies this will particularly be a challenge.

Determining the date on which an investor has de-facto control over an investee may in practice be a challenging issue. In some situations, it may lead to a conclusion that control is obtained at some point after the initial acquisition of voting interests. At the date that an investor initially acquires less than a majority of voting rights in an investee, the investor may assess that it does not have de-facto control over the investee if it does not know how other shareholders are likely to behave. As time passes, the investor obtains more information about other shareholders, gains experience from shareholders’ meetings and may ultimately assess that it does have de-facto control over the investee. Determining the point at which this happens may require significant judgment.

In the backdrop of companies getting capital infusion from private equity investors the assessment of de-facto control will be very challenging. While the investors may not have majority voting rights, they do obtain various rights that include appointment of key managerial personnel, guaranteed return on their investments, right to approve the annual operating plans/ budgets, etc. Such cases will need to be closely looked into for determining whether the investor has a de-facto control on the investee.

Let us consider an example: Company A acquired 45% in Company B (which is a listed company and balance shareholding is widely dispersed). Company B has 6 directors who are appointed by shareholders in their general meeting based on simple majority. Whether Company A needs to consolidate Company B as a subsidiary.

Analysis under AS-21 under Indian GAAP: Under Indian GAAP an investor consolidates the investee company only if it ‘controls’ the investee. Control is defined as

(a) the ownership, directly or indirectly through subsidiary(ies), of more than one-half of the voting power of an enterprise; or

(b) control of the composition of the board of directors in the case of a company or of the composition of the corresponding governing body in case of any other enterprise so as to obtain economic benefits from its activities.

Based on the aforesaid definition of control, in this example Company A does not have control of Company B (either majority voting power or control composition of Board), thus it cannot consolidate Company B as a subsidiary.

Analysis under IFRS: Under IFRS 10, Company A will need to determine whether it has control over Company B. As discussed earlier, the control definition under IFRS is wider and includes de-facto control as well. In the instant case, Company A is the largest shareholder of Company B and it is given that the balance shareholding is widely dispersed. Company A will need to evaluate the following:

(a) Number of shareholders that own the next 45 % shareholding: The higher the number, the greater are the chances that Company A will need to consolidate Company B, for example if the next 45% is held by around 5 shareholders it will be difficult to demonstrate de-facto control as 5 shareholders can get together and vote against Company A. However if the next 45% shareholding is owned by 1,000 shareholders (widely dispersed public shareholding), it can be demonstrated that Company A in effect would control the functioning of Company B as the probability of 1,000 shareholders coming together and vote against Company A will be remote.

(b) History of voting in the past general meetings: Company A will need to evaluate the number of shareholders actively attending the general meetings and participating in the decisions of shareholders. It is important to assess the number of shareholders that attend general meetings and not how they vote. Thus, in case past history reflects that all 100% shareholders attend the general meeting and cast their votes it may be difficult to demonstrate de-facto control, no matter that the balance shareholders voted for decisions in favour of Company A. However, if the total number of shareholders casting their votes in the general meeting are always less than 80%, then it can be demonstrated that de-facto control exists, since Company A has more than 50% voting power of effective votes cast in the general meetings.

(c) Rights of other shareholders: Before concluding whether Company has de-facto control of Company B, it will need to be assessed in any special rights are available to other shareholders or shareholder groups such as their consent is required prior to approving annual business plan or appointment and removal of key managerial personnel. Presence of such rights will impact the ability of Company A to consolidate Company B as a subsidiary.

After considering the above factors, under IFRS Company A may need to consolidate Company B as a subsidiary though it only holds 45% of the voting power in Company B. Under the earlier consolidation standard under IFRS IAS 27- application of de-facto control approach was an accounting policy choice, however under IFRS 10, consideration of de -facto control is mandatory for assessing control.

The requirement to assess control is continuous. De-facto control relies, at least in part, on the actions or inactions of other investors. Therefore, the requirement to assess control on a continuous basis may mean that the investor who is assessing whether it has de-facto control may need to have processes in place that allow it to consider who the other investors are, what their interests are and what actions they may or may not take with respect to the investee on an ongoing basis.

This is an important change for companies, as currently under Indian GAAP, consolidation is more rule driven based on the definition of control under AS -21. Under IFRS 10, companies will need to closely monitor aforesaid factors on a regular basis to determine control over entities and preparation of its consolidated financial statements.

Nirav Shah

IFRS Exposure Draft on Leases – Sectoral Impact

The
International Accounting Standards Board (IASB) and the U.S. Financial
Accounting Standards Board (FASB) released a joint revised exposure draft on
lease accounting on 16th May 2013 (the ED). This ED proposes fundamental
changes to lease accounting which would bring most leases on the balance sheet
for lessees. Recognising leases on the balance sheet is a long stated goal of
the standard setters. These proposals would achieve that goal.

In addition to recognising most leases on the balance sheet for lessees, the
proposals would also introduce new lease classification tests resulting in a
‘dual model’ for both lessees and lessors. This would preserve straight-line
expense recognition for most leases of property, i.e. land and/or buildings,
similar to operating leases today. However, there would be recognition of
interest and amortisation expense for most other leases, similar to finance
leases today – i.e. lease expense would not be recognised on a straight-line
basis.

The previous article of this series discussed the proposals of the ED in
detail. To recap, the significant changes introduced by the ED include the
following:

• The biggest change proposed is the introduction of dual lease accounting
models – and a new lease classification test to assess whether a lease is a
Type A lease or a Type B lease. This does away with the concept of operating
and finance leases. The classification criteria would be based on the nature of
the underlying asset and the extent to which the asset is consumed over the
lease term.

The proposed lease classification tests are fundamentally different from the
current ‘risks and rewards’ approach in IAS 17. Also, they perform a different
role, for example, for lessees, the outcome of the classification tests would
no longer determine whether a lease is recognised on the balance sheet, but
instead, would affect the profile of lease expense recognised over the lease
term.

• The ED proposes to bring on the balance sheet of the lessee, a lease
liability and a right-to-use (ROU) asset for both Type A and Type B leases.
Lease expenses in a type A lease comprise of amortisation of the ROU asset and
interest accretion to lease liability (a finance expense). The lease expense
would be front loaded over the lease term. Whereas, the lease expense will be
straight lined over the lease term in the case of Type B with both the components
i.e amortisation and accretion to lease liability to be presented as an
operating expense.

• The ED now proposes to include within its ambit the concept contained in
IFRIC 4 Determining whether an arrangement contains a lease. A lease would
exist when both of the following conditions are met: fulfillment of a contract
depends on the use of an identifiable asset; and the contract conveys the right
to control the use of the identifiable asset for a period of time in exchange
for consideration. While at the first glance, the proposal appears to be
similar to IFRIC 4, there are examples and clarifications in the ED with regard
to the portion of assets, control, direction to use, derivation of benefits and
substitution of assets which may lead to different conclusions about whether or
not a lease exists.

• The ED requires a reassessment of the lease payment and consequently a
computation of the new carrying value for its lease liability when there is a
change in assessment of lease term, economic incentive to exercise purchase
option, residual value guarantees and an index or rate used to determine lease
payments during the reporting period.

• The ED introduces new requirements from the lessor perspective as well. A
concept of ‘residual asset’, representing the interest of the lessor in the
underlying asset at the end of the lease term, has been introduced. The lessor
recognises a lease receivable for Type A leases by de-recognising the
underlying asset. There are specific rules around computation and recognition
of profit/loss on such de-recognition.

The above propositions will have far reaching impacts not only on the
accounting policies of companies, but also on their business strategies,
processes and systems. Significant impact will be felt on account of the
additional effort involved in reviewing and identifying lease arrangements and
extracting lease data, new requirements for estimation and judgment, balance
sheet volatility on account of reassessment, and communication of the changes
in lease accounting to the stakeholders. The foremost financial impact across
sectors will be the recording of new asset and liability which will impact the
key financial metrics such as financial ratios, debt covenants, etc. A summary
that highlights the key impact that the ED may have on certain specific sectors
is given below:

Aviation:

The airline operators deploy aircrafts taken on operating and finance leases.
The ED will require recognition of most of the operating leases on the balance
sheet. Considering the high value of the underlying asset, this will
significantly impact the debt to be recorded on balance sheet. The p r o p o s
a l will also impact the income statement profile for many leases, accelerating
e x p e n s e recognition compared to current operating lease treatment.

Example –
Company A enters into a 4-year lease contract for an aircraft which has a
total economic life of 20 years. The lease does not contain any renewal,
purchase, or termination options. The lease payments of Rs. 2,000,000 per year
are made at the end of the period, their present value is calculated at Rs.
6,339,731 using a discount rate of 10%. The fair value of the aircraft is Rs.
35,000,000 at the date of inception of the lease.

This lease would be classified as a Type A lease since it is not property and
the lease term is considered more than an insignificant part of the total
economic life (20%) and the present value of lease payments is more than
insignificant relative to the fair value of the aircraft (18%).

This lease would have been classified as an operating lease under the existing
principles of IAS 17, and Rs. 2,000,000 would be the annual lease cost to be
accounted by the airline operator. However, the Type A classification will lead
to much different accounting under the ED proposals.

The lessee would recognise a lease liability and a ROU asset of Rs. 6,339,731. In year 1, the amortisation expense would be Rs. 1,584,933 (6,339,731/4) and interest expense of Rs. 633,973 (6,339,731*10%). In year 2, the amortisation expense would be Rs. 1,584,933 and interest expense of Rs. 497,370 [(6,339,731+633,973-2,000,000)*10%]. The cash outflow of Rs. 2,000,000 will be reduced from the lease liability. Thus, under the Type A model, the lessee would see a front loading of the lease expense.

Generally, lease payments for aircrafts are denominated in USD or EUR considering the concentration of suppliers of aircraft in the countries with USD and EUR as the functional currency. The requirement of reassessment of lease liability will significantly impact the reporting entities which do not have USD or EUR as their functional currency. The foreign currency lease liability recorded on Type A leases (erstwhile operating leases) will need to be restated and the effect taken to profit and loss account. This will have a significant impact on Indian companies, given the depreciation of the Indian Rupee.

The new judgments to be made with regard to classification of leases with regard to ‘insignificant’ portion of the economic useful life of the asset and present value of lease payment in relation to the fair value of the asset may risk different interpretations. This is further complicated with the existence of second-hand aircrafts in the market.

The ED does not discuss whether a lessee should identify components of the ROU asset as would be required for an item of property, plant and equipment. If the componentisation principles are to be applied to the aircrafts, there will be additional efforts involved.

Infrastructure:

While at first glance the proposals of the ED appear similar to that contained in IFRIC 4, different conclusions may be reached in the assessment of whether an arrangement contains a lease. For e.g. some power purchase agreements that are identified as leases under IFRIC 4 may not be leases under these proposals. This is because ED’s approach to control has a greater focus on the purchasers’ ability to direct the use of the underlying asset than IFRIC 4. Accordingly, an agreement under which an entity agrees to purchase all of the electricity from a power plant but does not control the operations of the power plant might be a lease under IFRIC 4 but not under ED.

Retail

One of the critical success factors of the companies in this industry is to have retail spaces throughout the country to increase the customer reach. In India many retail companies enter into long term lease arrangements (3-9 years) to ensure business continu-ity. This could have a significant impact on the balance sheets of retail companies ie., grossing up of asset and liability and in turn may impact debt covenants and ability to raise more funds

The following example illustrates the impact as discussed above:

Consider a property lease under which a retailer and landlord enter into a lease of a retail premise for a 5-year period. Assume that the lease payments are Rs. 4,120 per year (paid in arrears) and the discount rate is 4.12%. The lease agreement does not contain a renewal or purchase option.

Under the EDs’ proposed lease classification tests, this lease would be classified as a Type B lease by both Lessee and Lessor. This is because the asset is property (property is defined as land or a building, or part of a building, or both), the lease term is for less than a major part of the economic life of the underlying asset, the present value of the lease payments is less than substantially all of the fair value of the underlying asset, and the lease does not contain a purchase option.

Lessee would recognize a ROU asset and a lease liability for its obligation to make future lease payments. Lessee would initially measure the lease liability and ROU asset at the present value of Rs. 4,120 per year over 5 years discounted at 4.12% (Rs. 18, 280). The following table summarises the amounts arising in lessee’s balance sheet and profit and loss account.

It is important to note that amortization and interest would be combined as a single lease expense in the profit and loss account.

In this example, the ROU asset would be amortized each period by the straight-line lease expense amount minus interest on the lease liability for the period.

In this simple fact pattern, the ROU asset would equal the lease liability throughout the lease term because the lease payments are constant through-out the lease term. If a lease contains variable lease payments that are based on an index or rate, rent escalations, or a rent-free period, then the calculation of the amortization of the ROU asset each period increases in complexity and the ROU asset will not equal the lease liability after lease commencement.

Certain retail companies have arrangements for sub-contracting warehousing, distribution and re-packaging of goods on an exclusive basis. These arrangements mostly qualify as lease arrangements following the guidance in IFRIC 4 and particularly because of the complete off-take of the services/goods from the sub-contractor by the retailer. Considering the proposals of ED, such arrangements may not qualify as a lease because the retailer may not have ability to direct the use of the underlying assets as envisaged in the ED.

Banking and leasing businesses

The new proposal, for a lessor, will result in the de-recognition of underlying assets given on operating lease by leasing companies and recognition of residual asset and lease receivable, representing the interest of the lessor in the underlying asset at the end of the lease term. The new principles of computation and recognition of profit on commencement of leases will need to be applied. There will also be a significant change in the profile of lease income to be recognised. Further, the lease income will now have a component of finance income (being accretion of interest on residual asset and lease receivable). This will significantly impact the EBITDA of companies. Application of the principles of the proposal in practice will pose a significant challenge with IT systems as well.

While it is not yet known how convergence with IFRS in India interplay with the RBI’s capital adequacy framework, a key consideration of the new proposal’s impact on the financial services sector is likely to be in the area of regulatory supervision. As all leases would be brought onto the balance sheet in a grossed-up manner, the increase in liabilities could have significant adverse implications on the capital adequacy requirement, thereby reducing the amount of capital available for business.

Lending entities would need to determine the impact on debt covenants of their clients, as service coverage and leverage ratios as well as net worth calculations may be affected. It will also affect their own decisions of whether to lease or purchase assets, as well as the same decisions made by clients to whom they provide lease financing.

While the ED proposes significant changes, the local tax and regulatory regulations may or may not factor in the principles specified in the ED proposals. This will possibly result in different accounting policies being followed for tax computations. All the proposals in the ED will have a consequential impact on the deferred taxes to be recognised.

The proposals of the ED are complex and create a far reaching fundamental difference from the existing principles. While accounting professionals are getting their arms around the proposals, it will be a significant challenge to educate the users of the financial statements in terms of communicating the change in accounting policies and explaining the volatility and complexities that it brings from both an operational, as well as financial standpoint.

Given that India has not yet converged with IFRS, it will be important to watch out for the position that standard setters and regulators take in India for implementation of the new leases standard (i.e., will Ind AS be based on the old lease principles of IAS 17 or the new standard that may be issued pursuant to the ED).

Nirav Shah

Day one fair valuation of financial instruments

This article
illustrates the accounting implications of day one fair valuation of assets and
liabilities on initial recognition and its subsequent measurement. When a
financial asset or financial liability is recognised initially in the balance
sheet, the asset or liability is measured at fair value (plus transaction costs
in some cases). Fair value is the amount for which an asset could be exchanged,
or a liability settled, between knowledgeable, willing parties in an
arm’s-length transaction.

In other words, fair value is an actual or estimated transaction price on the
reporting date for a transaction taking place between unrelated parties that
have adequate information about the asset or liability being measured.

The following are certain transactions where fair value on initial recognition
may be different than their transacted amounts.

1. Low-interest or interest-free loans Where a loan or a receivable is
transacted at market interest rates the fair value of the loan will equal the
transaction value. If a loan or a receivable is not based upon market terms,
then it is accounted for in accordance with IAS 39 which states that “the fair
value of a long-term loan or receivable that carries no interest can be
estimated as the present value of all future cash receipts discounted using the
prevailing market rate(s) of interest for a similar instrument (similar as to
currency, term, type of interest rate and other factors) with a similar credit
rating. Any additional amount lent is an expense or a reduction of income
unless it qualifies for recognition as some other type of asset.” In assessing
whether the interest charged on a loan is below market rates, consideration
should be given to the following factors:

Credit worthiness of the
counter-party
The terms and conditions of the
loan including whether there is any security
Local industry practice
Local market circumstances.

In particular, the entity would
consider the interest rates currently charged by the entity or by others for
loans with similar maturities, cash flow patterns, currency, credit risk,
collateral and interest basis.

Initial recognition

A. Repayable on demand: A loan repayable on demand is not required to be
discounted, as the fair value of the cash flows associated with the loan is the
face value of the loan (due to it being repayable on demand).

B. Repayable with fixed maturity: The fair value of the interest-free loan is
the present value of all future cash flows discounted using the market-related
rate over the term of the loan. The rate used to discount an interest-free loan
is the prevailing market interest rate of a similar loan. Any difference
between the cost and the fair value of the instrument upon initial recognition
is recognised as a gain or a loss, unless it qualifies to be recognised as an
asset or liability. Subsequent measurement If the loan is classified by the
lender as a ‘loan and receivable’, the loan is measured at amortised cost using
the effective interest rate method. The fair value of the loan will increase
over the term to the ultimate maturity amount. This accretion will be
recognised in the income statement as interest income.

For the borrower that measures the financial liability at amortised cost,
the liability will increase over the life of the loan to the ultimate maturity
amount. This accretion in the liability will be recognised in the income
statement as interest expense. Illustration — Nil interest loan between common
control parties When low-interest or interest-free loans are granted to
subsidiaries, in the separate financial statements of the investor, the
discount should be recognised as an additional investment in the subsidiary. In
the separate financial statements of the investee, the effect would be given in
the shareholders’ equity.

Illustrative examples

Assume the face value of the loan is Rs.100,000 and the fair value of the loan
is Rs.80,000 at the initial recognition date.

Case 1: Parent grants interest-free loan to the subsidiary

Case 2: Subsidiary grants an interest-free loan to its parent

Case3: Subsidiary grants an interest-free loan to another fellow subsidiary

Note: Deferred tax entries have been ignored

Accounting entries in the books of the

Parent in Case 3

Dr.

Cr.

Deemed Investment in
borrowing subsidiary

To deemed dividend
income from lending

subsidiary

(20)

2. Low-interest or interest-free loans to employees

Loans given to employees at lower than market interest rates generally are
short-term employee benefits. Loans granted to employees are financial
instruments within the scope of IAS 39 Financial Instruments. Therefore,
low-interest loans to employees should be measured at the present value of the
anticipated future cash flows discounted using a market interest rate. Any
difference between the fair value of the loan and the amount advanced is an
employee benefit. If the favourable loan terms are not dependent on continued
employment, then there should be a rebuttable presumption that the interest
benefit relates to past services, and the cost should be recognised in profit
or loss immediately. If the benefit relates to services to be rendered in
future periods (e.g., if the interest benefit will be forfeited if the employee
leaves, or is a bonus for future services), then the amount of the discount may
be treated as a prepayment and expensed in the period in which the services are
rendered. If the services will be rendered more than 12 months into the future,
then the entire benefit is a long-term benefit.

The above accounting treatment would not hold good if the loans are repayable on demand. This is because in absence of a fixed tenure and the feature of repayable on demand, the fair value of the loan would correspond with the amount of the loan.

3. Interest-free security/lease deposits

Initial recognition

In case of the provider of the deposit, the deposit should be recognised at fair value. The difference between the fair value and transaction amount would be considered as a prepaid rent under IAS 17 for the provider.

Subsequent measurement
The loan is classified by the provider of the deposit as a ‘loan and receivable’; the loan is measured at amortised cost using the effective interest rate method. The fair value of the deposit will increase over the term to the ultimate maturity amount. This accretion will be recognised in the income statement as interest income and prepaid rent will be amortised on a straight-line basis as rent expense under the principles enunciated in IAS 17.

For the receiver of the deposit, the deposit shall be classified as a financial liability at amortised cost; the liability will increase over the life of the loan to the ultimate maturity amount. This accretion in the liability will be recognised in the income statement as interest expense and advance rent received will be amortised on a straight-line basis as rent income. The amortisation would be similar to the prepaid salary as illustrated above.

Illustration

Assume Rs.1,000,000 lease deposit has been given — interest-free for a term of 5 years. Assuming market rate of borrowing is 10% for the lessee and market rate for investments is also 10% for the lessor. The fair value on the first day of the lease would be Rs.620,931 (i.e., fair value as discounted).

The accounting would be as follows:

Accounting
entries

Dr.

Cr.

In
the books of entity

giving
the deposit

Transaction
date —

Initial
recognition of

deposit
at fair value

and
difference treated

as
prepayment

Lease deposit receivable

620,921

Prepaid rent

379,079

To bank

1,000,000

End
of first period —

1. Accretion of interest

on
deposit using

original
discount rate

Lease deposit receivable

62,092

To Interest income on

deposit

62,092

Accounting
entries

Dr.

Cr.

2. Amortisation
of

notional
prepaid rent

Rent expense

(i.e., 379079/5 years)

75,816

To prepaid rent

75,816

In
the books of entity

receiving
the deposit

Bank

1,000,000

To lease deposit payable

620,921

To rent received in advance

379,079

End
of first period —

1. Accretion of interest on

deposit
using original

discount
rate

Interest expense on

deposit

62,092

To lease deposit payable

62,092

2. Recording
additional

notional
rental income

Rent received in advance

75,816

To rent income

75,816

The aforesaid accounting principles would not apply if the lease is a cancellable lease, since then the security deposit would be repayable on demand and as explained above would need to be accounted at the transaction value.

Nirav Shah

Ind AS 40 – Investment Property

Background

Current Indian GAAP provides limited guidance on accounting for investment properties under AS 13 Accounting for Investments. In order to converge the Indian Accounting Standards (Ind AS) with those under the International Financial Reporting Standards (IFRS), Ind AS 40 has been issued. Ind AS 40 will become applicable as and when Ind AS are notified.

Scope and definitions

Ind AS 40 provides guidance with respect to recognition, measurement and disclosure of investment property. It also provides detailed guidance on transfer to/from and disposals of investment property. Ind AS 40 specifically excludes below mentioned assets from its scope, as the relevant guidance relating to these assets is covered under other accounting standards:

• Biological assets (Ind AS 41 – Agriculture)

• Mineral rights and mineral reserves such as oil, natural gas and similar non-regenerative resources. This standard could be applied to measurement in lessee’s or lessor’s financial statements depending on certain specified conditions.

But Ind AS 40 does not deal with matters covered under Ind AS 17 – Leases like classification of leases, recognition of lease income, accounting for sale and leaseback transactions etc. Definitions Investment property is property (land or a building— or part of a building—or both) held (by the owner or by the lessee under a finance lease) to earn rentals or for capital appreciation or both, rather than for:

(a) use in the production or supply of goods or services or for administrative purposes; or

(b) sale in the ordinary course of business. Thus the classification depends on the use of the property. Owner-occupied property is property held (by the owner or by the lessee under a finance lease) for use in the production or supply of goods or services or for administrative purposes. Recognition Investment property is recognised as an asset only when both the following conditions are met:

• It is probable that the future economic benefits that are associated with the investment property will flow to the entity; and

• the cost of the investment property can be measured reliably. The above criteria are applied to all properties irrespective of whether the costs are incurred towards the property in the initial phase or subsequent phases. Measurement Initial measurement An investment property shall be measured initially at cost. Transaction costs which are directly attributable for preparing the asset for its intended use will form part of its initial cost. For example, property taxes, legal fees etc.

The principles are same as would be applied to determine the cost of asset under Ind AS 16 Property, Plant and Equipment (PPE). Maintaining consistency with Ind AS 16, abnormal amounts of inefficiencies incurred and initial operating losses incurred will not form part of the cost of the asset and will be expensed off as incurred. In case of acquisition of investment property on deferred payment terms, the investment property would be recognised, based on its current cash price equivalent. The difference between the current cash price equivalent and the deferred payment terms would be recognised as finance cost over the term of the deferred payment term.

Borrowing costs directly attributable to the acquisition, construction or development of an investment property that is a qualifying asset shall be capitalised in accordance with Ind AS 23 Borrowing Costs. The initial cost of a property interest held under a lease and classified as an investment property shall be as prescribed for a finance lease under paragraph 20 of Ind AS 17, i.e., the asset shall be recognised at the lower of the fair value of the property and the present value of the minimum lease payments. An equivalent amount shall be recognised as a liability as prescribed under Ind AS 17.

Subsequent measurement

Unlike IAS 40 which permits both cost and fair value model after initial recognition, Ind AS 40 does not provide such an accounting policy choice after initial recognition under Ind AS 40. Ind AS 40 permits application of only the cost model.

The cost model is similar to that prescribed under Ind AS 16 for Property, Plant and Equipment i.e. at cost less accumulated depreciation less accumulated impairment losses. Only if the asset is classified as held for sale, the same would be valued in accordance with Ind AS 105 Non-current Assets Held for Sale and Discontinued Operations i.e. at fair value. While initial recognition and subsequent measurement is at cost, an entity is required to disclose the fair value of the investment property.

Fair value determination

Fair value is the price at which the investment property could be exchanged between knowledgeable, willing parties in an arm’s length transaction. It should reflect the market conditions at the end of the reporting period and does not consider any transaction costs it may incur on sale or disposal. It also does not reflect future capital expenditure that will improve or enhance the value of the property.

It is best evidenced by current prices in an active market for similar properties in the same location and subject to similar terms of the contract. If information pertaining to similar term contracts is not available, then the value of such properties should be adjusted to reflect the differences in the contracts.

Transfers

Although an entity’s business model plays a key role in the initial classification of property, the subsequent reclassification of property is based on an actual change in use rather than on changes in an entity’s intentions. Transfers to and from investment property can be made only when there is change in use which has to be evidenced by:

• commencement of owner-occupation, for a transfer from investment property to owner-occupied property;

• commencement of development with a view to sell, for a transfer from investment property to inventories;

• end of owner-occupation, for a transfer from owner-occupied property to investment property; or

• commencement of an operating lease to another party, for a transfer from inventories to investment property.

As such, the subsequent reclassification is based on actual change in use and not just the intentions of the entity.

For example, Company S owns a site that is an investment property. S decides to modernise the site and sell it. The investment property is transferred to inventory at the date of commencement of the redevelopment of the site that evidences the change in use. However, a decision to dispose of an investment property without redevelopment does not result in it being reclassified as inventory. The property continues to be classified as investment property until the time of disposal unless it is classified as held for sale.
Let us take another example where Company G which previously classified a property as an investment property has now decided to use the property as its administrative headquarters due to an expansion of its business, and commences redevelopment for own use in February 2013 (e.g. builders are on site carrying out the construction work on G’s behalf). In this case, the redevelopment of the property for future use for administrative purposes effectively constitutes owner occupation. Therefore, G should reclassify the property to owner occupied property on commencement of the redevelopment in February 2013.

Transfers between investment property, owner-occupied property and inventories do not change the carrying amount of the property transferred and they do not change the cost of that property for measurement or disclosure purposes. In other words, transfers happen at the carrying amount. For example, if an investment property of Rs. 100,000 depreciated @ 10% SLM is transferred to inventory at the end of 3 years, the same will be transferred to inventory at Rs. 70,000 i.e., the carrying amount of investment property at the end of 3 years.

Disposals
The investment property shall be derecognised i.e. eliminated from the financial statements on disposal, providing an asset under finance lease or when it is permanently withdrawn from use and no future economic benefits are expected from its disposal. The criteria and guidance given in Ind AS 18 Revenue would be applied to determine the date of disposal, whereas Ind AS 17 would be applied in case the disposal is by way of finance lease or sale and leaseback.

Gains or losses resulting from difference in net sales proceeds and the carrying value of investment property will be recognised in profit or loss in the period in which the property is disposed or retired. In case the sales proceeds are deferred, the consideration receivable will have to be discounted to its present value and the difference would be recognised as finance income over the period of credit.

Practical issues

Classification issues
Determining what is or what is not investment property may raise practical issues, some examples of which are given below:

Subsequent cost
Subsequent costs of day-to-day servicing and maintaining a property are expensed as incurred and cannot be capitalised. But where statutory/fregulatory approvals are required to be obtained and any expenses incurred during the period required to get such approvals shall be capitalised as the property cannot be put to intended use till such time that the approvals are obtained.

Equipments and furnishings
Equipments and furniture and fittings that are physically attached to the building will be considered as integral part of the building and will not be accounted for separately. For example, lifts, escalators, air conditioning units etc., will all be considered as part of investment property. In case of movable property, the same would get accounted separately as PPE in accordance with Ind AS 16. In such cases, care must be taken while disclosing the fair value of the investment property, so that it does not include the fair value of moveable property that has been accounted for separately, otherwise it will be misleading.

Inventory vs. Investment Property
The entity’s intention regarding the property is a primary criteria for classification. Property held for short-term sale would be classified as inventory whereas the one held for long-term purposes would generally get classified under investment property. For example, if a builder acquires bare land with intention to construct buildings and sell them, the land would be classified as inventory because it is an asset held in the process of production for sale. However, if the company has brought land with no specific use in mind, then it gets classified as investment property. (Eg: Financial institution acquires a property as full and final settlement of loan given and is uncertain about its intention). In case a developer of the property holds a completed developed property and intends to rent the same, he could classify the same as investment property instead of classifying it as inventory.

Consolidated and separate financial statements
A property may also get classified differently in consolidated and separate financial statements of an entity. For example, when a holding company leases building to its subsidiary which uses the same as its administrative office, the property could be classified as investment property in the books of the holding company but would be classified as PPE in the Consolidated Financial Statements (CFS).

Dual-use property
Wherein a property could be used for dual purposes, say for own use and other for renting out, a portion of dual property can be classified as investment property, only if the portion could be sold separately. When a portion of the property can not be sold separately, the entire property is classified as investment property only if the portion of the property held for own use is insignificant. For example, Company X owns an office block and uses 3 floors as its own office; the remaining 12 floors are leased out to tenants on operating lease. Under the local laws, X could sell legal title to the 12 floors, while retaining legal title to the other 3 floors. In this case, the 12 floors would be classified as investment property.

Ancillary services
In case where the owner of the property provides ancillary services, the key factor in determining whether the same should be classified as investment property is its relative insignificance to the entire arrangement.

But in case of hotels, ancillary services would be considered as significant part and an owner-managed hotel would be regarded as owner-occupied property instead of investment property, as the property is used to a significant extent for the supply of goods and services. In case where the owner of the hotel is just a passive investor and the management function and provision of services is carried out by a third party and the owner is not exposed to variations in cash flow from the operations of the hotel, the same will be treated as investment property. As such, judgment is required in determining the classification of the property in case of different scenarios. An entity should assess on a case-to-case basis whether the arrangement is more like an example of owner-managed hotel (not investment property) or an example of office building with security services provided by the owner (investment property).

Even in case of classification of business centres, some of them which provide high level services such as secretarial support, teleconferencing and other computer facilities and where tenants sign relatively short term leases, the facilities provided are more in the nature of owner-managed hotel and hence should not be classified as investment property. In other cases where the owner provides just the basic furnishing and users are required to sign up for a minimum period, the same could be treated as investment property.

Disclosures
An entity is required to disclose the following:
•   accounting policy for measurement.
•   when classification is difficult, the criteria it uses to distinguish investment property from owner-occupied property and from property held for sale in the ordinary course of business.
•   the methods and significant assumptions applied in determining the fair value of investment property.
•   the extent to which FV is based on valuation by professional independent valuer; if not, such fact should be disclosed.
•   amounts recognised in profit or loss for rental income, direct operating expenses that generated as well as those that did not generate rental income.
•   the existence and amounts of restrictions on the realisability of investment property or the remittance of income and proceeds of disposal.
•   contractual obligations to purchase, construct or develop investment property or for repairs, maintenance or enhancements.
•   Depreciation method and useful life or rate of depreciation.
•   Gross carrying amount and accumulated depreciation at beginning and end of reporting period.
•   Reconciliation of carrying amount of investment property at the beginning and end of the period.
•   Impairment losses recognised or reversed.
•   Exchange differences.
•   Transfers to and from inventories and owner-occupied property.
•   Assets classified as held for sale.
•   Other changes.

Conclusion
This accounting standard prescribes accounting for investment property and the related disclosure requirements. It gives detailed guidance on the classification, recognition and measurement of investment properties. The guidance requires the measurement of the investment property using the cost model similar to measurement of PPE under Ind AS 16. It also gives guidance on transfers to and from investment property and states that these can be made only when there has been a change in the use of the property.

Judgment would be required on case to case basis to classify the property as investment property especially in cases of ancillary use or dual-use of the property.

Nirav Shah

Proposed Accounting for Leases – Will it Impact Business Operating Models?

On 16th May 2013, the IASB issued an exposure draft (ED) on Leases. This is the second exposure draft issued after much internal and external deliberation by the IASB.

The leases project is one of the joint projects between the FASB and IASB which has been a focus area for the boards. The ED proposes fundamental changes to the existing lease accounting and is aimed to bring most leases on balance sheet for lessees. The first exposure draft was issued in September 2010 and since then, there have been various IASB meetings and public consultations. The second exposure draft is open for comments until September 2013. It introduces a dual-model approach for lease accounting, which would have a significant impact on the classification of leases, as well as the pattern and presentation of lease expense and income.

In this article, we will discuss some of the fundamental changes that are proposed in the Leases exposure draft.

Identification of leases
The ED defines a lease as “a contract that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration”. An entity would determine whether a contract contains or is a lease by assessing whether:

(a) fulfillment of the contract depends on the use of an identified asset; and
(b) the contract conveys the right to control the use of the identified asset for a period of time in exchange for consideration.

A contract conveys the right to control the use of an identified asset if the customer has both the ability to direct the use and receive the benefits from use of the identified asset throughout the term of This definition encompasses the embedded leases concept currently under IFRIC 4. Hence arrangements which are not structured as leases but include an identified asset where the customer can direct the use and receive benefits will be considered leases. However, the ED puts a greater focus on the customer’s ability to direct the use of the underlying asset which means that contracts in which the customer uses substantially all of the output of an asset, but does not control its operations may not fall under the lease definition.

Lease term
The determination of the lease term is based on the non-cancellable period of the lease, together with any optional renewal periods which the lessee has a significant economic incentive to exercise and periods covered by a termination option, if the lessee has a significant economic incentive not to terminate. The proposals include many factors for an entity to consider which are contract-based, asset-based, entitybased and market-based such as the amount of lease payments in the secondary period, location of the asset, financial consequences of termination, market rentals, etc for determination of the lease term. Again, there are no bright lines for the term ‘significant economic incentive’.

These proposals are a significant change as the lease term is a crucial estimate in determining the classification and accounting for the lease.

Classification – Type A and Type B leases
The ED identifies two types of leases – Type A and Type B. These are in some ways akin to current finance lease and operating lease models under IAS 17 Leases. The classification criteria would be based on the nature of the underlying asset and the extent to which the asset is consumed by the lessee over the lease term.

If the underlying asset is not property (i.e. not land and/or a building), it is classified as a Type A lease, unless the lease term is for an insignificant part of the total economic life of the underlying asset or the present value of the lease payments is insignificant relative to the fair value of the underlying asset. An underlying asset that is property (i.e. land and/or a building), is classified as a Type B lease, unless the lease term is for the major part of the remaining economic life of the underlying asset or the present value of the lease payments accounts for substantially all of the fair value of the underlying asset.

However, in all cases, if the lessee has a significant economic incentive to exercise an option within the lease to purchase the underlying asset, then the lease is classified as a Type A lease.

The terms ‘insignificant’, ‘major part’ and ‘significant economic incentive’ are not defined in the ED and there are no explicit bright lines or threshold percentages to make this assessment.

In effect, most leases other than property would be Type A leases and most leases of property would be Type B leases unless the above presumptions are rebutted.

Example
Company A enters into a 2-year lease contract for an item of equipment which has a total economic life of 10 years. The lease does not contain any renewal, purchase, or termination options. The lease payments of Rs. 1000 per year are made at the end of the period, their present value is calculated at Rs. 1,735 using a discount rate of 10%. The fair value of the equipment is Rs. 5,500 at the date of inception of the lease.

This lease would be classified as a Type A lease since it is not property and the lease term is considered more than an insignificant part of the total economic life (20%) and the present value of lease payments is more than insignificant relative to the fair value of the equipment (31.5%).

This lease would have been classified as an operating lease under the existing principles of IAS 17. However, the Type A classification will lead to much different accounting under the ED proposals.

Accounting by lessee
In a Type A lease, the lessee would recognise a lease liability, initially measured at the present value of future lease payments, and also a right-of-use (ROU) asset measured at the amount of initial measurement of lease liability plus any initial direct costs and payments made at or before the commencement date less any lease incentives received. Subsequently, the lessee would measure the lease liability at amortised cost using the effective interest rate method and the ROU asset at cost less accumulated amortisation – generally on a straightline basis. The lessee would present amortisation of the ROU asset and interest expense on the lease liability as separate expenses on the statement of profit or loss. The ROU asset will be presented under property, plant and equipment as a separate category (bifurcated further between Type A and Type B leases residual assets).

Continuing the example above, the lessee would have recognised a lease liability and a ROU asset of Rs. 1,735. In year 1, the amortisation expense would be Rs. 867 (1735/2) and interest expense of Rs. 174 (1735*10%). In year 2, the amortisation expense would be Rs. 867 and interest expense of Rs. 91 ((1735+174- 1000)*10%). The cash outflow of Rs. 1000 will be reduced from the lease liability. Thus, under the Type A model, the lessee would see a front loading of the lease expense.

In a Type B lease, the lessee would follow the approach for Type A leases for initial measurement. Subsequently, the lessee would calculate amortisation of the ROU asset as a balancing figure, such that the total lease cost would be recognised on a straight-line basis over the lease term and would be presented as total lease cost (amortisation plus interest expense) as a single line item in the income statement. Hence, considering the example above, under the Type B model, in year 1, the lessee would record a total expense of 1000 split between interest expense of Rs. 174 and ROU amortisation of Rs. 826. This will effectively result in a straight-line recognition of the lease expense over the lease period.

Accounting by lessor
In a type A lease, on commencement, the lessor would derecognise the underlying asset and recognise a lease receivable, representing its right to receive lease payments as well as a residual asset, representing its interest in the underlying asset at the end of the lease term. The total profit i.e. difference between the fair value of the asset and the carrying amount of the asset (if any) will be divided between upfront profit and unearned profit. Upfront profit will be recognised at the lease commencement and is calculated as total profit multiplied to the proportion that the present value of the lease payments divided by the fair value of the underlying asset.

The lease receivable would initially be measured at the present value of future lease payments. The lessor would measure the lease receivable at amortised cost using the effective interest rate method. In addition, the lease receivable will be tested for impairment under IAS 39 Financial Instruments: Recognition and Measurement. The lessor would also be required to re measure the lease receivable to reflect any changes to the lease payments or to the discount rate. Such re measurement may be triggered due to a change in lease term, lessee having or no longer having a significant economic incentive to exercise purchase option, etc .

The residual asset would be measured at the present value of the amount that the lessor expects to derive from the underlying asset at the end of the lease term, discounted at the rate that the lessor charges the lessee adjusted for the present value of expected variable lease payments. In the balance sheet, the residual asset is presented as net residual asset after reducing the unearned profit. Subsequently the residual asset will be accreted with interest over the lease period. Also, this residual asset is subject to impairment provisions under IAS 36.

This accounting under Type A leases for the lessor is much more complex than the existing finance lease accounting model.

Continuing the example above, consider the following additional facts: the carrying amount of the equipment in lessor’s books is Rs. 5,000 on the inception of the lease. The lessor estimates that the future value of the equipment at the end of the lease term would be Rs 4,555 (the present value using 10% discount rate would be Rs. 3,765). The following entry would be recorded in the lessor’s books at commencement:

Lease receivable Dr. 1,735
Gross residual asset Dr. 3,765*
Equipment Cr. 5,000
Unearned profit Cr. 342
(500-158)
Gain on lease of equipment Cr. 158
((5500-5000)*(1735/5500))

*Rs. 3423 (3765-342) is the net residual asset to be presented in the balance sheet.

In Year 1, lessor would receive a cash flow of Rs. 1000 of which Rs. 174 (1735*10%) would be recorded as interest income and Rs. 826 would be reduced from the lease receivable. Also, the lessor will book interest income on accretion of the residual asset Rs. 375 (3765 x10%).

For Type B leases, the lessor would follow an accounting model similar to that of an operating lease per existing IAS 17 and would continue to recognise the underlying asset in its balance sheet and recognise the lease income on a straight line basis over the lease term. However, there are proposed additional disclosures requirements for lessors’ of Type B leases compared to current GAAP.

Exemption for Short-term leases

The ED gives the option to entities to elect not to apply the new accounting model to short-term leases. A short-term lease is a lease that has a maximum possible term under the contract including any renewal options of less than 12 months and does not contain any purchase options for the lessee to buy the underlying asset. Under this option, lessees and lessors would only recognise lease expense/income on a straight line basis.

Impact

The new proposals will have a significant impact on the future of lease accounting. Entities will need to reexamine lease identification and classification as per new proposals. Moreover, recognising new assets and liabilities will impact key financial performance metrics. Management will need to make new estimates and judgments. Some of these estimates and judgments need to be reassessed at each balance sheet date giving rise to volatility in the balance sheet. The new proposals may also impact the way lease contracts are structured. This ED does not propose an effective date but it is unlikely to be effective before 1st January 2017.

Nirav Shah

IFRS Conceptual Framework – Time to Revise

In July 2013, the International Accounting Standards Board (IASB) issued a discussion paper on review of the Conceptual Framework for financial reporting for comment only. Comments on this paper need to be given by 14th January, 2014.

The IASB’s discussion paper on the Conceptual Framework provides a welcome opportunity to set out the fundamental principles of accounting necessary to develop robust and consistent standards. Although this is not an immediate project, it would set the tone for the future direction of accounting.

Need for a review of the Conceptual Framework

In recent times, there have been many discussions regarding the extent of fair value accounting under IFRS, the measurement of performance, keeping assets on or off balance sheet etc. which raise questions on the fundamentals of accounting under IFRS. In the aftermath of the global financial crisis, as the accounting complexities increase, the IASB’s thinking about some of these fundamentals has also evolved. This gave rise to the need for a revised Conceptual Framework which reflects the recent changes in accounting and provides a backbone for future changes.

This discussion paper is designed to obtain initial views and comments on a number of matters, and focuses on areas that have caused problems in practice for standard setters as well as companies. It also sets out the IASB’s preliminary views on some of the topics under discussion.

Key changes envisaged

Revised definitions of assets and liabilities

The revised Conceptual Framework proposes to clarify the existing definitions of assets and liabilities. Rather than the focus of the current definition on inflow or outflow of resources, the proposals suggest that the focus should be on underlying resources or obligations as the basis for determining the recognition of an asset or liability. Given below are the proposed definitions:

(a) an asset is a present economic resource controlled by the entity as a result of past events.

(b) a liability is a present obligation of the entity to transfer an economic resource as a result of past events.

Additional guidance on applying the definitions of assets and liabilities

The IASB proposes to provide additional guidance on the meaning of economic resource, control, transfer of economic resource, constructive obligations and present obligation. Additional guidance would be provided also on reporting the substance of contractual rights and contractual obligations and executory contracts. These would be helpful to support the proposed new definitions of asset and liability explained above.

Revised guidance on when assets and liabilities should be recognised

The IASB’s preliminary view on recognition is that an entity should recognise all its assets and liabilities unless the IASB decides when developing or revising a particular standard that an entity need not, or should not, recognise an asset or a liability either because of cost benefit considerations or that such recognition would not be a faithful representation.

New guidance on when assets and liabilities should be derecognised

The existing Conceptual Framework does not address derecognition in a comprehensive manner. The IASB’s preliminary view is that an entity should derecognise an asset or a liability when it no longer meets the recognition criteria. However, for cases in which an entity retains a component of an asset or a liability, the IASB should determine, when developing or revising the standards, how the entity would best portray the changes that resulted from the transaction. This could be achieved by way of enhanced presentation or disclosure or continuing to recognise the original asset or liability and treating the proceeds received or paid for the transfer as a loan received or granted.

New way to present information about equity claims against the reporting entity

Financial statements currently do not clearly show how equity instruments with prior claims against the entity affect possible future cash flows to investors. Also, the IASB proposes to address the distinction between equity and liability, specifically the problems of applying the definition of liability consistently within IFRS.

Measurement requirements

This section of the discussion paper provides guidance to assist the IASB in developing measurement requirements in new or revised standards. The proposals state that there are different bases of measurement i.e cost, market prices including fair value and other cash flow based measurements. These bases should be applied based on their relevance, cost benefit analysis and their impact on the profit and loss/other comprehensive income (OCI) statement.

Principles for distinguishing profit or loss from OCI

The extant Framework does not provide guidance on presentation and disclosure. The reporting of financial performance (including the use of OCI and recycling) is a key topic that needs to be addressed. Further, the IASB proposes to provide more guidance in the area of materiality.

This Discussion Paper incorporates the views received through the IASB’s public consultation carried out in 2011. It has detailed discussions around the key topics mentioned above and other topics where different views have been deliberated and the IASB’s preliminary views have been stated out for comment. This is an important project for the IASB as it not only addresses concerns around the fundamental areas as they exist today but also set the principles for standards to be developed in the future.

levitra

Nirav Shah

Should Gains be Recognised due to ‘Own’ Credit Deterioration

Since the start of the global financial crisis in 2008, the credit risk of counter parties has become increasingly important. Globally, the financial environment has been very volatile and has created a lot of uncertainty in the minds of stakeholders as well as prospective investors.

Volatility in credit worthiness of entities, not only has a significant impact on the business of these entities (ability to raise funds and capital at attractive rates), but has also resulted in a unique accounting implications.

This implication arises from provisions relating to gains/ losses due to ‘changes in fair value of financial liability due to changes in ‘own’ credit risk’ in certain cases.

The International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board’s (FASB) inclusion of own credit risk in liability measurement has proved controversial over the years. Several media articles have focused on the fact that due to EU accounting rules, banks may have systematically overstated their net assets and distributed non-existent profits as dividends and bonuses.

Let us take an example to understand how change in own credit risk, results in reflecting a better performance and increases the net assets for entities.

Balance sheet for Bank XYZ

*Measured at fair value through profit or loss account Keeping all other external parameters constant, if the creditworthiness of Bank XYZ decreases, it will result in an increase in its credit spreads (as the cost of funds for a more risky instrument will be higher). This in turn will result in a reduction in the fair value of the underlying instruments issued by the Bank. The revised balance sheet of XYZ may be as under (fair value is presumed to be Rs 800)

Balance sheet for Bank XYZ (Rs)

This reduction in the financial liability by Rs 200 is recorded as a gain in the income statement and has a favourable impact on reported PAT and EPS of the Bank.

Relevant accounting literature under IFRS supporting the aforesaid accounting treatment

IAS 39 “Financial Instruments: Recognition and Measurement” permits an entity to classify any financial liability into the category of “Fair value through profit or loss (FVTPL)” when:

• It is acquired or incurred principally for the purpose of selling or repurchasing it in the near term

• Part of a portfolio managed together and evident by recent pattern of short term profit taking

• It contains more than one embedded derivatives.

Generally derivative liabilities, structured financial products etc are recognised by entities at fair value.

IAS 39 requires an entity to reflect credit quality in determining the fair value of financial instruments and related changes in fair value are accounted in the profit and loss account.

Impact on results

During 2011, a number of international banks reported positive earnings in spite of increasing credit spreads i.e., declining credit worthiness. This outcome was due to own-credit-risk adjustments allowed in terms of IAS 39 (referred above) and similar guidance under US GAAP laid down in FASB Standard No. 159 “Fair Value Option for Financial Assets and Financial Liabilities”. Own-credit risk adjustments can result in unrealised losses as well when banks’ creditworthiness improves.

Below is a summary of the impact, this provision had on the performance results of a few large banks

One can logically argue that it is misleading for an entity to report a gain on its liabilities as a direct result of its own creditworthiness deteriorating, particularly as the entity would not be able to realise this gain unless it repurchases its debt at current market prices. However, there is another view in support of fair valuation, which is based on the principle of “increase in shareholder value”. As per this view increase in shareholder value resulting from a credit downgrade is based on differing contractual claims of shareholders and bondholders. Under this approach wealth is transferred from the existing bondholders, who have already committed to a lower interest rate and thus bear the risk of changes in interest rates, to the shareholders. If bondholders had waited to purchase the obligations they may well have received a higher interest rate. Thus, the gain is attributable to the lower interest rate that the entity enjoys in the current period as compared to the market interest rate (for another entity with the present (deteriorated) credit rating).

In India, The Ministry of Corporate Affair (MCA) has issued accounting standards which are aligned to IFRS (known as “Ind AS’), to be notified at a future date. Ind AS 39 “Financial Instruments: Recognition and Measurement” prescribes that in determining fair value of a financial liability, which on initial recognition is designated at fair value through profit or loss, any change in fair value consequent to changes in the company’s own credit risk should be ignored. This was a concious difference from IFRS incorporated under Ind AS. This difference was because Indian standard setters were not comfortable with companies recognising ‘gains’ in the financial statements just because their credit worthiness has deteriorated.

Even Basel III rules, require banks to “derecognise in the calculation of Common Equity Tier 1, all unrealised gains and losses that have resulted from changes in the fair value of liabilities that are due to changes in the bank’s own credit risk.” This rule ensures that an increase in credit risk of a bank does not lead to a reduction in the value of its liabilities, and thereby an increase in its common equity.

Given the ongoing volatility in the economic environment, this is an area which needs to be closely monitored, particularly due to the implications on reported financial performance and capital adequacy considerations.

Nirav Shah

Companies Act, 1956 and IFRS Convergence — An overview

IFRS

IFRS Convergence in India has gained significant momentum due
to the issuance of the Press Announcement by the Ministry of Corporate Affairs
(MCA) in January and March 2010 and subsequent clarifications issued in May
2010.

The Institute of Chartered Accountants of India (ICAI), on
its part, has issued 38 exposure drafts of ‘Ind-AS’ — i.e., the converged
accounting standards, in line with the IFRSs.

ICAI has also issued a document identifying areas where
provisions of the Companies Act, 1956 (‘the Act’) need to be changed to bring it
in line with IFRS. This article attempts to discuss those areas (listed below)
and the recommendations proposed by ICAI :

Proposed dividends

Accounting of
depreciation

Restatement of prior
years’ numbers

Presentation of financial
statements

Financial instruments and
preliminary expenses

Definition of ‘Control’

Accounting for business
combinations

Proposed dividends :

Paras 12 and 13 of IAS 10 Events after the reporting
period state that proposed dividend does not meet the criteria of a present
obligation in IAS 37 (Provisions, Contingent Liabilities and Contingent Assets)
and hence it shall not be recognised as a liability, but disclosed in
notes.

The Company Law department via circular no. 3/124/75-CL-V,
dated November 22, 1976 had expressed its views that proposed dividends
should be shown as ‘Current liabilities and provisions’ and part I of the
Schedule VI also requires proposed dividends to be shown as ‘Current liabilities
and provisions’.

Actions required to comply with IFRS :

The said Circular should be suitably amended. Also, Schedule
VI should be revised (ICAI has already submitted the proposed revisions to
Schedule VI to the Ministry of Corporate Affairs).

Other matters to be considered :

Under the present provisions of the Act, profits reported as
per books of account can be utilised for declaration of dividend, provided
adequate depreciation as required by the Act, has been provided for.

Under IFRS there are situations (illustrated below) where the
Company has to record unrealised gains/losses in the financial statements.

1. Unrealised gains/losses on fair value of equity

investments classified as fair value through profit and loss
account and derivatives

2. Revenue recognised during the construction period for a
public private service concession arrangement.

Though, in such situations, the Company would have reported
profits which can be utilised for dividend, the Company may not have sufficient
cash flows to fund the same and at the same time maintain adequate liquidity in
the system.

Similarly, there are situations where the Company has
received the cash flows, however is not permitted to recognise revenue, for
example,

1. For real estate sale contracts, revenue is generally
recognised on transfer of possession of property as against the current practice
of recognising revenue on a proportionate completion basis. Though, in such
situations, the Company would have sufficient liquidity, since collections are
made on achievement of individual milestones, the Company would not have
sufficient profits, since all revenue will be recognised only at the end on
transfer of possession of the property.

Further, under IFRS there are certain gains/losses which are
not accounted in the profit and loss account, but in the ‘other comprehensive
income’ statement, such as :

1. Mark to market of derivatives designated as hedging
instruments (for all effective hedges)

2. Fair value changes of financial instruments classified
as available for sale securities

Regulators will need to consider, whether such items need to
be adjusted to compute profit available for distribution as dividends to
shareholders.

Accounting of depreciation :

1. Component accounting :

Para 43 (read with BC 26 and 27) of IAS 16 ‘Property,
Plant and Equipment’ (PPE) states that each part of an item of PPE
with a cost that is significant in relation to the total cost of the item shall
be depreciated separately. For example, the engine of an aircraft needs
to be separately depreciated from its body.

The Act, on the other hand, does not indicate any such
requirement.

2. Depreciation rates :

Paras 50 and 53 of IAS 16 ‘Property, Plant and Equipment’
state that the depreciable amount of an asset, determined after reducing its
residual value from its cost, shall be allocated on a systematic basis over
its useful life. Further, para 51 requires annual review of useful life
and residual value.

The Act, under Schedule XIV, prescribes minimum rates of
depreciation for different classes of assets based on shift working and does not
recognise allocation of depreciation based upon the useful life of an asset and
deduction of residual value of the asset from its cost for arriving at the
depreciable amount. Further, S. 205(2) and S. 205(5) of the Act permits
depreciation to be provided either for 100% of the cost of the asset or 95% of
the cost of the asset and also allows the Central Government to approve any
basis of providing depreciation on assets for which no rate has been laid down
in the Act.

3. Depreciation
method?:

Paras 60 to 62 of IAS 16 ‘Property, Plant
and Equipment’ state that the depreciation method used shall reflect the
pattern in which the asset’s future economic benefits are expected to be
consumed by the entity. The depreciation method applied shall be reviewed
annually. Further, it allows ‘units of production method’ as a method of
depreciation along with ‘straight-line method (SLM)’ and ‘diminishing balance
method (WDV)’.

The Act, under Schedule XIV, specifies
depreciation rates as per SLM and WDV methods only.

Actions required to comply with IFRS?:

Schedule XIV should be revised. It should
prescribe only industry-specific guidelines for indicative rates. These shall
serve as industry-specific benchmarks. It should state that the manner of
computing depreciation on assets, whether specified in the Schedule or not,
shall be as per the requirements of the accounting standards prescribed by the
Central Government referred to in S. 211(3C) of the Act. These shall be the
general guidelines and used as rebuttable presumptions.

The Ministry of Corporate Affairs has
already issued a draft Schedule XIV which is placed on their website. ICAI is
involved in the process of revising the same to make it consistent with IFRS.

The proviso (a), (b) and (c) u/s.205(1) and
item 3(iv) of Schedule VI-PART II — that recognises non-provision of
depreciation — should be repealed. Also, clauses (b), (c) and (d) of S. 205(2)
and S. 205(5) — that permit 95% of the cost to be depreciated and allows the
Central Government to approve any basis — should be repealed.

Restatement of prior years’ numbers:

Para 19 of IAS 8 Accounting policies,
changes in accounting estimates and errors requires an entity to apply any
changes in accounting policies retrospectively. As per para 22, when a change
in accounting policy is applied retrospectively, the entity shall adjust the
opening balance of each affected component of equity for the earliest prior
period presented and the other comparative amounts disclosed for each prior
period presented as if the new accounting policy had always been applied.

Similarly, para 42 requires correction of
material prior period errors retrospectively by restating the prior period
numbers. Further, para 46 requires exclusion of correction of a prior period
error from profit or loss for the period in which error is discovered.

As per the Circular No. 1/2003, dated
January 13, 2003 issued by the erstwhile Company Law Board, a company could
reopen and revise its accounts even after their adoption in the annual general
meeting only to comply with technical requirements of taxation laws and
of any other law to achieve the object of exhibiting true and fair view. It
does not permit revision for changes in accounting policies or prior period
errors. All such adjustments and corrections have to be included in the current
year’s profit or loss.

Actions required to comply with IFRS:

The Circular issued by the Company Law
Board should be revised to allow re-statement of the numbers in order to comply
with the requirements of IFRS.

The Circular should further state that the
financial statements presented shall be deemed to be in agreement with the
books of account to the extent of such re-statement for all such periods.

It should also allow the amount of net
profit, assets and liabilities as per the approved audited accounts for all
such periods to be considered as final for the purpose of the computation of
the total managerial remuneration payable u/s.198, u/s.199 and u/s.349 of the
Act or any provision u/s. 205 of the Act relating to declaration of any
dividend or any other such provision of the Act i.e., the managerial
remuneration, dividend paid as per profits reported in the prior years need not
change because of restatements in any of the subsequent periods.

Presentation of financial statements:

The existing form of balance sheet
(statement of financial position) set out in part I of Schedule VI and the
requirements as to Profit and loss account set out in part II of Schedule VI do
not comply with the requirements set out in IAS 1 Presentation of financial
statements regarding the presentation of financial statements, as mentioned
below?:

1. A
separate statement of changes in equity (SOCIE) presenting all owner
changes in equity is not permitted under the Act

2. The
concept of Comprehensive Income and Other Comprehensive Income (OCI)
is not recognised in the Act

3. Distinction
between owner changes in equity

(SOCIE) and non-owner changes in equity
(OCI) is not recognised in the Act

4. As
per para 39 of IAS 1, when an entity applies an accounting policy
retrospectively or makes a retrospective restatement of items in its financial
statements, it shall present, as a minimum, three statements of financial
position (as at the end of the current period, the end of the previous period
and the beginning of the earliest comparative period).

The Act does not mandate presentation of a
third statement of financial position.

5. As
per para 60 of IAS 1 Presentation of Financial Statements, an entity shall
present current and non-current assets and liabilities in its statement of
financial position except when a presentation based on liquidity provides
information that is reliable and more relevant. For example, in case of
long-term borrowings, the amount repayable within 12 months from the reporting
date shall be presented as current and the balance as non-current liabilities.

The form of balance sheet set out in Part I
of Schedule VI does not consider current/ non-current classification of
assets/liabilities.

6. Extraordinary
items?:

As per para 87 of IAS 1, an entity shall
not present any items of income or expense as extraordinary items.

Whereas, as per part II(3)(xii)(b) of the
Schedule VI, the profit and loss account shall disclose profits or losses in
respect of transactions of a kind, not usually undertaken by the company or
undertaken in circumstances of an exceptional or non-recurring nature,
if material in amount.

Actions required to comply with IFRS:

Schedule VI would need to be revised.
Further regulators will also need to consider that the companies in India would
be converging with IFRS in a phased manner, with only approximately 500+
companies converging from 1 April 2011 (phase 1). Hence, regulators may need to
consider two parts of Schedule VI — one that complies with the requirements of
IFRS and other which will be applicable to companies either covered in later
phases or exempt from convergence (i.e., companies not covered in any of the
phases).

Financial instruments and preliminary
expenses?:

1. Substance
v. legal form?:

As per para 18 of IAS 32 Financial
Instruments: Presentation, substance of a financial instrument, rather than its
legal form, governs its classification in the entity’s balance sheet. For
example, compulsorily convertible debenture is an equity instrument and
compulsorily redeemable preference share is a financial liability.

However, the Act mandates classification
based on legal form only i.e., as per S. 86 of the Act, share capital shall be
of two kinds — equity and preference.

2. Dividends
on capital designated as financial liability?:

As per IFRS, interest, dividends, losses
and gains relating to a financial liability shall be recognised as income or
expense in profit or loss. Distributions to holders of an equity instrument
shall be debited directly to equity.

However, as per the Act, dividend on all
types of capital is to be presented only as an appropriation of profit.

3. Transaction
costs?:

As per IFRS, transaction costs of an equity
transaction shall be accounted for as a deduction from equity, net of any
related income tax benefit.

However, as per the Act, these have to be
presented as Miscellaneous Expenditure on the assets side of the balance sheet.
They can also be written off against the securities premium account, as per S.
78(2)(c) of the Act.

4. Premium
on redemption of preference shares?:

As per IFRS, gains and losses associated
with redemptions or refinancings of financial liabilities are recognised in
profit or loss.

However, proviso (C) u/s.80(1) and u/s.78(2)(d)
of the Act permits writing off premium on redemption of preference shares
against the securities premium account.

Similarly, losses and expenses relating to
other financial liabilities like debentures may be allowed to be written off
against securities premium as per S. 78(2)(d) of the Act, but shall be
recognised in the profit or loss as per para 36 of IAS 32.

5. Preliminary
expenses?:

As per para 69 of IAS 38 Intangible Assets,
expenditure on start-up activities shall be recognised as an expense when
incurred. Start-up costs may consist of establishment costs such as legal and
secretarial costs incurred in establishing a legal entity.

However, the Act permits such costs to be
carried forward as Miscellaneous Expenditure (part I of the Schedule VI) or be
written off against securities premium account [S. 78(2)(b) of the Act].

Actions required to comply with IFRS:

Proviso (C) u/s.80(1) and u/s.78(2)(b), (c)
and (d), regarding utilisation of securities premium, should be suitably
amended.

Definition of ‘Control’:

Para 4 of IAS 27 Consolidated and Separate
Financial Statements define ‘control’ as the power to govern the financial and
operating policies of an entity so as to obtain benefits from its activities.
Further, as per para 13 of IAS 27, control is presumed to exist when the parent
owns, directly or indirectly through subsidiaries, more than half of the voting
power of an entity. Also, as per para 14 of IAS 27, the existence and effect of
potential voting rights that are currently exercisable or convertible,
including potential voting rights held by another entity, are considered when
assessing whether an entity has the power to govern the financial and operating
policies of another entity.

However, as per S. 4(1) of the Act, a
company shall be deemed to be a subsidiary of another if, but only if:

(a) that
other controls the composition of its Board of directors

(b) that
other?:

(ii) where
the first-mentioned company is any other company, holds more than half in
nominal value of its equity share capital;

Hence, the definition of ‘control’ as per
IAS 27 is wider in scope than the definition as per S. 4(1) of the Act.

Further, para 4 of IAS 27 defines
‘subsidiary’ as an entity including an unincorporated entity, such as
partnership, that is controlled by another entity (known as parent). However,
as per S. 4(1), only a company can be a subsidiary of another company.

Actions required to comply with IFRS:

The Act should be suitably amended to
facilitate preparation of Consolidated Financial Statements under the
principles prescribed under IFRS. However, the definition of a subsidiary
company presently given u/s.4 of the Act should not be used as it is rule-based
and different from AS 27 Consolidated and Separate Financial Statements. The
definition should be revised to be in line with the definition of ‘control’ as
under IAS 27.

Accounting for business combinations:

As per para 18 of IFRS 3 Business
Combinations, the acquirer shall measure the identifiable assets acquired and
the liabilities assumed at their acquisition-date fair value.

However, in accordance with clause (vi)
u/s.394(1) of the Act, the order of the Court may provide for such incidental,
consequential and supplemental matters concerning mergers and acquisitions
which may not be as per the recognition, measurement and disclosure
requirements of IFRS.

Further, as per IFRS the acquisition date
is to be factually determined i.e., the date on which an acquirer obtains
control of the acquiree, which is generally the date on which the acquirer
legally transfers the consideration, acquires the assets and assumes the
liabilities of the acquiree.

Conversely, the order of the Court, in accordance
with the powers granted under the clause (vi) u/s.394(1) of the Act, may
provide for any other date as the acquisition date.

Actions required to comply with IFRS:

Clause (vi) u/s.394(1) should be amended to
state that such incidental, consequential and supplemental matters shall not be
in conflict with the requirements of the accounting standards.

The Proviso u/s.391(2) should be amended to
require a certificate by the company that the scheme is not in conflict with
the requirements of the accounting standards. This is now required by SEBI for
listed companies, as per amendment to clause 24 of the Equity Listing
Agreement.

India has come a long way along the journey
of convergence with IFRS, increasing the confidence about the transition. The
regulators need to address some of these important matters to ensure a smooth
transition and ensure that an entity that complies with IFRS should not be in
non-compliance with other regulatory requirements in that process.
Implementation of the Converged Accounting Standards in the absence of
corresponding changes in the statute will dilute the implementation/convergence
process.

Nirav Shah

How will convergence with IFRS affect audit procedures ?

IFRS

The use of International Financial Reporting Standards (IFRS)
as a universal financial reporting language is gaining momentum across the globe
especially from the position only seven years ago where numerous different
national standards existed.

In line with the global trend, the Ministry of Corporate
Affairs (MCA) has notified a plan for convergence with IFRS in a phased manner.

Convergence with IFRS will also need careful analysis of the
present auditing standards. Auditing standard-setters may also need to assess
the requirement of auditor obtaining requisite IFRS knowledge which can be
evidenced through a certification process.

Auditing standard-setters will need to address the impact on
auditing procedures for the changes proposed in the accounting principles due to
convergence with IFRS.

Under IFRS, management is required to make several estimates
in the below-mentioned areas in applying accounting policies that have a
significant effect on the amounts recognised in the financial statements.

Audit of non-current assets :

Property, plant and equipment :

IFRS requires an asset to be depreciated over its own useful
life instead of rates suggested under regulations (like Schedule XIV to the
Companies Act). Further, significant components of an asset are depreciated
separately. The estimate of useful life of assets needs to be reassessed at
least once every balance sheet date.

The audit procedures relating to fixed assets would need to
be designed to obtain sufficient appropriate audit evidence whether the
management’s assessment of useful life is appropriate. The auditor may require
performance of inquiry procedures with the plant engineers to assess the
reasonableness of the process for estimating the useful lives and identification
of components within individual assets that have a different useful life and
needs to be separately depreciated. Companies would also need to maintain
suitable audit trail for the basis for estimation of useful life and
identification of components.

Intangible assets :

The depreciation/amortisation of an intangible asset depends
on whether its useful life is finite or indefinite (indefinite does not mean
infinite). An intangible asset has an indefinite useful life when, based on an
analysis of all relevant factors, there is no foreseeable limit to the period
over which the asset is expected to generate net cash inflows for the entity.

An intangible asset with indefinite useful life is not
depreciated; instead it is tested for impairment every balance-sheet date.

Classification of intangible assets acquired in business
combination (like brands, trademarks, customer relationships) needs to be
assessed closely by the auditor. For instance, in assessing whether the useful
life of a brand is indefinite or finite, the auditor may need to assess the
following factors :

How well and for how long has the brand been established in the market ?
If the brand is mature and contributes significant value to the business and
therefore its abandonment would represent an unrealistic decision, then this
might be an indicator of an indefinite useful life.

How stable is the industry in which the brand is used ? In rapidly
changing industries it is less likely that a brand will be identified as
having an indefinite useful life.

Is the brand expected to become obsolete at some point in the future ?

Is the brand used in a market that is subject to significant, enduring
entry barriers ?

Is the useful life of the brand dependent
on the useful lives of other assets of the entity ? If so, what are the
useful lives of those assets ?

Embedded leases under IFRIC 4 :

The purpose of IFRIC 4 — ‘Determining whether an arrangement
contains a lease’, is to identify an arrangement which, in substance, is or
contains a lease (even if the contract does not use the term lease). For
instance, A Company has a contract with its supplier (job worker) whereby the
Company is contractually bound to get 10,000 units of goods manufactured by the
supplier. The supplier has installed a machinery to manufacture and supply the
goods for the contract.

Price terms are as under :

For first 10,000 units — Rs.22 per unit

10,001 onwards — Rs.10 per unit

In case of any shortfall as compared to 10,000 units, a penalty of Rs.12
per unit of shortfall shall be levied.

An analysis of the arrangement would indicate that up to
initial 10,000 units, the Company is bound to pay Rs.120,000 (10,000 x 12) to
the contract manufacturer (as there is a penalty of Rs.12 per unit for any
shortfall in offtake by the Company up to 10,000 units) and this would be
nothing other than lease rent for the asset being used. The balance amount of
Rs.10 (22 – 12) per unit would be job work charges for the manufacture of goods.

A lease arrangement conveys rights to use an asset for agreed
period of time in return for a payment or series of payments.

The assessment whether an arrangement is or contains a lease
is based on whether :

fulfilment of the arrangement is dependent on the use of a specific asset
or assets; and

the arrangement conveys a right to use the asset(s).

A challenge to audit-embedded lease arrangements is to derive sufficient appropriate audit evidence that a specific asset(s) would be used throughout the arrangement. Further, audit procedures need to include determining fair values of embedded lease component and other components of the arrangement. This would involve judgment on the part of the company and a process to be set for determining appropriate audit trail for the basis of determination of fair value.

Appropriate representation may also be needed from the Company for identification of all embedded lease arrangements.

Investment property :
Investment properties include properties that are either held to earn rental income or capital appreciation, or are held with undetermined use. Investment properties are measured at cost or at fair value every balance-sheet date. If the client measures investment properties at cost, it still needs to disclose its fair value.

Audit procedures must include procedures to assess the classification of property as ‘Investment Property’. Further, the audit procedures may be performed on the appropriateness of assumptions/ factors considered in deriving the fair value of the Investment Properties.

Audit of Business Combinations and Consolidation :

Consolidation :
Unlike Indian GAAP, the definition of a subsidiary focusses on the concept of control and has two parts, both of which need to be met in order to conclude that one entity controls another :

the power to govern the financial and operating policies of an entity;
to obtain benefits from its activities.

Thus, if a Company A holds 80% of the issued share capital of Company B and another investor C holds balance 20% of the share capital and participates in the management (through shareholders agreement) of the Company, then Company A cannot treat Company B as a subsidiary, as it cannot unilat-erally control that Company.

Thus, the auditor needs to verify the shareholder’s rights for classification of an investee as subsidiary.

Appropriate representation may also need to be sought from the company for non-existence of participative rights with minority shareholders.

Consolidation of special purpose entities :
A special purpose entity (SPE) is an entity created to accomplish a narrow and well-defined objective, e.g., a vehicle into which trade receivables are securitised. The principles discussed above for identifying control apply equally to an SPE. The control concept in SIC-12 is based on the substance of the relationship between an entity and an SPE, and considers a number of indicators.

Audit procedures that auditor may need to apply to identify whether the SPE needs to be consolidated need to be established.

Appropriate representation may also need to be sought from the company for identification of all SPEs.

Accounting policies across the Group :
The separate financial statements of subsidiaries, joint ventures and associates are prepared based on their accounting policies. However for the purpose of consolidation with parent company, all the sub-sidiaries, associates, joint ventures and SPEs need to prepare IFRS financial statements with the same accounting policies as that of the parent company.

Auditors need to verify consistency in application of IFRS accounting policies throughout the group. Thus auditors of the parent company may need to engage actively with the management and auditors of the subsidiary, joint ventures and associates to assess application of consistent accounting policies within the group.

Business combinations :

A business combination is defined as ‘a transaction or other event in which an acquirer obtains control of one or more businesses’.

In relation to business combination, the following audit procedures may need to be performed :

Verify the date of actual transfer of control to the acquirer i.e., the date of acquisition. An appointed date as per agreement or court scheme cannot be termed as date of acquisition.

Verify valuation reports as at acquisition date relating to assets transferred, liabilities incurred and equity interests issued by the acquirer. Verify the reasonableness of the assumptions used for valuation purposes.

Verify intangibles assets that qualify for recognition. Verify the reasonableness of the assumptions used in the valuation of assets acquired, liabilities and contingent liabilities assumed.

Audit of income statement items :

Revenue : linked transactions :
In some cases, two or more transactions may be linked so that the individual transactions have no commercial effect on their own. For instance, a Company may enter into a contract to buy 100,000 units of goods from a vendor for Rs.1.5 per unit when market price for the goods is Rs.4 per unit (thus a cost savings of Rs.250,000). At the same time, the Company shall subscribe to the debentures of the vendor for Rs.400,000, whereby the vendor has a call option over the debentures to settle the liability at Rs.150,000 in all. Such transactions are linked transactions as the individual contracts have no commercial effect of their own.

In these cases it is the combined effect of the two transactions together that is accounted for. Audit procedures for linked transactions may include :

Verify whether two or more transactions are linked based on the substance of the transaction.

Verify identification of components in the overall arrangement.

Verify allocation of consideration to the different components of the arrangement either on relative fair value method or on residual fair value method.

Verify the basis for recognition of revenue for every delivered component of the arrangement.

Share-based payments :
Share-based payments under IFRS are measured at fair value, unlike Indian GAAP that allows use of intrinsic value method. The auditors need to verify the underlying assumptions relating to the fair value of the instruments. If the client has subsidiaries, the audit procedures are required to verify the extent of grants given to employees of the subsidiary company.

The auditor needs to verify the classification of the share-based payment into equity-settled and cash-settled share-based payment for the parent and subsidiary. Under certain circumstances, the classification of share-based payment could differ in the books of parent and subsidiary. For instance, subsidiary issues options to its employees that it settles by issuing its own shares. Upon termination of employment, the parent entity is required to purchase the shares of the subsidiary from the former employee. In such cases, as the subsidiary has an obligation to deliver its own equity instruments, the arrangement should be classified as equity-settled in its financial statements. However, the arrangement should be classified as cash-settled in the consolidated financial statements of the parent.

Audit of presentation of financial statements :

Current and non-current classification :
IFRS requires the assets and liability to be segregated into current and non-current assets/liabilities. Thus the audit procedures are required to determine the entity’s business cycle and thereby classification into current/non-current.

Disclosure of segment information :
IFRS requires segment disclosure based on the components of the entity that management monitors in making decisions about operating matters (the ‘management approach’). Such components (operating segments) are identified on the basis of internal reports that the entity’s ‘Chief operating decision maker’ (CODM) reviews regularly in allocating resources to segments and in assessing their performance.

Audit of segment information under IFRS would also lead to additional audit procedures like :

Identification of the entity’s CODM;

Audit of information reviewed by the CODM in the decision-making process; and

Use of accounting policy for internal review.

The auditor might face challenges in performing audit procedures relating to information used by the management for decision-making process, as this information is always considered as strictly confidential and for internal use. Further, the information reviewed by the CODM (for instance, contribution margin analysis) may not be in strict compliance with GAAP. Hence test of completeness and accuracy of such financial information may be difficult.

Others :

Audit of IT system controls :
Entities where the use of Information systems is dominant (ERPs like SAP or Oracle) may require modifications in the IT configuration to track the information as required under IFRS. In such a scenario, the auditor would also require to test the new IT controls.

Audit of opening IFRS balance sheet :
To audit the opening balance sheet of the client, the auditor may prepare an audit programme to assist engagement team in issuing an audit opinion on the opening IFRS balance sheet prepared prior to the first complete set of IFRS financial statements. The audit programme may include the following audit steps :

Understand the client’s transition process

Update the understanding of the client’s business environment for transition matters

Review compliance of the selected IFRS accounting policies with IFRS

Assess the completeness and accuracy of the client’s gap analysis

Identify IFRS balances with significant and/or high-risk gaps

Identify appropriate audit objectives relating to gaps

Evaluate the design and test the effectiveness of relevant internal controls

Evaluate audit evidence and conclude.

Conclusion :
An entity may expect significant changes to its balance sheet and income statement due to transition to IFRS. It is essential for an auditor to carefully evaluate the IFRS impact areas both at the time of first-time adoption of IFRS and on a go-forward basis.

The auditor would need to suitably modify the design of its audit procedures to obtain sufficient appropriate audit evidence that the financial statements are not materially misstated.

Given the enhanced use of fair value in the presentation/preparation of IFRS financial statements and use of management judgment, the auditor will have to constantly be abreast of the client’s products/services, business and the related industry developments.

Nirav Shah

Convergence with International Financial Reporting Standards (‘IFRS’) — Impact on fundamental accounting practices and regulatory framework in India

IFRS — fast gaining adoption and acceptance globally :

The use of International Financial Reporting Standards (IFRS) as a universal financial reporting language is gaining momentum across the globe, especially as compared to a few years ago where a number of different national accounting standards existed. More than 100 countries now require or allow use of IFRS and by 2011 the number is expected to increase to 150. Some of the major countries that are seeking to converge/adopt IFRS by 2011 include Canada, Korea, India and Brazil.

The last two years have also seen significant momentum in the United States on converging from US GAAP to IFRS. The momentum started with the US Securities and Exchange Commission allowing foreign companies listed in the US to file financial statements prepared in accordance with IFRS (without a reconciliation to US GAAP) and continued with a proposal to evaluate IFRS convergence for all US Listed companies between 2014 and 2016.

Convergence with IFRS in India :

In line with the global trend, the Institute of Chartered Accountants of India (ICAI) has proposed a roadmap for convergence with IFRS for certain defined entities (listed entities, banks and insurance entities and certain other large-sized entities) with effect from accounting periods commencing on or after April 1, 2011. Large-sized entities are defined as entities with turnover in excess of Rs.100 crores or borrowings in excess of Rs.25 crores.

Accordingly, as part of its convergence strategy, the ICAI has classified IFRS into the following broad categories :

Category I : IFRS which can be adopted immediately or in the immediate future in view of no or minor differences (for example, construction contracts, borrowing costs, inventories).

Category II : IFRS which may require some time to reach a level of technical preparedness by the industry and professionals, keeping in view the existing economic environment and other factors (for example, share-based payments).

Category III : IFRS which have conceptual differences with the corresponding Indian Accounting Standards and where further dialogue and discussions with the IASB may be required (consolidation, associates, joint ventures, provisions and contingent liabilities).

Category IV : IFRS, the adoption of which would require changes in laws/regulations because compliance with such IFRS is not possible until the regulations/laws are amended (for example, accounting policies and errors, property and equipment, first-time adoption of IFRS).

Impact of IFRS convergence on fundamental accounting practices :

Harmonising existing Indian accounting standards with IFRS will have an impact on some fundamental accounting practices followed in India. A few of these are enumerated below:

Use of fair value concept :

Indian GAAP requires financial statements to be prepared on historical cost except for fixed assets which could be selectively revalued. Use of fair value is presently limited for testing of impairment of assets, measurement of retirement benefits and ‘mark-to-market’ accounting for derivatives. Under IFRS, there is a growing emphasis on fair value. In addition to the requirements under Indian GAAP, the carrying amounts of the following assets and liabilities are based on fair value under IFRS :

Initial recognition of all financial assets and financial liabilities is at fair value

Subsequent measurement of all derivatives, all financial assets and financial liabilities held for trading or designated at fair value through profit or loss, and all financial assets classified as available-for-sale, are measured at fair value

Non-current provisions are measured at fair value, which is derived by discounting estimated future cash flows

Share-based payment awards are measured at fair value

Option available for measurement of property, plant and equipment at fair value, subject to certain conditions

Option available for measurement of intangible assets at fair value, subject to certain conditions

Option available for measurement of Investment property at fair value.

Substance over form :

Considering the overall theme of substance over form, IFRS mandates preparation of consolidated financial statements to reflect the true picture of the net worth to various stakeholders. Exceptions for preparation of consolidated financial statements are very limited. In India, currently consolidated financial statements are mandatory only for listed companies and that also only for the annual financial statements and not the interim financial statements.

Similarly, Indian accounting continues to be driven by the written contract and the form of the transaction – as opposed to the substance. Consider, upfront fees charged by a telecom service provider. Under Indian GAAP, several companies recognise such up front fees as income because it is contractually non-refundable and is contractually received as fees for the activation process. Under IFRS, the fee is accounted for in accordance with the sub-stance of the transaction. Under this approach, the customer pays the upfront activation fee not for any service received by the customer, but in anticipation of the future services from the telecom company. Thus, despite the non-refundable nature of the fees, revenue recognition would be deferred over the estimated period that telecom services will be provided to the customer.

Inconsistencies with existing laws and regulations:

As per the preface to the Indian accounting standards, if a particular accounting standard is found to be not in conformity with a law, the provisions of the said law will prevail and the financial statements shall be prepared in conformity with such law. However, under IFRS, the entity needs to comply with all the accounting standards and other authoritative literature issued by IASB in order to comply with IFRS. If entities adopt accounting practice as approved by another regulatory authority or in conformity with a law, which is not in accordance with IFRS, the financial statement so prepared would not be considered to be in compliance with IFRS.

Disclosures:

In India, Schedule VI to the Companies Act, 1956, which prescribes a detailed format for preparation and disclosure of financial statements, lays great emphasis on quantitative information such as quantitative details of sales, amount of transactions with related parties, production capacities, CIF value of imports and income and expenditure in foreign currency, etc. Contrary to the same, IFRS is more focused on qualitative information for the stakeholders, such as terms of related party transactions, risk management policies, currency exposure for the entity with sensitivity analysis,etc. To more correctly report the liquidity position of the entity, IFRS also . requires segregation of all assets/liabilities into current and non-current portions. Presently under Indian GAAP even long-term deposits and advances are disclosed under current assets, loans and advances, thereby not reflecting the true position.

Exceptional and extraordinary items:

Indian GAAP requires companies to disclose significant events which are not in the ordinary course of business as extraordinary items and material items as exceptional to facilitate the reader to consider the impact of these items on the reported performance. Under IFRS there is no concept of extraordinary or exceptional since all events/transactions are in the normal course of business and if an item is material, it can be disclosed separately, but cannot be termed as ‘extraordinary’ or ‘exceptional’.

Restatement of financial statements:

Under Indian GAAP, changes in accounting policies or rectification of errors (prior period items) are recognised in the current year’s profit and loss account (for errors) and are generally recognised prospectively (for changes in accounting policies). Under IFRS, the prior period comparatives are re-stated in both cases. Indian GAAP does not have the concept of restatement of comparatives except in case of special-purpose financial statements prepared for public offering of securities.

Determination of functional currency:

Entities in India prepare their general purpose financial statements in Indian rupees. However under IFRS, an entity measures its assets, liabilities, revenues and expenses in its functional currency, which is the currency that best reflects the economic substance of the underlying events and circumstances relevant to the entity i.e.,the currency of the primary economic environment in which the entity operates. Functional currency of an entity may be different from the local currency.

For example, consider an Indian entity operating in the shipping industry. For such an entity it is possible that a significant portion of revenues may be derived in foreign currencies, pricing is determined by global factors, assets are routinely acquired from outside India and borrowings may be in foreign currencies. All these factors need to be considered to determine whether the Indian rupee is indeed the functional currency or whether another foreign currency better reflects the economic environment that most impacts the entity.

Other significant aspects :

Under Indian GAAP, provision has to be made for proposed dividend, although it may be declared by the entity and approved by the shareholders after the balance sheet date. Under IFRS, dividends that are proposed or declared after the balance sheet date are not recognised as liability at the balance sheet date. Proposed dividend is a non-adjusting event and is recorded as a liability in the period in which it is declared and approved.

Impact of existing laws and regulations:

Accounting standard-setting in India is subject to direct or indirect oversight by several regulators, such as the National Advisory Committee on Accounting Standards (NACAS) established by the Ministry of Corporate Affairs, the Reserve Bank of India (RBI),the Insurance Regulatory and Development Authority (IRDA) and the Securities and Ex-change Board of India (SEBI). Further, the Indian Companies Act, ;1956 (the Act) directly provides guidance on accounting and financial reporting matters. Courts in India also have the powers to endorse accounting for certain transactions – even if the proposed accounting treatment may not be consistent with Generally Accepted Accounting Principles.

Companies Act:

The requirements of Schedule VI of the Act, which currently prescribes the format for presentation of financial statements for Indian companies, is substantially different from the presentation and disclosure requirements under IFRS. For example, the Act determines the classification for redeemable preference shares as equity of an entity, whereas these are to be considered as a liability under IFRS. Also, Schedule XIV of the Act provides minimum rates of depreciation – such minimum depreciation rates are also inconsistent with the provisions of IFRS.

Regulatory guidelines :

The Reserve Bank of India (RBI) and Insurance Regulatory and Development Authority (IRDA) regulate the financial reporting for banks, financial institutions and insurance companies, respectively, including the presentation format and accounting treatment for certain types of transactions. For example, the RBI provides detailed guidance on provision relating to non-performing advances, classification and valuation of investments, etc. Several of these guidelines currently are not consistent with the requirements of IFRS.

The Securities and Exchange Board of India has also prescribed guidelines for listed companies with respect to presentation formats for quarterly and annual results and accounting for certain transactions, some of which are not in accordance with IFRS e.g., Clause 41 of the Listing Agreement permits companies to publish and report only standalone quarterly financial results, however IFRS considers only consolidated financial statements as the primary financial statements for reporting purpose.

Court procedures:

Courts in India commonly approve accounting under amalgamation/restructuring schemes, which may not be in accordance with the accounting principles/standards. Under the current accounting/ legal framework such legally approved deviations from the accounting standards/principles are acceptable.

Income tax:

Computation of taxable income is governed by detailed provisions of the Indian Income Tax Act, 1961. Convergence with IFRS will require significant changes/ clarifications from the tax authorities on treatment of various accounting transactions.

For example, consider unrealised losses and gains on derivatives that are required to be marked-to-market under IFRS. Different taxation frameworks are possible for the tax treatment of such unrealised losses and gains. The treatment of such unrealised losses/ gains will need to be addressed in line with the convergence time frame. It is imperative that tax authorities are engaged sufficiently in advance to decide on such critical aspects of taxation.

One of the risks of IFRS convergence without adequate involvement of all stakeholders and adequate regulatory changes is that financial statements prepared using the’ converged’ Indian standards may still not fully comply with IFRS issued by the International Accounting Standards Board (IASB). This would be very unfortunate as Indian entities that may be required to present IFRS-compliant financial statements to stakeholders outside India (overseas stock exchanges, overseas regulators, investors and alliance partners) would still need to reconcile with such’ converged’ IFRS financial statements prepared using the Indian framework, with IFRS financial statements that are globally accepted.

Accordingly, at the onset of the convergence, there is a need to develop an enabling regulatory frame-work and infrastructure that would assist and facilitate IFRS convergence. The Government would need to frame and revise laws in consultation with the NACAS and the ICAL Similarly, regulators such as the RBI, IRDA and SEBI would need to consider accepting IFRS in substitution of the present set of specific accounting rules prescribed by them.

As the timelines for convergence approach, all entities will have to consider their own roadmap and gear up for complying with the GAAP differences. Convergence to IFRS will be time-consuming, challenging and will require complete support and sponsorship of the Board of Directors/Members of Audit Committee/Senior Management. Given the task and challenges, all entities should ensure that their convergence plans are designed in a manner to achieve the objective of doing it once, but doing it right.

Nirav Shah

Impact of IFRS on the real estate sector : Developing a new reporting framework

IFRS

Impact of IFRS on the real estate sector : Developing a new
reporting framework

As Indian companies get poised to converge with IFRS in April
2011, some of the sectors may witness significant changes in the financial
statements used for reporting their performance to various stakeholders. The
foremost amongst them is the real estate industry. This article seeks to discuss
these changes and their related impact in greater detail.

Revenue recognition :

Generally, developers start marketing the project before
construction is complete or perhaps, even before construction has started.
Buyers enter into agreements to acquire a spe+cific unit within the building on
completion of the construction. The contracts may require the buyer to pay a
deposit and progress payments, which are refundable only if the developer fails
to complete and deliver the unit.

Under IFRS, IFRIC 15 Agreements for the Construction of
Real Estate provides detailed guidance on recognition of revenue from real
estate contracts. Under the Indian GAAP, the matter is currently dealt through
the Guidance Note on Accounting for Real Estate Developers issued by the
Institute of Chartered Accountants of India (‘ICAI’).

There are significant differences between the accounting
recommended under the two pronouncements.

Under the Indian GAAP, the ICAI Guidance Note permits the
real estate development contracts to be accounted on percentage of completion
method.

Accounting for real estate construction arrangements under IFRS

An agreement for construction of real estate can be accounted
as :

(a) Construction contract, which is within the scope of
IAS 11 on construction contracts; or

(b) Sale of goods and service, which is within the scope
of IAS 18 on revenue recognition.

An agreement for construction of real estate meets the
definition of a construction contract when the buyer is able to specify 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). In such cases, IAS 11 on
construction contracts applies.

In contrast, an agreement for 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 sale of goods within the scope of IAS 18. IAS 18 prescribes the following
criteria for revenue recognition — Revenue from the sale of goods shall be
recognised when all the following conditions have been satisfied :

(a) the entity has transferred to the buyer the
significant risks and rewards of ownership of the goods;

(b) the entity retains neither continuing managerial
involvement to the degree usually associated with ownership, nor effective
control over the goods sold;

(d) it is probable that the economic benefits
associated with the transaction will flow to the entity; and

(e) the costs incurred or to be incurred in respect of
the transaction can be measured reliably.

An analysis of general agreements for sale of real estate in
India shows that the buyers have only limited ability to influence the design of
the real estate, in fact they have no influence over the basic design/layout of
the building/apartment. Hence the sale would generally fall under IAS 18
principles as an agreement for sale of goods.

There could be two scenarios under sale of goods :

? the entity may transfer to the buyer control and the significant risks and
rewards of ownership of the real estate in its entirety at once (e.g.,
at completion, upon delivery). In such cases, the revenue will be recognised
only at the point of completion coupled with delivery.

? 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, and then the revenue is recognised on percentage
completion method, provided all criteria (mentioned above) of IAS 18 are
satisfied.

Determining continuing managerial involvement :

At the time of signing the provisional letter of allotment or
the agreement for sale, generally the seller has significant pending acts to
perform for completion of its obligations to deliver the apartment. All
decisions related to construction are with the seller and also, the construction
risk is to the account of the seller. This indicates continuing managerial
involvement in the property.

Determining transfer of risks and rewards :

The following indicators in real estate sale agreements
demonstrate that the risk and rewards of ownership are not continuously
transferred to the buyer :

— If the agreement is terminated before completion of the
construction by the buyer, the buyer does not retain the work-in-progress
and the developer does not have the right to be paid for the work performed.
The developer has to refund the money received from the buyer.

— The agreement does not give the buyer the right to take
over the incomplete property in case of default by the developer or
otherwise.

These indicate that the seller effectively retains control
and has continuing managerial involvement over the flats until possession is
transferred.

Hence the completed contract method will have to be applied
and revenue shall be recorded in its entirety on transfer of possession.
Construction costs incurred will be carried in the books of the developer as
work-in-progress under ‘Inventory’.

Difference from accounting for construction contracts :

As discussed above, determining whether an agreement for the
construction of real estate is within the scope of IAS 11 or IAS 18 depends on
the terms of the agreement and all the surrounding facts and circumstances. Such
a determination requires judgment 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 construction of real estate meets the definition of a construction contract when the buyer is able to specify 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).

One view could be that IAS 11 should apply to all agreements for the construction of real estate. In support of this view, it is argued that:

a) these agreements are in substance construction contracts. The typical features of a construction contract — land development, structural engineering, architectural design and construction — are all present

b) IAS 11 requires a percentage of completion method of revenue recognition for construction contracts. Revenue is recognised progressively as work is performed. Because many real estate development projects span more than one accounting period, the rationale for this method — that it ‘provides useful information on the extent of contract activity and performance during a period’ (IAS 11 paragraph 25) — applies to real estate development as much as it does to other construction contracts. If revenue is recognised only when the IAS 18 conditions for recognising revenue from the sale of goods are met, the financial statements do not reflect the entity’s economic value generation in the period and are susceptible to manipulation.

In reaching the consensus that IAS 11 should apply only when the agreement meets the definition of a construction contract and apply IAS 18 when the agreement does not meet the

definition of a construction contract, the IFRIC noted that:

a) the fact that the construction spans more than one accounting period and requires progress payments are not relevant features to consider when determining the applicable standard and the timing of revenue recognition;

b) determining whether an agreement for the construction of real estate is within the scope of IAS 11 or IAS 18 depends on the terms of the agreement and all the surrounding facts and circumstances. Such a determination requires judgement with respect to each agreement. It is not an accounting policy choice;

c) IAS 11 lacks specific guidance on the definition of a construction contract and further application guidance is needed to help identify construction contracts.

The IFRIC concluded that the most important distinguishing feature is whether the customer is actually specifying the main elements of the structural design. In situations involving the sale of real estate, the customer generally does not have the ability to specify or alter the basic design of the product. Rather, the customer is simply choosing elements from a range of options specified by the seller or specifying only minor variations to the basic design. The IFRIC decided to include guidance to this effect in the Interpretation to help clarify the application of the definition of a construction contract.

Currently under the Indian GAAP, guidance note on recognition of revenue by real estate developers states that revenue can be recognised once significant risks and rewards are transferred. In case of real estate sales, price risk is considered as the most significant risk; and the buyer has the right to sell or transfer his interest in the property without any conditions or with immaterial conditions attached. Thus under the current scenario, revenue from real estate sales can be recognised on the completion of an agreement for sale, even though the legal title or possession has not been delivered.

Consolidation of land acquisition companies:
Real estate companies in India are regulated under the Land Ceiling Act, 1976, which fixes a maximum limit on the area of land that may be owned by one company. To overcome these restrictions, real estate companies float various special purpose entities (SPEs) that purchase land from the market. A real estate company may have differing arrangements with SPEs. These arrangements would have to be closely evaluated and in light of SIC Interpretation 12 Consolidation — Special Purpose Entities.

In certain cases, real estate companies directly or indirectly hold 100% or majority share capital of such SPEs and/or have majority representation on their board of directors. However in other cases, the share capital of SPEs, which is generally a small amount, is held by a third party that also controls the governing body of the SPE. In such cases, the real estate companies are involved with the SPE in various other ways, such as provision of finance to carry out the activities, exclusive rights to develop land, provide guarantee against finance taken by SPEs, guarantee minimum return to the shareholders and/or enter contract, which may restrict the decision-making powers of SPE.

Under the Indian GAAP, companies consolidate only those entities where they directly or indirectly hold majority share capital and/or have majority representation on the board of directors or other governing bodies. However, under IFRS a special purpose entity may have to be consolidated even in cases where a company is not holding majority share or controlling the composition of the governing board of the SPE on account of certain arrangements like provision of finance to carry out the activities, exclusive rights to develop land, etc. which may be indicative of a control. As per SIC 12, the following circumstances, for example, may indicate a relationship in which an entity controls an SPE and consequently should consolidate the SPE?:

a) In substance, the activities of the SPE are being conducted on behalf of the entity according to its specific business needs, so that the entity obtains benefits from the SPE’s operation.

b) In substance, the entity has the decision-making powers to obtain majority of the benefits of the activities of the SPE or, by setting up an ‘autopilot’ mechanism, the entity has delegated these decision-making powers.

c) In substance, the entity has rights to obtain majority of the benefits of the SPE and therefore may be exposed to risks incident to the activities of the SPE.

d) In substance, the entity retains majority of the residual or ownership risks related to the SPE or its assets in order to obtain benefits from its activities.

Upon transition to IFRS, real estate companies will need to evaluate their relationship with SPEs based on the criteria laid down in SIC 12. Further, real estate companies will also need to examine whether such consolidation may have any legal or other implications.

Structured financing arrangements:

Structured financing arrangements for entities floated by real estate companies for projects, would need to be closely evaluated to identify the substance of the transaction; and accounting will have to reflect this underlying substance. For example, instruments issued for which the entity has an obligation to pay cash would need to be classified as debt and the underlying committed returns or fluctuations in the value of such instruments would have to be recorded in the income statement. This would also increase the volatility of the reported earnings and reduce reported profits.

Impacts of change in financial reporting framework on other operational areas:

Executive compensation plans:

Some real estate companies pay commissions/ variable incentives to employees based on sales or profits. Given the impact of IFRS, there will be a high degree of volatility in the reported revenues and reported profits of companies, thereby impacting these compensation plans. Further in case of payments to directors, which in India is limited to a specified percentage of profits, companies will need to address the impact on managerial remuneration due to insufficient profits in the period when construction activity is ongoing but possession is not transferred, though companies would have positive cash flows.

Tax:

Another important area which deserves attention is the impact on the tax liability for a company due to the change in the accounting framework with special emphasis on changes in revenue recognition. It will be important to understand whether tax authorities will recognise profits under IFRS as taxable profits and thereby postpone the tax incidence till the possession of the property is transferred. Alternatively, the authorities may require the companies to recompute revenue using percentage of completion method for tax purposes. Further, interplay between the minimum alternate tax (MAT) provisions and the reported profits under IFRS would be equally important.

Debt covenants:

In preparing its first IFRS financial statements, an entity recognises all assets and liabilities in accordance with the requirements of IFRS, and derecognises assets and liabilities that do not qualify for recognition under IFRS. Further, the entity would have to reclassify items that it recognised in accordance with previous GAAP as one type of asset, liability or component of equity, but are a different type of asset, liability or component of equity in accordance with IFRS.

This may impact various business ratios like gearing, liquidity and profitability ratios of a first-time adopter. Further, a reclassification of a long-term loan as current due to, say, a default in meeting any covenant (example business ratios) may impact debt covenants of other loans. In extreme situations, it may even impact the company’s ability to continue as a going concern. It would be therefore pertinent to conduct a detailed examination of the various loan and borrowing agreements and identify the covenants which may be impacted by the transition. An early discussion with the lenders of funds around these areas would go a long way in avoiding last minute surprises.

Conclusion:

As convergence with IFRS is inevitable, the key now lies in getting this transition right. The most important factors for real estate companies would be educating their stakeholders including investors, bankers and align internal budgets and performance measurement matrices. Companies would have to closely examine various debt covenants and clearly identify the ones which may be impacted due to the transition and discuss the same with their financiers/ bankers. At the same time, it will have to sensitise the market participants with respect to the unique impact of certain standards on the industry. This in turn would help to realign the valuation matrices based on the different set of accounting policies that will be used by these companies to report their performance results. Given the aforesaid implications, an early start towards the convergence process is pertinent for both preparers and users of financial statements to understand the impact on how the financial performance will be reported going forward.

Nirav Shah

Consolidation — redefining control and reflecting true net worth

Background :

Consolidated financial statements in India have traditionally been a reporting requirement only for listed companies. Companies not listed on stock exchanges are not required to prepare or present consolidated financial statements.

The fundamental change under IFRS is that IFRS recognises consolidated financial statements as the primary set of financial statements for any entity that has subsidiaries or joint ventures or associates. The only exception for an entity not to report consolidated financial statements is if it meets all the following conditions :

(a) the parent is itself a wholly-owned subsidiary, or is a partially-owned subsidiary of another entity and its other owners, including those not otherwise entitled to vote, have been informed about, and do not object to, the parent not presenting consolidated financial statements;

(b) the parent’s debt or equity instruments are not traded in a public market;

(c) the parent did not file, nor is it in the process of filing, its financial statements with a securities commission or other regulatory organisation for the purpose of issuing any class of instruments in a public market; and

(d) the ultimate or any intermediate parent of the parent produces consolidated financial statements available for public use that comply with International Financial Reporting Standards.

In this article we shall discuss the differences in principles of consolidation as laid down in IAS 27 ‘Consolidated and separate financial statements’ under IFRS and AS-21 ‘Consolidated financial statements’ under Indian GAAP. We will cover some of the implementation challenges and impact of the subtle differences in the consolidation standard between Indian GAAP and IFRS in our next article.

Key differences and implication :

Definition of control :

Under the IFRS framework, consolidation is based on the power to control (i.e., the ability of one entity to control another). Hence, understanding what constitutes ‘control’ is of utmost importance. Control is defined as the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities. This definition is not unlike what is stated under AS-21 in Indian GAAP. However, where Indian GAAP takes a narrow view and assumes that holding a majority of the voting interest of an entity automatically results in controlling the entity, IFRS treats the same as a rebuttable presumption. Thus, IFRS provides that control is presumed to exist when the parent owns, directly or indirectly through subsidiaries, more than half of the voting power of an entity, unless in exceptional circumstances, it can be clearly demonstrated that such ownership does not constitute control.

The implication of the control principles under IFRS is that companies cannot consolidate an entity only based on holding of current voting interests. Since consolidation is based only on control, only one holding entity will practically be able to demonstrate such control and hence there will never be a scenario where the same entity is being consolidated by two separate holding entities as a subsidiary. As a result of the transition to IFRS, the holding in the entity will need to be re-looked for assessment of potential voting rights held and more importantly an evaluation of the nature of any veto rights held by other shareholders, which are discussed below.

Potential voting rights :

In assessing control, the impact of potential voting rights that currently are exercisable should be considered. Such potential voting rights may take many forms, including call options, warrants, convertible shares, and contractual arrangements to acquire shares. This is because the potential voting rights give the holders the power to control the entity because they can step in and acquire control at any time if they wish to.

For example, X owns 40% of the voting power in A, Y owns 25% and Z owns the other 35%. Further, X holds a call option to acquire from Y an additional 20% of the voting power in A; the call option can be exercised at any time. Accordingly, it is X that has the power to govern A. Therefore X consolidates A, but reflects 60% as non controlling interest.

Participative rights with other shareholders :

The presumption of control may be rebutted in exceptional circumstances if it can be demonstrated clearly that such ownership does not constitute control. To ascertain whether ownership constitutes control, the rights of minority interests need to be analysed. In many cases minorities have certain rights even if another party owns the majority of the voting power in an entity. Sometimes these rights are derived from law, and other times from the entity’s constitution.

IFRSs do not address the issue of minority rights but as discussed above it is necessary to consider the nature and extent of the rights of minority in determining control, including the distinction between participating rights that allow minority to block significant decisions that would be expected to be made in the ordinary course of business, and rights that are protective in nature. Since IFRS does not have specific literature on minority rights, guidance is drawn from EITF 96-16 under US GAAP to determine if certain rights are participative and hence demonstrate absence of control with the majority shareholder. Examples of participative rights are :

Approval from minority shareholders for selecting, terminating, and setting the compensation of management responsible for implementing the investee’s policies and procedures.

Approval from minority shareholders for establishing operating and capital decisions of the investee, including budgets, in the ordinary course of business.

For example, two companies A and B come together to form a company X in which company A holds 75% with 3 directors on the board of company X and company B holds 25% with 2 directors on the board of company X. By virtue of majority holding, company A consolidates company X as a subsidiary under Indian GAAP. The Articles of Association of company X state that for certain decisions, a unanimous approval of the board of directors is required. These decisions include approving the annual and semi-annual budgets of the company and selection and appointment of senior management personnel. In such a case, Under IFRS, company A does not control company X, instead it shares joint control over it along with company B. Hence it shall not consolidate company X as a subsidiary but account for it as a joint venture arrangement.

Indirect holding:

Indirect holding mayor may not result in one entity having control over another. Although the total ownership interest may exceed 50%, this may not mean that the entity has control.

For example, entity L owns 35% of the voting power in entity N, and 40% of the voting power in entity M. M owns 60% of the voting power in N. There-fore, L has, directly and indirectly, a 59% [35% + (60% x 40%)] ownership interest in N.

However, L doesn’t control 59% of the vote because it does not have control over the votes exercised by M; rather, it is limited to significant influence. Therefore, in the absence of any contrary indicators, L does not control N and should not consolidate N.

Non-controlling interest (‘NCI’) :

Minority interests are referred as non-controlling interests (‘NCI’) under the revised IAS 27 standard and are presented as a part of consolidated equity. It is defined as ‘the equity in a subsidiary not attributable, directly or indirectly, to a parent’. This is unlike Indian GAAP, where minority interests are reflected outside consolidated equity (generally, as a liability).

Losses applicable to NCI are allocated irrespective of whether the NCI has a contractual obligation to make good such losses to the parent, even if doing so causes the NCI to be in a deficit position. Once again, this is unlike the treatment of excess losses under Indian GAAP.

Changes in controlling interests:

Under IFRS, changes in the parent’s ownership interest in a subsidiary after control is obtained that do not result in a loss of control need to be accounted for as transactions with owners in their capacity as owners. As a result no gain or loss on such changes is recognised in the income statement. Also, no change in the carrying amounts of assets (including goodwill) or liabilities is recognised as a result of such transactions.

For example, Entity A owns 60% of the shares in Entity B. On 1st January 2010 Entity A acquires an additional 20% of Entity B. The consideration transferred for the additional shares of Entity B is INR 400. The carrying amount of non-controlling interest in the consolidated financial statements of Entity A on 1st January 2Q10 is INR 500.

The acquisition of the 20% interest of the non-controlling interest is recorded as follows:

Entity A recognises the decrease in equity in its consolidated financial statements. No adjustments are made to the recognised amounts of assets and liabilities or to goodwill.

Under Indian CAAP, the above acquisition of 20% additional interest would result in additional good-will for .the difference between the consideration transferred (INR 400) and the book value of the minority interest purchased.

Similarly, a reduction in equity interests from 80% to 60% due to sale of shares to minority interests (however control retained by the Company) would also have been adjusted in equity in the same manner as above, unlike Indian CAAP where a gain or loss on such sale of stake would have been rec-ognised in profit and loss e.g., : If the sale of 20% stake was made for a consideration of INR 500 (thus reducing the overall stake from 80% to 60%), and the net assets of the subsidiary were INR 1500 – Under IFRS, this transaction would result into an additional credit of INR 300 (1500*20%) to non-controlling interests and a credit of INR 200 to other equity, whereas under Indian CAAP the adjustment of INR 200 would have been recognised as a gain in the income statement.

Under IFRS, when a change in controlling interests results in loss of control (e.g., due to sale of investment in the subsidiary, due to which the investee company ceases to be a subsidiary), such a change is accounted for in two parts. Firstly, derecognise the net assets and goodwill of the subsidiary and recognise the relating gain or loss in income statement (by comparing it to the fair value of consideration received). Secondly, recognise any balance investment in the former subsidiary at fair value.

For example, Entity A owns 60% of the shares in Entity B. On 1st January 2010 Entity A disposes of a 20% interest in Entity B and loses control over Entity B. The consideration received for the sale of shares of Entity B is INR 400. At the date that Entity A disposes of a 20% interest in Entity B, the carrying amount of the net assets of Entity B is INR 1,750. The amount of non-controlling interest in the consolidated financial statements of Entity A on 1st January 2010 is INR 700. The fair value of the remaining 40% investment is determined to be INR 800.

Entity A would record the following entry to reflect its disposal of a 20% interest in Entity B at 1st January 2010 :

The gain represents the increase in the fair value of the retained 40% investment of INR 100 [INR 800 – (40% x INR 1,750)], plus the gain on the sale of the 20% interest disposed of INR 50 [INR 400 – (20% x INR 1,750)].

Assuming that the remaining interest of 40% represents an associate, the fair value of INR 800 represents the cost on initial recognition and IAS 28-Accounting for associates applies going forward.

Under Indian CAAP, the gain on sale in the above case would be recognised based on the difference between the consideration received (INR 400) and the proportionate carrying value of the investment in the subsidiary. The carrying value of the balance investment would not be revalued to the fair value
unlike IFRS. ‘

Special purpose entities:

Under IFRS, there is no requirement for the parent to have a shareholding in a subsidiary, and this is not a necessary pre-condition for control. Sometimes an entity is created to accomplish a narrow and well-defined objective (e.g., conduct research and development activities, securitise financial assets, or own a specified asset). Such entities are referred to as Special Purpose Entities (SPE) and SIC 12 ‘Consolidation – Special purpose entities’ lays down the guidance for consolidation of SPEs. Important to bear in mind when analysing an SPE is the requirement to account for the substance and economic reality of a transaction rather than only its legal form. Conditions where an entity controls an SPE and hence needs to apply consolidation are given below:

a) in substance, the activities of the SPE are being conducted on behalf of the entity according to its specific business needs so that the entity obtains benefits from the SPE’s operation;

b) in substance, the entity has the decision-making powers to obtain the majority of the benefits of the activities of the SPE or, by setting up an ‘autopilot’ mechanism, the entity has delegated these decision-making powers;

c) in substance, the entity has rights to obtain the majority of the benefits of the SPE and there-fore may be exposed to risks incidental to the activities of the SPE; or

d) in substance, the entity retains the majority of the residual or ownership risks related to the SPE or its assets in order to obtain benefits from its activities.

Using this approach, several SPE’s that have been set up by Indian companies for specific purposes (without any direct holding of voting interest or Board representation) may need to be consolidated, if the conditions of SIC 12 are met. This involves significant use of judgment and an evaluation of all the facts and circumstances of the case. Such entities are typically not consolidated under Indian CAAP. In the Indian context, some of the above parameters may get triggered in arrangements of ‘toll manufacturers’ – a practice which is fairly common in the FMCC and pharmaceuticals industry.

Conclusion:

Consolidation is an area which needs careful evaluation on convergence with IFRS. The changes due to such transition could result in a change in the group i.e., subsidiaries which were earlier part of the group may now become joint ventures or associates; and special purpose entities which were earlier not consolidated would now form part of the consolidation group. Consolidation in IFRS essentially revolves around the concept of unilateral control of the financial and operating policies of the investee company and lays importance on substance over form. It is important to note here that IASB has issued an Exposure Draft ‘ED 10 – Consolidated Financial Statements’ that under one standard now covers concepts of participative and protective rights of non-controlling interest and special purpose entities.

Nirav Shah

Framework to IFRS : The foundation to financial accounting concepts

IFRS

Purpose and scope of framework :

The Framework to IFRS (‘the framework’) sets out the concepts
that underline the preparation and presentation of financial statements for
external users. The basic purpose of the IFRS framework is to (i) assist the
standard-setting body with the development and review of existing and new
accounting standards; (ii) assist the preparers of financial statements in
applying the IFRS; (iii) assist the auditors to assess whether the financial
statements are prepared in line with IFRS; and (iv) assist the users of
financial statements to interpret the financial statements prepared in
conformity with IFRS.

The framework is not an accounting standard and hence does
not prescribe recognition, measurement and disclosure requirements. As per the
framework, in limited circumstances where there is a conflict between the
framework and the accounting standards, the accounting standard is required to
be followed. Further, the framework is applied in preparation of general-purpose
financial statements, which under IFRS are consolidated financial statements.
This is a significant departure from traditional Indian GAAP where the
general-purpose financial statements are separate financial statements of the
reporting entity.

The framework deals with :

(i) the objective of financial statements;

(ii) the qualitative characteristics that determine the
usefulness of information in financial statements;

(iii) the definition, recognition and measurement of the
elements from which financial statements are constructed; and

(iv) concepts of capital and capital maintenance.

Objective of financial statements :

The objective of the financial statements is to provide
information about the financial position, financial performance and cash flows
of the reporting entity to the users of financial statements.

As compared to Indian GAAP, IFRSs place more emphasis on cash
flows. For instance, the framework states that financial statements provide
information on the ability of an entity to generate cash and cash equivalents
and of the timing and certainty of their generation. Users are better able to
evaluate this ability to generate cash and cash equivalents if they are provided
with information that focusses on the (1) financial position, (2) performance,
and (3) changes in financial position of an entity.

The information about financial position of an entity is
affected by the economic resources it controls, its financial structure, its
liquidity and solvency, and its capacity to adapt to changes in the environment
in which it operates. Information about the performance of an entity, in
particular its profitability, is required in order to assess potential changes
in the economic resources that it is likely to control in the future.
Information concerning changes in the financial position of an entity is useful
in order to assess its investing, financing and operating activities during the
reporting period.

Underlying assumptions :

The framework sets out the underlying assumptions upon which
the IFRS accounting standards are based.

Accrual basis of accounting :

The financial statements are prepared on the accrual basis of accounting, i.e., the effects of transactions and other events are recognised when they occur (and not as cash or its equivalent is received or paid) and they are recorded in the accounting records and reported in the financial statements of the periods to which they relate.

Going concern :

The financial statements are normally prepared on the assumption that an entity is a going concern and will continue in operation for the foreseeable future.

Prudence :

Unlike Indian GAAP, IFRS does not consider ‘Prudence’ as an underlying assumption. For instance, the unrealised gains on an ‘available-for-sale financial asset’ is required to be recognised under IFRS, whereas the same is prohibited under Indian GAAP on the grounds of prudence. The framework makes it clear that prudence means exercising a degree of caution in making judgments under conditions of uncertainty, but that it should not lead to the creation of hidden reserves or excessive provisions.

Qualitative characteristics of financial statements :

The qualitative characteristics are the attributes that make the information provided in financial statements useful to users. There are four principal qualitative characteristics
(1) understandability, (2) relevance, (3) reliability, and (4) comparability, of which some are divided into sub-categories.

1. Understandability :

Information should be presented in a manner that it is readily understood by users.

2. Relevance :

Information must be relevant to the decision-making needs of users. Information has the quality of relevance when it influences the economic decisions of users by helping them evaluate past, present or future events or confirming, or correcting, their past evaluations. Financial statements must have both predictive value and confirm past events.

Materiality :

The relevance of information is affected by its nature, and materiality. In some cases the nature of information alone is sufficient to determine its relevance (e.g., managerial remuneration). In other cases both nature and materiality are important (e.g., estimates of provisions that involve significant judgment). Information is material if its omission or misstatement could influence the economic decision of users taken on the basis of the financial statements (e.g., no provision made on non-performing assets in case of banks). As materiality depends on the size and nature of the item or error judged in the surrounding circumstances, materiality provides a threshold or cut-off point rather than being a primary qualitative characteristic which information must have if it is to be useful.

Either the size or the nature of the item, or a combination of both, could be the determining factor. Consideration of materiality is relevant to judgments regarding both the selection and application of accounting policies and to the omission or disclosure of information in the financial statements.

Materiality needs to be assessed on disclosures in case when items may be aggregated, the use of additional line items, headings and sub-totals. Materiality also is relevant to the positioning of these disclosures (on the face of the financial statements or in the notes). As such, IFRSs are not intended to apply to immaterial items.

3. Reliability:

Information has the quality of reliability when it is free from material error and bias and can be depended upon by users to represent faithfully that which it either purports to represent or could reasonably be expected to represent. Information may be relevant but so unreliable in nature or representation that its recognition may be potentially misleading. Reliability depends on:

a) Faithful representation:
To be reliable, information must represent faithfully the transactions and other events it either purports to represent or could reasonably be expected to represent, e.g., a statement of financial position should represent faithfully the transactions and other events that result in assets, liabilities and equity at the reporting date which meet the recognition criteria.

        b) Substance over form:
    Information must be accounted for and presented in accordance with its substance and economic reality and not merely its legal form.

        c) Neutrality:
    Information must be free from bias. Financial statements are not neutral, if by the selection or presentation of information, they influence the making of a decision or judgment in order to achieve a predetermined result or outcome.

d) Prudence:
Prudence is the inclusion of a degree of caution in the exercise of the judgments needed in making the estimates required under conditions of uncertainty. However, the exercise of prudence does not allow, for instance, the creation of hidden reserves or excessive provisions, the deliberate understatement of assets or income, or the deliberate overstatement of liabilities or expenses, because the financial statements would not be neutral and, therefore, not have the quality of reliability.

e) Completeness:
To be reliable, the information must be complete within the bounds of materiality and cost. An omission can cause information to be false or misleading and thus unreliable and deficient in terms of its relevance.

4. Comparability:
Users must be able to compare the financial statements of an entity (a) through time — internal comparability and (b) with different entities — external comparability. The measurement and display of the financial effect of like transactions and other events must be carried out in a consistent manner throughout an entity and over time for that entity and in a consistent manner for different entities. It is important that the accounting policies used and changes to these are disclosed. It also is important that the financial statements present corresponding information for the preceding periods.

Constraints on relevant and reliable information:

1. Timeliness:
If there is undue delay in the reporting of information it may lose its relevance. Management may need to balance the relative merits of timely reporting and the provision of reliable information.

        2. Benefit and cost:
    The benefits of information should be greater than the cost of providing it. The evaluation of benefits and costs is, however, a judgmental process.

        3. Balance between qualitative characteristics:
    In practice, a balancing or trade-off between qualitative characteristics is often necessary. The relative importance of the characteristics in different cases is a matter of professional judgment.

    Definitions of assets, liabilities and equity:

        1. Assets:
    An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity. The future economic benefit embodied in an asset is the potential to contribute, directly or indirectly, to the flow of cash and cash equivalents to the entity. Like Indian GAAP, the physical form is not essential to the existence of an asset, e.g., patents and copyrights. However, unlike Indian GAAP, the legal ownership is not of primary concern under IFRS; economic ownership is the essential characteristic.

        2. Liabilities:
    A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. It is important to note here the term ‘present obligation’ (as opposed to ‘future commitment’), i.e., a decision by management to buy an asset in the future does not give rise to a present obligation — an obligation normally arises only when the asset is delivered or when management enters into an irrevocable agreement to acquire the asset.

        3. Equity:
    Equity is the residual interest in the assets of the entity after deducting all its liabilities. Although equity is defined as a residual, it may be sub-classified in the balance sheet. For instance, in a corporate entity, funds contributed by shareholders, retained earnings, reserves representing appropriations of retained earnings and reserves representing capital maintenance adjustments may be shown separately.

Recognition criteria for assets and liabilities: Assets and liabilities must be recognised if the recognition criteria are satisfied. Items are to be recognised as assets or liabilities (or as income and expenses) if:

1. it is probable that any future economic benefit associated with the item will flow to or from the entity, and

2. the item has a cost or value that can be measured with reliability.

The recognition criteria stresses on the ‘probability’ rather than ‘certainty’ of occurrence of future economic benefits. The probability of future economic benefits is to be assessed when the financial statements are prepared. The concept of probability refers to the degree of uncertainty that the future economic benefits associated with the item will flow to or from the entity. Assessments of the degree of uncertainty attaching to the flow of future economic benefits are made on the basis of the evidence available when the financial statements are prepared.
Specific criteria for recognition of assets:

Probable that future economic benefits will flow to the entity, and

The cost or value can be reliably measured.

The future economic benefits may flow to the entity in a number of ways. For instance:

Inventories, fixed assets and know-how may be used in the production of goods or services to be sold by the entity;

Cash and cash equivalents, receivables or marketable securities may be exchanged for other assets;

Cash and cash equivalents may be used to settle a liability; or

Cash and cash equivalents may be distributed to the owners of the entity.

Specific criteria for recognition of liabilities:

Probable outflow of resources will result from settlement of a present obligation, and

The amount can be measured reliably. The settlement of a present obligation usually involves the entity giving up assets in order to satisfy the claim of the other party.

Settlement may occur in a number of ways, for instance, by:

The payment of cash or cash equivalents as is the case with most payables;

The transfer of other assets, for example, in a barter transaction or in some business combination;

The rendering of services to the other party as is the case with a liability for warranty repairs; or

The replacement of the obligation with another obligation.

Definition of income and expense:

Income:
Income is an increase in economic benefits during the accounting period, in the form of direct inflow, enhancement of assets, or decrease in liabilities; and that results in increase in equity, other than those relating to contributions from equity participants.

The definition of income encompasses both revenue and gains. Revenue arises in the course of the ordinary activities of an entity, including sales, fees, interest, dividends, royalties and rent. Gains represent other items that meet the definition of income and may not arise in the course of the ordinary activities of an entity (e.g., gains on the disposal of non-current assets). Gains represent increase in economic benefits and as such is no different in nature from revenue. Hence, gains are not regarded as constituting a separate element in the framework. Unlike Indian GAAP, the definition of income also includes unrealised gains (e.g., unrealised gains arising on the revaluation of marketable securities).

Expense:

The definition of expenses encompasses losses as well as those expenses that arise in the course of the ordinary activities of the entity. Losses represent other items that meet the definition of expense and may, or may not, arise in the course of the ordinary activities of the entity.

Recognition criteria for income and expense: The recognition criteria for income and expense are the same as for the recognition of assets and liabilities.

Income is recognised in the profit and loss account when increase in future economic benefits related to an increase in an asset or a decrease of a liability has arisen that can be measured reliably. This means, in effect, that recognition of income occurs simultaneously with the recognition of increase in assets or decrease in liabilities.

Expenses are recognised in the profit and loss account when decrease in future economic benefits related to a decrease in an asset or an increase of a liability has arisen that can be measured reliably. This means, in effect, that recognition of expenses occurs simultaneously with the recognition of an increase in liabilities or a decrease in assets.

Measurement of elements of financial statements:
Different measurement bases mentioned in the framework are historical cost, current cost, realisable (settlement) value and present value.

Historical cost:
Assets are recorded at the amount of cash or cash equivalents paid or the fair value of the consideration given to acquire them at the time of their acquisition. Liabilities are recorded at the amount of proceeds received in exchange for the obligation, or in some circumstances (for example, income taxes), at the amounts of cash or cash equivalents expected to be paid to satisfy the liability in the normal course of business.

Current cost:
Assets are carried at the amount of cash or cash equivalents that would have to be paid if the same or an equivalent asset was acquired currently. Liabilities are carried at the undiscounted amount of cash or cash equivalents that would be required to settle the obligation currently.

Realisable (settlement) value:

Assets are carried at the amount of cash or cash equivalents that could currently be obtained by selling the asset in an orderly disposal. Liabilities are carried at their settlement values; that is, the undiscounted amounts of cash or cash equivalents expected to be paid to satisfy the liabilities in the normal course of business.

Present value:

Assets are carried at the present discounted value of the future net cash inflows that the item is expected to generate in the normal course of business. Liabilities are carried at the present discounted value of the future net cash outflows that are expected to be required to settle the liabilities in the normal course of business. This is different from Indian GAAP, where the assets and liabilities are recognised at transaction values without reference to the time value of money.

Key GAAP differences in the frameworks:

The primary financial statement is consolidated financial statement under IFRS framework, unlike Indian GAAP where the primary financial statement is standalone financial statements.

Unlike Indian GAAP, IFRS does not identify ‘Prudence’ as one of the fundamental accounting assumptions in preparation of financial statements. Thus unrealised gains of available-for-sale securities are recognised under IFRS, unlike Indian GAAP.

As compared to Indian GAAP, IFRS places more importance on the statement of cash flows as it provides information on the ability of an entity to generate cash and cash equivalents and of the timing and certainty of their generation.

Unlike Indian GAAP, the legal ownership is not a criterion for recognition of an asset. IFRS recognises an asset based on the assessment of ‘control’ over the economic benefits accruing from the asset.

Unlike Indian GAAP, certain assets and liabilities are recognised at the present value of future cash flows when the time value of money is significant.

While barring the above differences, the framework under Indian GAAP and IFRS are similar, the said differences will have far-reaching implications on the Indian industry. Some of the accounting and reporting GAAP differences have their roots in the differences in the underlying frameworks.

Nirav Shah

Comparison of IFRS Exposure Draft on Insurance Contracts and Insurance Accounting in India

Comparison of IFRS Exposure Draft on Insurance

On 30 July 2010, the International Accounting Standards Board
(IASB) issued its long-awaited exposure draft on Insurance Contracts. This
Exposure Draft (ED) has been many years in preparation and represents a
significant step forward towards the IASB’s goal of providing comprehensive
guidance for accounting for insurance contracts.

Although IFRS 4 Insurance Contracts (the existing accounting
standard) addressed some of the more urgent issues in insurance contract
accounting, it was only transitionary. It permits a wide variety of existing
accounting practices to continue, which hinders comparability for users.

Given the Indian context and impending convergence with IFRS
from 1 April 2012 for insurance companies in India, the provisions of this ED
are critically important and will guide the corresponding provisions of the
Indian accounting standard to be issued in this regard.

Insurance contracts often expose entities

to long-term and uncertain obligations. There are several complex policies,
principles and calculations involved in measuring these obligations. As a
result, stakeholders need to be informed adequately about the insurer’s business
model, risk management practices, measurement approaches, solvency, asset
management, profitability, etc. The ED is a step in the right direction.

This article is a summary of the ED. It provides an overview
of the main proposals published for public comment by the IASB and the
differences with regards to the existing practice in India for the insurance
industry.

Executive summary of the Exposure Draft on Insurance Contracts :

The
ED proposes a new standard on accounting for insurance contracts which would
replace IFRS 4 Insurance Contracts.

The
ED proposes a comprehensive measurement model for all types of insurance
contracts issued by entities with a modified approach
for some short-duration contracts. The measurement model is based on a
principle that insurance contracts create a bundle of rights and obligations
that work together to create a package of cash inflows (premiums) and outflows
(benefits, claims and costs). The measurement model, which applies to that
package of cash flows, uses the following building blocks :

a
current estimate of future cash flows;

a
discount rate that adjusts those cash flows for the time value of money;

an
explicit risk adjustment; and

a
residual margin.

For
short-duration contracts, a modified version of the measurement
model applies. As a proxy for the measurement model, during the coverage
period, the insurer measures the pre-claims liability by allocating premiums
receivable across the coverage period. For these contracts, the insurer would
apply the building block measurement model to measure claim liabilities for
insured events that have already occurred and for onerous contracts.

The
ED proposes that an insurer include incremental acquisition costs (i.e.,
costs of selling, underwriting and initiating an insurance contract) as part
of the contract’s cash flows. As a result, those costs would generally affect
profit or loss over the coverage period rather than at inception. All other
acquisition costs (i.e., fixed salary related to underwriting and
front-line sales staff) would be expensed when incurred through profit and
loss account.

The
proposals also include revised unbundling criteria for non-derivative
components of an insurance contract; a revised presentation for the statement
of financial position and statement of comprehensive income; a building block
measurement model for reinsurance contracts; an expected loss model for credit
risk of reinsurance assets; accounting guidance for investment contracts with
a discretionary participation feature (DPF) including an expanded definition
of a DPF compared to IFRS 4; revised accounting guidance for business
combinations and portfolio transfers; and extensive disclosure requirements.
Below, we consider some of the critical areas in the ED.

Differences between the IFRS ED and existing practice of
recognition and measurement of insurance contracts in the Indian insurance
industry :

The differences are broadly classified and discussed below :

Classification of insurance contracts;

Measurement of insurance contracts;

Treatment of acquisition costs;

Unbundling;

Embedded derivatives

Derecognition;

Reinsurance;

Presentation, and

Disclosure

Classification of insurance contracts :

The
proposals in the ED apply to all insurance contracts (including reinsurance
contracts) that an entity issues and reinsurance contracts that an entity
holds. Financial instruments containing a discretionary participation feature
(DPF) that an entity issues are also in the scope of this proposal.

Under the proposal, an insurance contract is de-fined as a contract under which one party (the insurer) accepts significant insurance risk from another party (the policyholder) by agreeing to compensate the policyholder if a specified uncer-tain future event (the insured event) adversely affects the policyholder. This definition is consistent with the current definition of an insurance contract under IFRS 4.

Under the proposals, insurers should begin recognising the contract when they are bound by the coverage, which could be prior to the effective date or the date on which a contract is signed (i.e., when there is an unconditional offer extended for coverage) and may be heavily influenced by local regulatory requirements.

Classification of insurance contracts in India:

There is no specific standard for the purpose of classifying Insurance contracts under Indian GAAP. Currently, traditional, unit-linked insurance plan and pension products are sold by insurance companies and premium received on all these policies are accounted as premium income in revenue account.

This will be a significant shift in the method of accounting for premium for life insurance companies as pension products having zero death benefits will not fall under the purview of insurance contracts and have to be accounted as Investment contracts and investment component pertaining to ULIP contracts would have to be accounted separately.

However this will be a P/L neutral adjustment as currently they are adjusted as part of provision for insurance liabilities at the period end.

Measurement of insurance contracts — The building-block approach?:
The proposed model uses a building- block ap-proach to the measurement of insurance contracts The measurement model includes a ‘fulfilment’ objective which reflects the fact that an insurer generally expects to fulfil its liabilities over time by paying benefits and claims to policyholders as they become due, rather than transferring the li-abilities to a third party.

An insurer measures a contract as the sum of

the present value of the fulfilment cash flows, being the expected present value of the future cash outflows less future cash inflows that will arise as the insurer fulfils the contract, including a risk adjustment for the effects of uncertainty about the amount and timing of those future cash flows; and

a residual margin that eliminates any gain at inception of the contract. A residual margin arises when the present value of the fulfilment cash flows is less than zero. If the present value of the fulfilment cash flows at inception is positive (i.e., the expected present value of cash outflows plus the risk adjustment is greater than the expected present value of cash inflows), then this amount is immediately recognised as a loss in profit or loss.

The residual margin is determined on initial recognition at a portfolio level for contracts with a similar inception date and coverage period. This residual margin amount is ‘locked-in’ at inception. The residual margin is recognised in profit or loss over the coverage period in a systematic way that best reflects the exposure from providing insurance coverage, either on the basis of the passage of time or on the basis of the expected timing of incurred claims and benefits if that pattern differs significantly from the passage of time. Also, the insurer accretes interest on the carrying amount of the residual margin using the discount rate determined on initial recognition to reflect the time value of money.

The present value of the fulfilment cash flows contains the following ‘building blocks’ and is re-measured at each reporting period.

an explicit, unbiased and probability-weighted estimate (i.e., expected value) of the future cash outflows less the future cash inflows that will arise as the insurer fulfils the insurance contract;

a discount rate that adjusts those cash flows for the time value of money; and

a risk adjustment — an explicit estimate of the effects of uncertainty about the amount and timing of those future cash flows.

Measurement of insurance liabilities by Indian insurance companies?:

The Gross Premium Methodology for life insurance contracts is governed by the IRDA (Assets, Liabilities and Solvency Margin of Insurers), Regulations, 2000 and Guidance Notes GN1, GN2 and GN7 issued by the Institute of Actuaries of India (IAI). The regulations govern the valuation of liabilities for both non -linked and linked business with some additional requirements for linked business.

Mathematical reserves are determined separately for each contract. The valuation method primarily takes into account all prospective contingencies including cost of any options that may be available to the policyholder. The reserves have to be at least as large as any guaranteed surrender value and never less than zero.

In addition, for unit-linked business?:

The value to be placed on the unit reserve shall be the current value of the assets underlying the unit fund determined in accordance with the IRDA Regulations.

If unit liabilities are not matched, a mismatch reserve shall be created.

Separate unit and non-unit reserves shall be held. The sum of these reserves would represent the total reserve for a unit-linked policy.

The total reserve in respect of a policy shall not be less than the guaranteed surrender value on the valuation date. Neither the unit reserve nor the non-unit reserve in respect of a policy shall be negative.

The proposed IFRS measurement model focusses on the key drivers of insurance contract profit-ability, and would provide users with a clearer insight than they gain from today’s patchwork of different models for different types of contract. The same model would apply to all insurance contracts. However a modified version would apply to short duration insurance contracts.

Insurers would present information in the financial statements that focusses on the drivers of performance, i.e.,?:

release from risk, as the risk adjustment decreases

what insurers expect to earn from providing insurance services

investment returns on invested premiums, and

the investment returns provided to policyholders (either implicitly through pricing or explicitly) differences between expected and actual cash flows and changes in estimates and the discount rate.

The current problem in cash flow estimates is that insurers use ‘locked in’ estimates which do not provide current information about insurance liabilities. However the proposed changes in ED would require changes in cash flow estimates to be reflected in profit or loss in the period in which they arise. This would enhance transparency and provide more relevant information for users.

Pre-claims liabilities for short-duration contracts (General Insurance Contracts):

The proposals contain a modified measurement approach for pre-claim liabilities of short duration contracts. This model is intended to be a proxy for the building-block measurement model in the pre-claims period. In the proposals ‘short-duration’ contracts are defined as insurance contracts with a coverage period of approximately 12 months or less that do not contain any embedded options or derivatives that significantly affect the variability of cash flows.

In this measurement approach an insurer is required to measure its pre-claims obligation at inception as premiums received at initial recognition plus the present value of future premiums within the boundary of the contract less incremental acquisition costs.

This pre-claims obligation is reduced over the coverage period in a systematic way that best reflects the exposure from providing insurance coverage, either on the basis of the passage of time or the expected timing of incurred claims and benefits if this pattern differs significantly. Pre-claims liabili-ties are the preclaims obligation less the present value of future premiums within the boundary of the contract. The insurer is also required to accrete interest on the carrying amounts of the preclaims liabilities. If the contract is onerous, the excess of the present value of the fulfilment cash flows over the carrying amount of the pre-claims obligation is recognised as an additional liability and expense.

Liabilities for claims incurred are measured at the present value of fulfilment cash flows in accor-dance with the general measurement model.

Measurement of general insurance contracts by Indian insurance companies:

For short-duration contracts the IRDA regulations specifies

reserve for unexpired risks as a percentage of the premium, net of reinsurances, received or receivable during the preceding twelve months, and

reserve for outstanding claims reasonably estimated according to the insurer, on a ‘case-by-case method’ after taking into account the explicit allowance for changes in the settlement pattern or average claim amounts, expenses and inflation.

The ED on insurance contract gives a comprehensive measurement model for general insurance contracts as against the existing practice currently followed.

Acquisition costs:

Incremental acquisition costs (costs of selling, underwriting, and initiating an insurance contract that would not have been incurred if the insurer had not issued that particular contract) are included in the present value of the fulfilment cash flows of a contract. All other acquisition costs are expensed when incurred in profit or loss.

Non-incremental acquisition costs would be recognised as an expense.

Indian insurers recognise acquisition costs as an expense immediately. This would result smaller losses at inception than they do today.

Unbundling:
Insurance contracts may include multiple elements, such as insurance coverage, investment compo-nents and embedded derivatives i.e., insurance contracts contain one or more components that would be within the scope of another IFRS if the insurer accounted for those components as if they were separate contracts, e.g., an investment (financial) component or a service component.

If a component is not closely related to the in-surance coverage specified in a contract, the ED proposes that an insurer does unbundle and ac-count separately for that component.

This would require Indian life insurance companies to unbundle the investment component from ULIP contracts from total premium and disclose it sepa-rately since inception. Currently the deposit portion is unbundled only at the end of the reporting period by way of including them in the actuarial reserves and then disclosing them in provision for linked liabilities.

Moreover, the pension and annuity products which are having no risk cover i.e., zero death benefits would not be under the purview of insurance contracts. These would have to be accounted as investment contracts under IAS 39 and the premium received on such contracts would have to separately shown in the balance sheet.

Embedded derivatives

Under the proposals, IAS 39 applies to an embed-ded derivative in an insurance contract unless the embedded derivative itself is an insurance contract. If the economic characteristics and risks of the embedded derivative are not closely related to those of the host insurance contract, the insurer is required to separate the embedded derivative and measure it at fair value with recognition of changes in fair value in profit or loss if the embed-ded derivative meets the following criteria?:

a) the economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host insurance contract

b) a separate instruments with the same terms as the embedded derivative would meet the definition of a derivative and be within the scope of IAS 39 (e.g., the derivative itself is not an insurance contract).

Derecognition

An insurer shall remove an insurance contract liability (or a part of an insurance contract liability) from its statement of financial position when, and only when it is extinguished, i.e., when the obligation specified in the insurance contract is discharged or cancelled or expires. At that point, the insurer is no longer at risk and is therefore no longer required to transfer any economic resources to satisfy the insurance obligations.

The insurance liability ceases as soon as the policy lapses i.e., if the premium is not honoured on the due date including grace period provided by the insurance company.

However the Indian life insurance companies carry out an analysis of lapsed unit-linked policies not likely to be revived and likely to be revived. For policies not likely to be revived, the insurance reserves are transferred to funds for future appropriation and then to the profit and loss account after a period of two years and for policies likely to be revived the insurance liabilities are still maintained though the policy has lapsed and the risk cover has expired.

It appears that the ED on insurance contracts would require the risk reserves to be derecognised as soon as the policy lapses. Only the deposit component would be maintained as a liability for such policies with corresponding investments.

Reinsurance

At initial recognition, a cedant measures reinsurance contract as the sum of:

the present value of the fulfilment cash flows, which is made up of the expected present value of the cedant’s future cash inflows plus a risk adjustment less the expected present value of the cedant’s future cash outflows less any ceding commissions received; and

a residual margin that eliminates any loss at inception of the contract.

The expected present value of losses from default by the reinsurer or coverage disputes are incorporated in the measurement of reinsurance assets.

The ED on insurance contract requires reinsurance assets and reinsurance liabilities to be shown separately.

However the current practice in India is that the insurance companies net-off the reinsurance receivable and payable and disclose only the net amount as receivable or payable, as the case may be.

Presentation in the statement of financial position and the statement of comprehensive income

Statement of financial position

The ED proposes that an insurer present each portfolio of insurance contracts as a single-line item within insurance contract assets or insurance contract liabilities. It also proposes that an insurer present a pool of assets underlying unit-linked contracts as a single- line item separate from the insurer’s other assets and that the portion of the liabilities linked to the pool be presented as a single-line item separate from the insurer’s other liabilities. Reinsurance assets are not offset against insurance contract liabilities.

Statement of comprehensive income

The ED proposes a presentation model that focuses on margins and other key insurance performance information. The ED proposes a new presentation for the statement of comprehensive income which follows the proposed measurement model. The underwriting margin is subject to disaggregation requirements (in the notes or on the face of the financial statements), disclosing the change in risk adjustment and release of the residual margin. The margin presentation requires insurers to treat all premiums as deposits and all claims and benefits as repayments to the policyholder. An insurer is expected to present at a minimum, the following items?:

Change in the risk adjustments;

The release of the residual margin during the period;

The difference between the expected and the actual cash flows;

Changes in estimates; and

Interest on insurance liabilities.

Other items to be presented in the statement of comprehensive income include?: gains and losses at initial recognition (further disaggregated on the face or in the notes into losses at initial recognition of an insurance contract, losses on insurance contracts acquired in a portfolio transfer, and gains on rein-surance contracts bought by a cedant); acquisition costs that are not incremental at the level of an individual contract; experience adjustments and changes in estimates (further disaggregated on the face or in the notes into experience adjustments, changes in estimates of cash flows and discount rates, and impairment losses on reinsurance as-sets); and interest on insurance contract liabilities. Income and expense from unit-linked contracts are presented as a separate single-line item.

Premiums and claims generally are not presented in the statement of comprehensive income on the basis that they represent settlements of insurance contract assets or liabilities rather than revenues or expenses. However, for short-duration contracts subject to the alternative measurement approach for pre-claims liabilities, the underwriting margin is disaggregated into line items reflecting each of pre-mium revenues, claims and other expenses, amortisation of incremental acquisition costs and changes in additional liabilities for onerous contracts.

Presentation of insurance accounts by Indian insurance companies

The financial presentation format currently comprises the Revenue Account, Profit and Loss Account and Balance Sheet. The Revenue account contains all insurance-related captions and income earned from investments out of policyholders’ funds.?The?Profit and Loss account includes deficit funding if any, profit transfers from revenue account and investment income earned out of shareholders’ funds.

The proposed method of accounting is a complete paradigm shift as compared to the existing financial reporting model.

Disclosures:

To help users of financial statements understand the amount, timing and uncertainty of future cash flows arising from insurance contracts, extensive disclosures are required that include qualitative and quantitative information about the amounts arising from insurance contracts, including?: the reconciliation of contract balances; methods and inputs used to develop the measurements; and the nature and extent of risks arising from insurance contracts.

Currently the insurance disclosures are not very extensive for Indian insurance companies. The current actuarial disclosures merely give basic assumptions, interest rates and references to mortality and morbidity tables published by Life Insurance Corporation of India.

Effective date, transition and impact on other aspects:

The ED does not include an effective date for the proposals or state whether they may be adopted early. The IASB plans an additional consultation, in conjunction with the FASB, on the effective dates of these proposals and other proposed standards to be issued in 2011, including consideration of IFRS 9 Financial Instruments. The Board will con-sider delaying the effective date of IFRS 9 (annual periods beginning on or after 1 January 2013) if the new IFRS on insurance contracts has a mandatorily effective date later than 2013 so that an insurer would not have to face two major rounds of change in a short period.

Additionally, an insurer is exempt from disclosing previously-unpublished information about claims development that occurred earlier than five years before the end of the first financial year in which it applies the proposals. An insurer is required to disclose if it is impracticable to prepare information about claims development that occurred before the beginning of the earliest period presented.

The ED requires that an insurer should measure each portfolio of insurance contracts at the present value of the fulfilment cash flows, starting at the beginning of the earliest period presented. If there is a difference between the new measure-ment amount and the amount under the insurer’s previous accounting policies, the difference should be recognised in retained earnings.

The insurer also should derecognise any existing balances of deferred acquisition costs.

The transition requirements apply both to a first-time adopter of IFRS and to an insurer currently reporting under IFRS.

Example measurement of insurance contracts — Indian GAAP v. IFRS ED:

An insurer issues an insurance contract, receives Rs.50 as the first premium payment and incurs acquisition costs of Rs.70, of which incremental acquisition costs are Rs.40. The insurer estimates an expected present value (EPV) of subsequent premiums of Rs.950 and a risk adjustment of Rs.50. In the example the insurer estimates that the EPV of future claims is Rs.900.

Measurement under Indian GAAP

Particulars

Indian
GAAP

Premium

Acquisition costs

(70)

Policy liability reserve (Estimate)

(40)

Loss
at initial recognition

Liability
at initial recognition

(40)

Measurement under IFRS ED

Particulars

IFRS
ED

EPV of cash outflows

940

Risk adjustment

EPV of cash inflows

(1000)

Present value of the fulfilment

cash flows

(10)

Residual margin

Liability
at initial recognition

Loss
at initial recognition

(Non-incremental acquisition costs)

Nirav Shah

Financial instruments : Disclosures — Practical application and challenges

Nirav Shah

Embedded leases : The scope under IFRS is much wider (IFRIC 4)

IFRS

Background:

It is not uncommon for enterprises to have contracts with
service providers for providing goods/services on a dedicated basis to these
enterprises. As certain assets may be dedicated for use only for a particular
enterprise, binding procurement commitments may be provided to the service
provider to the extent of entire production capacity of the assets. In certain
other cases, the enterprise may provide minimum procurement guarantee whereby it
pays a fixed price per unit of shortfall in procurements. Through these
arrangements the service provider is assured of compensation for the capital
cost incurred.

An entity may enter into an arrangement, comprising a
transaction or a series of related transactions, that does not take the legal
form of a lease but conveys a right to use an asset (e.g., an item of
property, plant or equipment) in return for a payment or series of payments.
Examples of arrangements in which one entity (the supplier) may convey such a
right to use an asset to another entity (the purchaser), often together with
related services, include :

(1) Outsourcing arrangements, and

(2) take-or-pay and similar contracts in which purchasers
must make specified payments regardless of whether they take delivery of the
contracted products or services (e.g., a take-or-pay contract to
acquire substantially all of the output of a supplier’s power plant).

Embedded leases :

IFRIC 4 provides guidance on determining whether an
arrangement is or contains a lease. The following example illustrates
take-or-pay contracts that would be classified as embedded lease :

An entity has a contract with its supplier (job worker)
whereby the entity is contractually bound to get 100,000 units of goods
manufactured by the supplier. The supplier has installed dedicated machinery to
manufacture and supply the goods only to serve the entity. The supplier has no
other machinery that can manufacture these goods.

Price terms are as under :

For first 100,000 units —
Rs.3 per unit

100,001 onwards — Re.1
per unit;

In case of any shortfall
as compared to 100,000 units, a penalty of Rs.2 per unit of shortfall shall be
levied.

In the above case, the assets are deployed for use only for
the entity. Further, irrespective of the actual purchase from the supplier, the
entity is bound to pay a fixed charge in the form of per unit charge and
penalty, if applicable (Rs.200,000 in the above example i.e., even if the
purchaser does not purchase at all, a penalty on 100,000 units would be levied
at Rs.2 per unit). This fixed charge, in substance, is a lease arrangement where
the supplier’s machinery is taken on lease for a lease rent of Rs.200,000.

Determining whether an arrangement is, or contains, a lease :

Guidance in IFRIC 4 helps the entity to assess if
outsourcing/service contract is a simple supply contract or whether in substance
there is actually a lease embedded in the contract. The assessment whether the
above arrangement is or contains a lease is based on whether :

the fulfilment of the
arrangement is dependent on the use of a specific asset or assets; and

the arrangement conveys a
right to use the asset(s).

Arrangement dependent on use of a specific asset or assets :

For classifying an arrangement as a lease, one needs to
assess whether the arrangement is dependent on the use of a specific/identified
asset. For an arrangement to be determined as an embedded lease, there needs to
be reasonable certainty at inception of the contract that the same asset would
be used throughout the term of the contract. In other words, the asset needs to
be a ‘specified asset’.

The asset may be a ‘specified asset’ either explicitly by way
of a contract or could be identified impliedly, based on the facts and
circumstances of the case.

Specified assets explicitly identified in an arrangement :

An asset may be explicitly specified in the contract when,
for instance, the service provider’s plant/ warehouse is mentioned in the
agreement along with the address. Thus it is reasonably certain that the same
plant/warehouse shall be used throughout the contract period.

Although a specific asset may be explicitly identified in an
arrangement, it is not the subject of a lease if fulfilment of the arrangement
is not dependent on the use of the specified asset.

Specified assets implied in an arrangement :

An asset has been implicitly specified if, for instance, the
supplier owns or leases only one asset with which to fulfil the obligation and
it is not economically feasible or practicable for the supplier to perform its
obligation through the use of alternative assets.

The entity will have to use its judgment in determining
whether it is economically feasible or practicable to perform obligations
through use of alternative assets, based on the facts and circumstance in each
case. Assessing whether the use of alternative asset is economically feasible
and practical will not always be straightforward.

Fulfilment of the contract is dependent on the use of
specified asset :

If the supplier is obliged to deliver a specified quantity of
goods or services and has the right and ability to provide those goods or
services using other assets not specified in the arrangement, then fulfilment of
the arrangement is not dependent on the specified asset and the arrangement does
not contain a lease.

The arrangement conveys a right to use the asset :

An arrangement conveys the right to use the asset if the arrangement conveys to the purchaser (lessee) the right to control the use of the underlying asset. The right to control the use of the underlying asset is conveyed if any one of the following conditions is met?:

   a) The purchaser has the ability or right to oper-ate the asset or direct others to operate the asset in a manner it determines.
   b) The purchaser has the ability or right to control physical access to the underlying asset.
   c) Facts and circumstances indicate that it is re-mote that one or more parties (other than the purchaser) will take more than an insignificant amount of the output or other utility that will be produced or generated by the asset during the term of the arrangement, and the price that the purchaser will pay for the output is not contractually fixed per unit of output, nor equal to the current market price per unit of output. In the conditions (a) and (b) above, the lessee obtains the right to operate the asset or restrict the physical access of third parties to the asset by way of an explicit contract. In such cases, the lessee need not take the entire output generated from the asset for an arrangement to be a lease.

In the condition (c) above, a purchaser controls the usage of an asset and a lease exists only when the purchaser is taking substantially all of the output i.e., others cannot obtain the output from the specified asset.

However, an exemption was incorporated in the condition (c), so that arrangements in which the price is either contractually fixed per unit of output or equal to the market price per unit of output at the time of delivery of the output should not be ac-counted for as leases, since the payments in such arrangements are considered as a consideration only for ‘use of an asset’ and not for the ‘availabil-ity of an asset’. This exemption should be applied narrowly and only for arrangements in which a pur-chaser clearly pays for the actual output. Thus, if any variability is introduced to the price per unit, such an arrangement contains a lease. There is a strong presumption that any variability in the price per unit that depends on the output of the asset means that the arrangement conveys the right to use the asset.

If the arrangement is based upon a specific asset, the entity must determine whether the arrange-ment conveys a right to use the asset, based on the above guidance. It is often a challenge to determine whether a right to use the item has been conveyed. Consider the terms ‘fixed price per unit of output’ or‘current market price per unit of output at the time of delivery’. In practice, interpretations of these terms widely vary. Some entities interpret the term ‘fixed price’ as absolutely fixed with no variance per unit, based on costs or volumes. However, other en-tities accept certain adjusted prices as fixed, such as fixed price per unit adjusted for inflation or a fixed percentage increase, etc.

Typical clauses that indicate a lease arrangement:
An illustrative list of contract features that indicate lease arrangement is as under:

a) a contract whereby the purchaser agrees to buy the entire output of a specified asset and requires the asset to be operated at full capacity, then there is a strong presumption that the purchaser has effective control over the use of assets and therefore the arrangement contains a lease.
b) If in case of dedicated assets, any variability is introduced to the price per unit, then such an arrangement contains a lease. There is a strong presumption that any variability in the price per unit that depends on the output of the asset means that the arrangement conveys the right to use the asset.

c) If in case of dedicated assets, pricing arrangements include a minimum procurement guarantee (i.e., the purchaser shall pay a penalty if procurement is lower than minimum guaranteed volumes), the price cannot be termed as current market price. Hence these would be classified as leases.

Assessing or reassessing whether an arrangement is, or contains, a lease:

Initial assessment:

The assessment of whether an arrangement contains a lease shall be made at the inception of the arrangement on the basis of all of the facts and circumstances.

Subsequent reassessment:

A reassessment of whether the arrangement contains a lease after the inception of the arrangement shall be made only if any one of the following conditions is met:

i) There is a change in the contractual terms, unless the change only renews or extends the arrangement.
ii) A renewal option is exercised or an extension is agreed to by the parties to the arrangement, unless the term of the renewal or extension had initially been included in the lease term in accordance with paragraph 4 of IAS 17 — Leases.

iii) There is a change in the determination of whether fulfilment is dependent on a specified asset.

iv) There is a substantial change to the asset, for example, a substantial physical change to property, plant or equipment.

A reassessment of an arrangement shall be based on the facts and circumstances as of the date of reassessment, including the remaining term of the arrangement. Changes in estimate (for example, the estimated amount of output to be delivered to the purchaser or other potential purchasers) would not trigger a reassessment.

Classification of embedded leases — operating or finance:
If an arrangement contains a lease as per guidance provided under IFRIC 4, the parties to the arrangement shall apply the requirements of IAS 17 — Leas-es to the lease element of the arrangement.

Separation of lease payments from other elements of the contract:
For the purpose of applying the requirements of IAS 17 — Leases, payments and other consideration required by the arrangement shall be separated at the inception of the arrangement (or upon a reassessment of the arrangement) into those for the lease and those for other elements on the basis of their relative fair values.

In some cases, separating the payments for the lease from payments for other elements in the arrangement will require the purchaser to use an estimation technique. For example, a purchaser may estimate the lease payments by reference to a lease agreement for a comparable asset that contains no other elements, or by estimating the payments for the other elements in the arrangement by reference to comparable agreements and then deducting these payments from the total payments under the arrangement to determine the lease component.

For instance, a contract for warehouse management services, whereby the vendor shall manage a warehouse on a dedicated basis for a single customer against a fixed monthly fees. The inputs of the vendor includes warehouse premises, assets deployed therein and warehouse labour. Thus, the arrangement may contain a lease of warehouse and warehouse assets. The overall consideration shall be separated into lease rentals for warehouse, lease rentals for warehouse assets and consideration for warehouse management (labour). In practice separation of individual components pose significant challenges to entities.

Impracticality in separation of lease components: If a purchaser concludes that it is impracticable to separate the payments reliably, it shall:

a) in the case of a finance lease, recognise an asset and a liability at an amount equal to the fair value of the specified asset under the lease. Subsequently the liability shall be reduced as payments are made and an imputed finance charge on the liability recognised using the purchaser’s incremental borrowing rate of interest

b) in the case of an operating lease, treat all payments under the arrangement as lease payments for the purposes of complying with the disclosure requirements (i.e., applicable to disclosures only) of IAS 17 — Leases, but
i) disclose those payments separately from minimum lease payments of other arrangements that do not include payments for non-lease elements, and

ii) state that the disclosed payments also include payments for non-lease elements in the arrangement.

Terms of arrangements:

Cancellation clause in embedded lease:

If an arrangement qualifies for recognition as an embedded lease and the arrangement is cancellable, the assets under such arrangement shall be accounted as taken on a cancellable operating lease. Hence the payments made need to be separated between lease payments and other elements of the contract for recognition purposes.

However, as the arrangement is cancellable, the entity need not provide disclosures in relation to the lease.

Absence of binding contract:

If the entity neither contractually require the job worker to use the asset exclusively for the company, neither does it contractually restrict the access of third parties to the asset, nor has obtained any contractual right to operate the asset, such arrangement shall not be classified as a lease. This would be a normal purchase of goods/services.

Thus, it is essential that there should be contractual arrangement that provides the right to use a specified asset. If there is only a mutual understanding between the two contracting parties relating to minimum guarantee commitments or adjustment to price based on level of output, without a binding contract, then it would not be classified as an embedded lease.

Financial statement impact:

Once, an arrangement is covered under IFRIC 4, an entity needs to determine whether the underlying embedded lease is an operating lease or a finance lease in accordance with IAS 17 — Leases and apply the accounting principles as set out in that standard.

a) Accounting by lessee — Finance lease:

Initial recognition and measurement:

If the arrangement is or contains a finance lease, the lessee shall recognise finance lease as assets and li-abilities in their statements of financial position at amounts equal to the fair value of the leased property or, if lower, the present value of the minimum lease payments, each determined at the inception of the lease.

Subsequent measurement:

As mentioned above, the total lease component shall be separated from the non-lease component.

The lease component in case of finance lease would be further separated into payments towards the lease obligation and interest on lease obligation.

The leased asset is depreciated over the asset’s useful life or over the lease period whichever is shorter.

The payments made would be adjusted against the lease obligation and interest thereon.

Impact on Indian companies on adoption of IFRS?: Indian GAAP does not have specific guidance on embedded leases. Thus, the contract payments are recognised, in most cases, as revenue expen-diture (say, job work expenses) on accrual basis. On adoption of IFRS by the Indian companies, such arrangements may be classified as embedded finance leases. Thus the charge to the income statement would be in the form of depreciation on assets taken on finance lease, interest expense on finance lease obligation and job worker charges; instead of the entire amount being treated as job work charges. This may impact the asset base (as the assets are capitalised) and income statement classification of the lessee.

b) Accounting by lessor — Finance lease:

Initial recognition and measurement:

Lessor shall derecognise assets given under an em-bedded finance lease in their balance sheet and present them as a receivable at an amount equal to the net investment in the lease.

Subsequent measurement:

As mentioned above, the total lease component shall be separated from the non-lease component. The lease component in case of finance lease would be further separated into payments towards the lease receivable and interest on lease receivable.

The recognition of finance income on lease receivable shall be based on a pattern reflecting a con-stant periodic rate of return on the lessor’s net in-vestment in the finance lease.

The receipts from the lessee would be adjusted against the lease receivable and interest thereon.

Impact on Indian companies on adoption of IFRS?: Indian GAAP does not have specific guidance on em-bedded leases. Thus, the actual contract receipts are recognised, in most cases, as revenue (say, job work income) on accrual basis. On adoption of IFRS by the Indian companies, such arrangements may be classified as embedded finance leases.

Thus, such transactions will be treated as sale of as-set with a corresponding debit to lease receivable asset. Unlike Indian GAAP, there will be no impact on the income statement on account of deprecia-tion on fixed assets as they were never recognised. The receipts out of the lease component received from the lessee shall be adjusted against the lease receivable to the extent of the principal and interest income.

This may significantly impact the fixed asset base (as the fixed assets are not recognised), the timing of revenue recognition and the EBIT (on account of in-terest income on lease receivable) of the lessor.

c) Accounting by lessee and lessor — Operating lease:

Recognition and measurement:

As mentioned above, the lease component would be recognised separately from the non-lease component. Thus, the lessor and lessee shall recognise lease income/expense separately from other revenue/expense, respectively.

Impact on Indian companies on adoption of IFRS: The lessor shall present lease income separately within revenue from non-lease revenue. Similar presentation would be required by the lessee for its payments. However, this would impact only the in-come statement presentation.

The operating lease payments would be required to be recognised on a straight-line basis. This may lead to additional impact on the profits for the year on account of adoption of IFRS.

First-time adoption of IFRS:

IFRIC 4 shall have to apply retrospectively to all agreements existing as on the date of transition. Hence, entities shall have to assess all agreements existing as on the date of transition, irrespective of the year in which the same has been entered into i.e., either before or after the date of applicability of IFRIC 4.

Conclusion:

An entity can expect significant changes to its balance sheet and income statement due to application of IFRIC 4 and it is thus essential for an entity to carefully evaluate its implications at the time of entering into arrangements with dedicated vendors.

Nirav Shah

Financial Instruments — Indian corporates need to gear up for significant changes in the accounting landscape

IFRS

In recent times, a lot has been written and discussed in the
various forums regarding the role played by financial instruments-related
accounting standards and the contribution of ‘fair value’ accounting to the
current global liquidity crisis.

Accounting for financial instruments in general and fair
value accounting in particular is a highly complex and judgmental area, and
requires a very high degree of understanding and experience to implement and
interpret the guiding principles as envisaged in those standards.

Accounting for Financial Instruments is a complex exercise in
view of the varied kinds of instruments that are emerging in the market in the
recent past. International Financial Reporting Standards (IFRS) encompassing
IAS-32, IAS-39 and IFRS-7 deal with the principles involved in recognition,
measurement, disclosures and presentation of financial instruments. The
Institute of Chartered Accountants of India (ICAI) has also published Accounting
Standards (AS), viz., AS-30 on ‘Financial Instruments — Recognition and
Measurement’ and AS-31 on ‘Financial Instruments — Presentation’ which has been
pronounced and is made recommendatory from 01.04.2009 and mandatory from
01.04.2011. Further, AS-32 Exposure draft on ‘Financial
instruments — Disclosures’ has also been published in December 2007 issue of the
Chartered Accountant Journal. These are largely similar to their IFRS
counterparts. Thus, whether India converges to IFRS from 2011 or not, accounting
for financial instruments will largely be in accordance with the principles of
IAS-39 and IAS-32 from 1 April 2011.

The use of these standards ushers in the concept of fair
valuation, which records financial instruments at fair value and changes thereon
in reported earnings or within shareholders funds, depending on the nature of
the financial instrument. The impact of these standards shall cover a large
number of captions in a corporate financial statement including receivables,
payables, borrowings, loans and advances given, security deposits, investments
and even certain types of ‘equity’ instruments, thereby having a significant
impact on accounting for routine transactions entered into by companies in the
normal course of business. These impacts necessitate careful consideration by
corporates and their impact is not restricted to finance companies and banks.

Definition and classifications

Under IFRS, a financial instrument has been defined as a contract that gives rise to a financial asset in one entity with a corresponding liability or equity in another entity. Most monetary items will get covered by this definition such as trade receivables/payables, investments in shares/debentures, retention money, trade deposits, derivatives, financial guarantees, and loans and advances.

Under the present Indian GAAP, Accounting Standard (‘AS’) 13 classifies an investment into long-term and current investment. Long-term investments are required to be recorded at cost, less any permanent diminution. Current investments are recorded at lower of cost or market. Detailed classification exists for banks as per RBI guidelines. Loans and receivables are stated at cost. Interest income on loans is recognised based on time-proportion basis as per the rates mentioned in the underlying loan agreement.

On the other hand under IFRS, all financial assets are required to be initially classified into four categories, comprising (i) fair value through profit or loss (FVTPL), (ii) held-to-maturity (HTM), (iii) loans and receivables, and (iv) available-for-sale (AFS). All financial assets will have to be recorded at respective fair values at the time of initial recognition.

Further, IAS-39 requires FVTPL and AFS assets to be measured at fair values at each subsequent reporting period. In case of FVTPL assets, the unrealised gain/loss is recognised in the profit and loss account whereas for AFS investments, it is recognised in equity until actually realised, whereupon it is transferred to the income statement. HTM and loans and receivable assets are reflected at amortised cost using effective interest method. However, the rules for classification of an investment as HTM are extremely stringent and any subsequent decision to sell these investments would result in adverse consequences, whereby all other existing HTM investments would need to be fair valued and there would be restrictions on future classifications.

Financial liability is classified into two categories, viz., (i) financial liability at fair value through profit or loss (ii) residual category. The initial measurement is at cost, being the fair value of a consideration received, less transaction costs. Financial liabilities at fair value through profit or loss (including trading) liabilities are measured at fair value, and the change is recognised in the income statement for the period. All other (non-trading) liabilities are carried at amortised cost. Entities may elect to classify certain liabilities as ‘fair value through profit and loss’ if the liabilities are incurred to hedge certain related financial assets which are required to be recorded at fair value. In such a case, a fair value designation for the liabilities can be used to set off the fair value changes in the assets — a form of economic hedge accounting, without following the complex hedge accounting designation and effectiveness testing rules.

Derivatives

The current Accounting Standards in India do not have any specific standard providing guidance on the recognition and valuation of derivatives. Accounting for certain plain vanilla foreign exchange forward contracts is based on AS-11. Certain exchange traded futures and options are accounted as per ‘Guidance Note on Accounting for Equity Index and Equity Stock Futures and Options’. As per this Guidance Note, mark-to-market losses are recognised but gains are ignored. Further, some derivative instruments may be required to be accounted as per the March 2008 announcement of the ICAI, whereby derivative instruments are to be mark to market with the resulting losses required to be recognised in the income statement based on the principles of prudence. Effective 1 April 2011, the treatment for the aforesaid transactions will need to comply with AS-30 issued by the ICAI. As stated earlier, the guidance in AS-30 is consistent with the requirements of IAS-39.

IAS-39 deals with derivative instruments in a very comprehensive manner. A derivative is defined as a financial instrument or other contract with the following three characteristics, namely,

1) its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract (sometimes called the ‘underlying’);

2) it requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors; and

3) it is settled at a future date. Further all derivatives are recorded on balance sheet at fair value with changes in fair value being recognised in income statement unless it satisfies the hedge accounting criteria. This often results in significant volatility in reported income, which is not seen under the current Indian Accounting Standards.

Apart from stand-alone derivatives, IAS-39 requires derivatives embedded or contained in other contracts to be separated and accounted separately. For example, for convertible bonds an investor will have to account for the equity option component separately from the host debt contract. The value of the equity option component would be initially credited to equity. The resultant discount on the debt host would be amortised over the period of the debt to reflect the real cost of the debt instrument (based on market rates for non-convertible debt). Similarly, if an Indian entity has a contract for supply of goods/services denominated in Euros, with a counterparty based in a non-Euro zone country (for example, the U.S.), then there is an embedded rupee-Euro forward currency derivative, which will need to be separated from the host contract of supply of goods/ services and valued separately. The requirements for embedded derivatives will significantly enhance the valuation and measurement complexity of such instruments from current practice.

Hedge accounting

As seen above, IAS-39 uses a measurement model that sometimes requires the measurement of assets and liabilities on different basis. This results in an accounting mismatch in profit or loss account, which results in volatility in reported results (and does not reflect the true performance of the Company in the income statement). Consequently the standard permits an entity to selectively measure assets, liabilities, firm commitments and certain forecast transactions on a basis different from that prescribed, or to defer /match the recognition of gains or losses on derivatives using hedge accounting.

The hedge accounting rules under IFRS are quite stringent and narrowly defined. Hedge accounting is permitted if at the inception of the hedge and on an ongoing basis, the expectation is that the hedge will be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk during the period for which the of hedge is designated and ‘actual’ results are within the 80-125% range. If the changes don’t fall within this band, then the hedge is ineffective and, therefore, fair value gains/losses on the hedging contract will have to be taken to the income statement. Hedges need to be on specifically identified items as against portfolios and should hedge-specific risks and characteristics identified and documented upfront. Stringent documentation criteria prescribed shall also have to be followed.

Hedge accounting is voluntary and the decision to apply hedge accounting should be made on a transaction by transaction basis. The correct use of hedge accounting (for example, designating foreign currency forward contracts as cash flow hedges of forecasted foreign currency sales) can ensure that gains and losses relating to the derivatives are recorded to reflect the economic rationale for undertaking the transaction. In the absence of hedge accounting, gains and losses on derivatives would be recorded in periods that may be different from the periods in which the underlying transactions are recorded.

Substance over form

Under Indian GAAP, a financial instrument is v classified as either liability or equity, depending on form rather than substance.

Redeemable preference shares are treated as capital under Schedule VI of the Companies Act,1956, even though in substance it may be a liability. However, under IAS-32, they will get classified as debt in the balance sheet of the issuers, since they meet the characteristic of a liability, i.e., redemption after a fixed period and dividend at a fixed rate. This would result in profit after tax numbers being lower, as preference dividend would be reflected as interest cost. Further, premium on redemption of preference shares will no longer be able to be adjusted in the securities premium account but will have to be recognised as an interest expense in the income statement.

Another significant area of impact would be the accounting for Foreign Currency Convertible Bonds (‘FCCB’). FCCBs are bonds that can be converted into equity by the investors before a certain date, or are repaid at an agreed premium at the end of the tenure. FCCBs (and other debt instruments) may be issued with a structure that allows the borrower to pay the entire interest on the instrument (along with the principal) to the investor only when the bond matures, in the form of a ‘redemption premium’. The Companies Act, 1956, Section 78, permits companies to adjust the redemption premium on debentures just as in equity shares, through the share premium account. This accounting treatment is currently fairly common amongst many Indian companies. This accounting treatment would not be permitted under IFRS, as all cost of issuing an instrument (including the redemption premium) would need to be recorded as interest cost over the life of the debt using the effective interest yield method.

Further, under IFRS, FCCBs will be subjected to split accounting. In accordance with the guidance in IAS-39 on the basis of which the conversion option is separated from the host contract i.e., the debt liability depends on the characteristic of the conversion option. If the conversion option meets the definition of equity, then the fair value of the liability without the conversion option is first determined and the residual amount of proceeds is then allocated to equity. If the conversion option is a derivative (i.e., if the conversion price is determined in a currency other than the functional currency of the Company), the fair value of the derivative is first determined with the residual allocated to the debt amount and the derivative portion is fair valued at every reporting date.

Impairment

In the case of banks, the existing provisions on non-performing assets are based on guidelines laid down by the Reserve Bank of India. IFRS prescribes an impairment model that requires case-by-case (for significant exposures) assessment of the facts and circumstances surrounding the recoverability and timing of the future cash flows relating to the credit exposure. An expectation that all contractual cash flows would not be recovered (or recovered without full future interest applications) will lead to an account being classified as impaired and impairment shall be measured on present value basis using the effective interest rate of the exposure as the discount rate. For groups of loans that share homogenous characteristics (such as mortgage and credit card receivables), impairment can be assessed on a collective basis. General provisions are permissible only to extent that they relate to a specified risk that can be measured reliably and for incurred losses. No provisions are permitted for future or expected losses. Provisioning for standard assets will not be permitted under IFRS.

For investments, a similar analysis is conducted, the key difference being that the fair value of the investment is also considered as an input in addition to the financial! credit standing of the issuer. The application of IAS-39 would also change accounting for items such as financial guarantees. It will affect key ratios and performance indicators for most banks and financial institutions, including capital adequacy ratios.

De-recognition

Under IFRS, de-recognition of financial assets is a complex, multi-layered area with the de-recognition decision dependent largely on whether there has been a transfer of risks and rewards. If the assessment of the transfer of risks and rewards is not conclusive, an assessment of control and the extent of continuing involvement are required to be performed.

Securitisation transactions shall be the most impacted area since most Indian securitisation vehicles are currently structured to meet Indian GAAP de-recognition norms stated under the Guidance Note on Accounting for Securitisation issued byfhe ICAL Substantially, all those securitisation vehicles would collapse into the transferor’s balance sheet and assets would fail the de-recognition test under IFRS. For example, securitisation transactions where credit collaterals are provided/guarantee is provided to cover credit losses in excess of the losses inherent in the portfolio of assets securitised, may not meet the de-recognition principles enunciated in IAS-39. This would lead to more instances of transfers failing the de-recognition criteria, thereby resulting in large balance sheets and capital adequacy requirements, lower return on assets and deferral of gains/losses on such securitisation transactions.

Disclosures

IFRS 7 requires entities to provide detailed disclosures in their financial statements that enable users to evaluate:

a) the significance of financial instruments for the entity’s financial position and performance; and

b) the nature and extent of risks arising from financial instruments to which the entity is exposed during the period and at the reporting date, and how the entity manages those risks. On 5 March 2009, the IASB has issued Improving Disclosures about Financial Instruments (Amendments to IFRS 7). The amendments require enhanced disclosures about fair value measurements and liquidity risk.

The disclosures required under IFRS 7 include quantitative as well as qualitative information. There is a significant amendment in IT/reporting systems which shall be required as there is no accounting standard in India corresponding to IFRS 7 requiring such extensive disclosures. The Announcement on ‘Disclosure regarding Derivative Instruments’, issued by the ICAI, requires the following disclosures to be made in the financial statements:

a) categorywise quantitative data about derivative instruments that are outstanding at the balance . sheet date,

b) the purpose, i.e., hedging or speculation, for which such derivative instruments have been acquired, and

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

Netting assets and liabilities will also be less common as the rules will require more conditions to be met before assets and liabilities can be offset. A mere right to set off will not be adequate and needs to be supplemented with a right and an intention to settle on a net basis the assets and liabilities under consideration.

To conclude, the advent of IFRS shall thus represent a significant challenge to preparers, auditors, accountants, regulators and analysts. As the complexity of accounting increases, focus on need for increased education and training on areas relating to the valuation and accounting for financial instruments increases. Accounting for financial instruments will not only lead to a major impact on measurement of results, but also impact the existing functionalities of the IT systems and processes of companies.

Nirav Shah

The Countdown to Ind-AS — careful evaluation of policy choices

IFRS

On January 14, 2011, the Institute of Chartered Accountants
of India (ICAI) issued the much-awaited ‘near final’ version of the
IFRS-converged Indian Accounting Standards (Ind-AS). The issuance of these
standards brings us closer to answering the question — would the Indian version
of IFRS be different from the international version of IFRS?

An analysis of these near-final Ind-AS brings out that whilst
every effort seems to have been made to keep these standards as close to IFRS,
we have also chosen a different approach in the application of a few of these
standards, to suit our economic scenario, and to address the concerns raised by
Indian companies. This article segregates these deviations into four categories:
clear deviations from IFRS, removal of certain choices given under IFRS,
optional deviations from the application of IFRS and additional guidance under
Ind-AS.

Deviations from IFRS:

The exclusion/inclusion of these principles in the Ind-AS
standards have created an anomaly with the IFRS-equivalent standards, making
companies affected by these principles clearly non-compliant with IFRS. These
deviations (carve-outs) have been summarised below:

The near-final Ind-AS
standard on revenue recognition has not adopted IFRIC 15 for revenue
recognition from real estate development. Consequently, these agreements have
been included in the scope of construction contracts, making it mandatory for
real estate developers in India following Ind-AS to recognise revenue using
the percentage completion method. This also means that Ind-AS financial
statements of such real estate developers cannot be considered as
IFRS-compliant.

Ind-AS, in its definition
of equity instruments, includes the equity conversion option embedded in a
foreign currency convertible bond (FCCB). FCCBs will be considered compound
financial instruments under Ind-AS and split between the liability and equity
component at inception, as opposed to being split between liability and
derivative component under IFRS. This would ensure that the issuer’s income
statement is not volatile due to changes in value of the conversion option
driven by changes in the market price of its own equity shares.

Ind-AS requires that the
measurement of fair value of financial liabilities designated at fair value
through profit and loss at inception should not include fair value changes
arising out of changes in the entity’s own credit risk. However, since the
option to designate financial liabilities as at fair value through profit and
loss at inception is not widely exercised, this is expected to impact only the
few entities which exercise this option.

Ind-AS requires the
recognition of bargain purchase gain on day one accounting for a business
combination in capital reserve, as opposed to profit or loss account under
IFRS. This is also consistent with the existing principles under Indian GAAP
enunciated in the current accounting standards on amalgamations and
consolidation. Our experience indicates that such situations will be rare.

Ind-AS requires the use
of government bond rate as discount rate for measurement of employee benefit
obligations, as opposed to a highly rated corporate bond rate required under
IAS 19 (unless a deep corporate bond market does not exist). One of the key
reasons for this deviation is in the argument that a deep bond market does not
exist in India.

IFRS 1 mandatorily
requires a company to present comparative financial statements on first-time
adoption. Ind-AS gives companies a choice in presenting comparative financial
statements on first-time adoption. However, the choice to present comparatives
for the prior year is also only on a memoranda basis and hence would not meet
the IFRS 1 requirements. Clearly then, an Indian company’s first-time-adopted
Ind-AS financial statements will not be IFRS 1-compliant financial statements.
However, this specific carve-out will not impact Ind-AS financial statements
beyond the first period of transition.

Eliminations of certain options available under IFRS:

The removal of the following choices given under IFRS from
the relevant Ind-AS standards does not result in non-compliance with IFRS, but
merely restricts choices for Indian companies:

Ind-AS 1 requires
entities to present analysis of expenses in the profit and loss account only
by nature of expenses, e.g., personnel costs, depreciation and amortisation,
removing the option of reporting expenses by function under IFRS. This is
expected to be further clarified by the format of financial statements in the
revised Schedule VI.

Ind-AS removes the choice
of subsequently measuring investment property at fair values and requires
these to be subsequently measured using only the cost model. This may not have
a significant implication, since companies generally would be inclined to
adopt the cost model to reduce the volatility in the income statement.

Ind-AS requires the
recognition of all actuarial gains and losses arising from employee benefits
directly in equity, unlike the corridor approach or recognition directly in
the profit and loss account which are also permitted by IFRS. This is a
deviation from the current Indian GAAP practice of recognising these directly
in the profit and loss account. This will reduce the volatility in the income
statement due to fluctuations in various actuarial assumptions, such as
discount rate, salary escalation rate, employee attrition rate, etc.

Ind-AS removes the option of deducting capital grants from the government from the cost of the underlying fixed asset and allows it only to be set up as deferred income. It also removes the option of initially measuring non-monetary government grants at their nominal value and requires such grants to be measured only at their fair value at inception. This will result in grossing up the balance sheet.

IAS 27 includes in its scope an exemption for entities from preparing consolidated financial statements if certain criteria are met. This exemption has not been included in Ind-AS, making it mandatory for all companies to present consolidated financial statements. Currently, under Indian GAAP, only listed companies are required to prepare consolidated financial statements. However, the scope of entities covered in this standard is much wider and covers all unlisted and private companies, including subsidiaries of listed companies.

Optional deviations from application of IFRS:

The adoption of the following options permitted by Ind-AS would result in non-compliance with IFRS as issued internationally. These anomalies with IFRS can be avoided by companies by choosing optimal accounting policies that are aligned to IFRS.

Ind-AS gives a choice on first-time adoption whereby the carrying value as on the transition date for all property, plant and equipment capitalised before 1st April, 2007, can be the ‘deemed cost’ for first-time adoption of Ind-AS. This exemption entails that all depreciation adjustments to these assets would be applied from the date such deemed cost has been established. Since this is an option, companies may alternatively choose to restate their property, plant and equipment to comply with principles laid in Ind-AS on a retrospective basis, making adjustments for decapitalisation of preoperative expenses, foreign exchange differences and depreciation methods to ensure compliance with international IFRS as well. Entities choosing the carrying value exemption will need to make certain disclosures till the time significant value of the block of existing fixed assets is retained in the books of accounts.

Ind-AS gives entities a policy choice to defer the recognition of foreign exchange fluctuations on long-term monetary assets and liabilities over the period of their maturity in an appropriate manner. IAS 21 requires full recognition of such exchange differences in the income statement in the period when incurred. The option under Ind-AS is a one-time accounting policy choice with Indian entities on the date of transition. This policy choice needs careful evaluation, since this will also impact other aspects of accounting, such as capitalisation of borrowing costs and application of hedge accounting principles.

Derecognition provisions for financial assets can be applied prospectively from the transition date. Companies who choose to take this exemption will be non-compliant with IFRS till such time that the underlying financial assets continue in the books.

Ind-AS also gives an additional ‘impracticability’ exemption for financial instruments to be carried at amortised cost, i.e., if it is impracticable for the effective interest rate or impairment requirements under Ind-AS 39 to be applied retrospectively from the date of the financial instrument. In such a case, for financial assets, the fair value as on the transition date would be the deemed cost as on the transition date.

Additional guidance under Ind-AS where IFRS currently has no guidance:

Ind-AS gives additional guidance on accounting for common control transactions which are currently excluded from the scope of IFRS 3 — Business Combinations. Ind-AS requires accounting for these transactions as per the pooling of interest method and requires the acquisition to be accounted for at book values of the acquiree entity on the combination date. All reserves of the acquiree entity will be carried forward in the acquiring entity with any difference between the book value of net assets and consideration recorded as goodwill or capital reserve, as the case may be. Further, this transaction needs to be reflected from the beginning of the earliest period presented in the financial statements, and financial statements in respect of prior periods should be accordingly restated.

Since IFRS currently has no guidance on this topic, companies take the option of either accounting for such transactions at book values or at fair values under IFRS. However, this topic is currently an open project at the IASB level, and the deviation from IFRS would be clearly understood only when final guidance under IFRS is issued.

There is additional guidance under Ind-AS 33 Para 12, on earnings per share ‘Where any item of income or expense which is otherwise required to be recognised in profit or loss in accordance with Indian Accounting Standards is debited or credited to securities premium account/other reserves, the amount in respect thereof shall be deducted from profit or loss from continuing operations for the purpose of calculating basic earnings per share.’ This guidance has been added since Indian laws may continue to override accounting standards. Accordingly, if companies are permitted to account for income/expenses directly in reserves pursuant to any law, the impact of the same is appropriately captured in the EPS (a key performance metric for companies).

In summary, barring certain transactions summarised in part 1 of this discussion, Indian companies can choose to be compliant with IFRS through making optimal accounting policy choices on transition. It should be recognised that while the carve-outs discussed above would ease the transition process, the management of each company needs to give careful thought in deciding on accounting policy choices on transition to Ind-AS. The reporting strategy would depend on whether a company wishes to be fully compliant with IFRS on an ongoing basis and fully benefit from the advantages of convergence, i.e., achieve comparability with global peers, avoid dual reporting for raising capital overseas and move towards international quality of financial reporting.

Nirav Shah

Revenue recognition principles under IFRS for Real Estate Industry

IFRS

Background

Around the world, real estate development and sale
transactions are structured with various permutations and combinations, in order
to comply with local tax regulations, local practices and other market
conditions. As a result, a sale deed may be entered on the date of allotment or
it can be entered into on the date of delivery. Many geographies also permit the
developers to sell the underlying land first to be followed by the development
of land.

The divergence in the manner in which real estate
transactions are carried out was also reflected in the accounting principles
applied by companies prior to the introduction of IFRIC 15 in respect of revenue
recognition from real estate development. Some developers accounted for such
agreements under IAS 18 Revenue, i.e., revenue is recognised when the completed
real estate is delivered to the buyer. Other developers accounted for them under
IAS 11 Construction Contracts, i.e., revenue is recognised by reference to the
stage of completion as construction progresses.

The International Accounting Standards Board (‘IASB’) noted
that divergence in practice exists in these circumstances with regard to the
identification of the applicable accounting standard for the construction of
real estate and the timing of the associated revenue recognition. To address
this, IFRIC 15 – Agreements for the construction of real estate, was issued on 3
July 2008 and is effective for annual periods beginning on or after January
2009.

IFRIC 15 addresses this divergence and provides guidance on
the accounting for agreements for the construction of real estate with regard
to:

the accounting standard to
be applied (IAS 11 or IAS 18); and

the timing of revenue
recognition.

The scope of the interpretation also includes agreements that
are not solely for the construction of real estate, but which include a
component for the construction of real estate.

Revenue recognition

Broadly, the analysis required by IFRIC 15 has four possible
outcomes with the following revenue recognition requirements in each case:

(1) Agreements meet the definition of a construction
contract in accordance with IAS 11 Construction Contracts – revenue recognised
by reference to the stage of completion of the contract activity (“stage of
completion approach”).

Example:
Company A, owner of the land, appoints Company B to construct a residential
property for a fixed sum of INR 1 million. Company A decides the technical
specifications of the residential property and will remain the owner of the
land as well as the constructed property. This will be a contract specifically
negotiated for construction of an asset as specified in paragraph 3 of IAS 11.

Accordingly, revenue will be recognised by the stage of
completion set out in IAS 11.

(2) Agreements which are only for rendering of services in
accordance with IAS 18 Revenue – stage of completion approach.

If an entity is not required to acquire and supply
construction materials, the agreement may be only an agreement for the
rendering of services, which need to be accounted for under IAS 18. For
example: an agreement to maintain a real estate property.

(3) Agreements for the sale of goods but the
revenue recognition criteria of IAS 18.14 are met continuously as construction
progresses – stage of completion approach.

Example: Company A, a real estate developer, who owns a
piece of land, enters into an agreement with Company B to construct a bungalow
on the aforementioned land for a fixed sum of INR 1 million. As per the terms
of the agreement, the title and risk and rewards of the land as well as the
property under construction get transferred to Company B.

This principle is discussed in further detail in the
following paragraphs. In case a transaction meets the continuous transfer of
risk and rewards criteria, Company A will recognise revenue by the stage of
completion approach set out in IAS 11.

(4) Agreements for the sale of goods other than those in
type 3 – revenue recognised when all of the criteria of IAS 18.14 are
satisfied (“sale of goods approach”).

Example:
Company A, a real estate developer, who owns a piece of land, enters into an
agreement with Company B to construct a bungalow on the aforementioned land
for a fixed sum of INR 1 million. The title to the land and the property under
construction gets transferred to Company B. However, Company A still continues
to have managerial involvement and control over the property under
construction (for e.g. Company A controls the design and specifications of the
property, Company B’s right to sell / let / sub-let the property is
established only on physical completion of the property etc.).

Principle of continuous transfer of risk and rewards

One of the practical difficulties faced in the above assessment is the identification of agreements, which will fulfil the continuous transfer of risk and rewards and control (i.e. those which fall with in type 3 above), and so qualify for stage of completion accounting on the grounds that the revenue recognition criteria of IAS 18.14 are met continuously as construction progresses.

The approach of meeting the revenue recognition criteria in IAS 18.14 on continuous basis has not previously been common under IFRS. Historically, it was generally assumed that the stage-of-completion method for construction of real estate was only ap-plicable if the activity fell within the scope of IAS
11. However, other GAAPs (like Indian GAAP for example) have permitted stage-of-completion basis more readily than was generally the case under IFRS, prior to IFRIC 15. IFRIC 15 itself does not provide extensive guidance on identifying when this approach may be appropriate, though it includes some simplistic illustrative examples.

Paragraph 17 of IFRIC 15 states the following:

“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 con-struction 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”.

Paragraph 14 of IAS 18 states the following:

“14 Revenue from the sale of goods shall be recognised when all the following conditions have been satisfied:

the entity has transferred to the buyer the significant risks and rewards of ownership of the goods;

the entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold;

the amount of revenue can be measured reliably;

it is probable that the economic benefits associated with the transaction will flow to the entity; and

the costs incurred or to be incurred in respect of the transaction can be measured reliably.”

Identifying indicators of continuous transfer under IAS 18.14

In the context of the requirement of paragraph 14 above, it will be important to identify which indicators / factors are more important to assess the question of whether continuous transfer is, or is not, occurring while the con-struction activity progresses.

Some factors, collectively or individually, may in-dicate that continuous transfer is occurring while construction progresses:

The construction activity takes place on land owned by the buyer and the buyer has clear title to the land and the construction work in progress;

The buyer cannot cancel the contract before the construction is complete;

If the agreement is terminated before construc-tion is complete, the buyer retains the work in progress and the entity has the right to be paid for the work performed; and

The agreement gives the buyer the right to take over the work in progress (albeit with a penalty) during construction, e.g., to engage a different entity to complete the construction.

Some other factors, collectively or individually, may indicate that continuous transfer is not occurring while construction progresses:

The sales agreement gives the buyer the right to acquire a specified unit in an apartment building when it is ready for occupation;

The sales agreement restricts the right of the buyer to sell / let or sub-let the property while under construction, or requires the developer’s explicit permission;

The deposit paid by the buyer is refundable if the entity fails to deliver the completed unit in accordance with the contractual terms;

The developer is required to perform significant obligations (for e.g. rental guarantee commitment) subsequent to completion of the property; and

the balance of the purchase price is paid only on contractual completion, when the buyer obtains possession of its unit.

Other factors to be considered

It will be important to consider all the relevant facts and circumstances of the agreement before reaching a conclusion on which category the sale agreement should fall into. In addition to the illustrative examples set out in IFRIC 15, the following questions, collectively or individually, may provide indicators as to whether the continuous transfer of risk and rewards and control is met during the construction phase:

Which party is able to sell / let / sublet or mortgage the property under construction?

What are the rights of the buyer in case the developer is unable to complete the construction (i.e. if the developer files for bankruptcy)?

In such a case, will the buyer be able to enforce his rights on the property under construction? Will the buyer have preferential rights over other parties i.e. creditors of the developer?

Are the payments made by the buyer to the developer held in an escrow account to be used solely for the construction of the property? Or are these funds available for the developer to fund his other projects?

Which party bears the construction risk and which party bears the market risk related to the value of the property?

Who bears the risk of loss or damage to the construction in progress and who pays the insurance cost of damage to the construction work? Who bears the loss in case the actual loss exceeds the insurance cover?

Which party has the right to cancel / withdraw from the contract?

Does the buyer have the right to complete the construction by replacing the developer?

Accounting for real estate development under current Indian GAAP

Based on the Guidance note on recognition of revenue by real estate developers issued by the Institute of Chartered Accountants of India, on the seller transferring all significant risks and rewards of ownership to the buyer, revenue can be recognised at that stage, provided the following conditions of AS 9, Revenue recognition, are fulfilled:
a) no significant uncertainty exists regarding the amount of the revenue; and

b) it is not reasonable to expect ultimate collection, provided the seller has no further substantial acts to complete under the contract.

However, in case the seller is obliged to perform any substantial acts after the transfer of all significant risks and rewards of ownership, revenue is recognised by applying percentage of completion method as stated under AS 7, Construction Contracts.

In India, the title to the property is considered to be transferred on entering into a sale deed / agreement to sell with the buyer. However, the developer retains control and has managerial involvement in the property under development till physical possession is handed over to the buyer. The developer also retains the significant obligation of completing and handing over the property to the buyer.

As the developer still retains the obligation to construct and deliver the property, revenue is generally recognised on stage of completion basis under Indian GAAP. However, the Guidance note on recognition of revenue by real estate developers does not explicitly require the entity to consider if the risk and rewards and control over the property under construction have been transferred to the buyer on a continuous basis throughout the construction period, as required by IAS 18 and IFRIC 15.

Summary

To summarise, under IFRS, there is specific guidance on when one can use the completed contract method vis -à-vis the stage of completion method, in order to recognise revenue from real estate development held for sale. IFRS lays emphasis on absence of continuing managerial involvement to the degree usually associated with ownership and effective control over the constructed real estate, which impact the timing of revenue recognition.

Further, determining whether an agreement falls within one of the four categories outlined earlier is not a matter of accounting policy choice, but rather an application of a single accounting policy to specific facts and circumstances. That is, the specific terms of each agreement should be analysed in the context of the relevant legal jurisdiction in
order to determine which of the aforementioned categories it falls into.

In case an entity wants to continue the current Indian GAAP mode of recognising revenue on percentage of completion basis (as per the Guidance note on recognition of revenue by real estate developers), it will have to make a positive assertion in respect of continuous transfer of risk and rewards and control (to be classified as a type 3 arrangement mentioned earlier) based on the various indicators discussed earlier in this article. This positive assertion will be based on facts and circumstances specific to each arrangement, taken individually or collectively. Such judgements in the application of the accounting policy will need to be disclosed in accordance with IFRIC 15.20(a).

Currently there is limited guidance available on ‘continuous transfer’ requirements in the nature of illustrative examples and this will be developed over a period of time. In the interim, there will continue to be some divergence in actual implementation of IFRIC 15, based on the legal laws practised in different geographies. Due to the practical challenges in being able to demonstrate continuous transfer of risk and rewards and control, IFRIC 15 will prompt more and more entities to recognise revenue on completion or delivery of the projects.

Nirav Shah

Taxing times — IFRS and Taxation

IFRS

On 22 January 2010, the Ministry of Corporate Affairs (MCA)
in India issued a press release setting out the roadmap for International
Financial Reporting Standards (IFRS) convergence in India.

It is now a widely held view that in addition to accounting
issues, transition to IFRS would trigger implications under various
legislations, including taxes, corporate laws and other regulations.

Through this article we aim to bring to light a few key
direct tax issues that are likely to arise when companies transition to IFRS.

Potential additional areas of differences between book
profits (per IFRS) and taxable profits :

Accounting policies and practices for many transactions will
change on convergence with IFRS. The discussion below provides an illustrative
listing of items involving a change in accounting, where the tax implications of
the change need to be evaluated. Several additional changes may require a
similar assessment from a taxation perspective.

Treatment of dividend and premium on redemption of preference shares :

Currently preference shares are treated as part of share
capital, consequently the dividend on preference shares is charged to the
profit and loss appropriation account. Under IFRS, preference shares will be
treated as a financial liability and dividend thereon will be in the nature of
a finance expense. Under Indian GAAP, the premium or discount on redemption of
preference shares is adjusted from the securities premium account. IFRS
requires such premium or discounts to be charged to the income statement.

Presently, dividend and premium on redemption of preference
shares is considered to be capital in
nature and hence not tax deductible.

The Government would need to clarify whether such costs
charged to income statement would be allowed as a tax deductible expense.

Also, this would lead to reduction in the tax liability of
a company under MAT provisions. The Government would need to clarify whether
this would be acceptable from a tax perspective.

Stock compensation cost :

Under Indian GAAP, the employee stock options are
recognised at their intrinsic value. IFRS requires the stock options to be
recognised at their fair value. The impact of the same will be in the employee
cost.

The Government would need to clarify whether the employee
costs resulting from fair valuation of the stock option will be a deductible
expense.

Cost of stock options granted by a related entity to
employees of the reporting entity would need to be recorded e.g. : companies
would need to accrue for notional compensation cost for options granted by
parent to subsidiary employees with a corresponding impact on the cost of
investments or dividend distribution, respectively.

The Government would need to consider the deductibility of
such compensation cost in the hands of the entity receiving the grant and
impact on cost of acquisition for tax purposes to compute capital gain tax or
tax impact on dividend distribution in the hands of the entity giving the
grant.

Unrealised gains and losses :

IFRS requires all financial assets and liabilities to be
measured initially at fair value. Subsequent measurement of the financial
instrument would depend on their classification. This accounting treatment
results in unrealised gains and losses in the income statement. For instance —
all derivatives will have to be fair valued at each reporting date and the
gain or loss on such fair valuation is charged to the income statement (unless
hedge accounting is followed).

The Government would need to clarify whether the unrealised
gains and losses will be taxable in the reporting period in which they arise.
This may pose difficulty to entities, given that they may not have the
liquidity to settle the tax dues on these unrealised gains. Alternatively, the
Government could tax these instruments based on the actual realised gains or
losses.

Further, the Government would also need to consider the tax
implications of unrealised gains/losses on financial instruments which are
permitted to be adjusted directly in the reserves without impacting the income
statement. For example : Unrealised gains/losses related to available for sale
(AFS) securities and effective portion of cash flow hedges are recognised
through other comprehensive income within equity.

Taxation of notional gains and expenses :

In many instances, the accounting treatment envisaged by
IFRS could result in recognition of notional gains and expenses. The following
are examples of instruments which could give rise to notional gains or
expenses :

(1) Low interest or interest-free loans to employees —
Loans given to employees at lower than market interest rates should be
measured at fair value which is the present value of anticipated future cash
flows discounted using a market interest rate. Any difference between the fair
value of the loan and the amount advanced shall be a prepaid employee benefit.
The Government will need to consider implication of tax deducted at source on
salaries.

(2) Inter-group loans, advances and deposits at
concessional interest rates — If low interest/interest-free loans and
deposits have been forwarded among group entities, the loan or deposit is
initially measured at fair value using market rate of interest. Thus, where
the parent has granted a loan to the subsidiary, in the separate financial
statements of the parent, the difference between the nominal value and fair
value of the loan should be recognised as an additional investment in the
subsidiary and notional interest income is recognised by the parent and
corresponding interest expense by the subsidiary during the loan period. On
the other hand, where a loan has been given by the subsidiary to the parent,
in the separate financial statements of the subsidiary, the difference shall
be accounted for as dividend distribution to the parent and notional interest
income is recognised by the subsidiary and interest expense by the parent
company.

The Government will need to consider the taxation aspects of these notional interest and expenses and also implications on provision for tax deducted at source for such interest. Authorities will also need to consider impact on cost of acquisition for tax purposes to compute capital gain tax or tax impact on dividend distribution in the hands of the entity giving the loan at concessional interest rate.

   Interest-free security deposit on leasing arrangements — If an interest-free deposit is given as part of leasing transaction, the interest-free deposit will have to be discounted at the market rate and the difference will be treated initially as prepaid rent. The prepaid rent will be amortised to the income statement over the life of the lease.

The Government will have to clarify the tax treatment for such notional gains and expenses. Also the Government will need to consider implications on provision for tax deducted at source on rent.

   Revenue recognition :

Some of the revenue recognition principles under IFRS are different and will need to be carefully evaluated from tax perspective. For example :

   Under IFRS, if a contract contains multiple elements which have stand-alone value to the customer, the contract will have to be split and only revenue relating to the delivered component will be recorded in the reporting period. Further, the split of revenue between components will have to be done based on their relative fair values. For instance, if an entity sells machinery along with operations and maintenance services (O&M) for the machinery, the entity can recognise the fair value of the machinery in the reporting period in which the risk and rewards of the machinery are transferred to the buyer and the revenue from operations and maintenance will be deferred and recognised over the life of the O&M contract. The Government would need to clarify whether the entity will be taxed upfront only on the revenue recognised in a reporting period, or also on the deferred portion of the contract or will the tax impact of the deferred income also be deferred and taxed in the year in which such income is recognised in the accounts.

   In some cases two or more transactions may be linked so that the individual transactions have no commercial effect on their own. In these cases, IFRS requires that the combined effect of the two transactions together is ac-counted for. For instance a telecom company may sell mobile subscription to the customer and charge them the activation fees and talk time separately. However, in practice, these are linked transaction and the activation fee does not have any stand-alone value to the customer (in absence of the talk time or subscription agreement). Thus the telecom operator cannot recognise the activation revenue upfront and will have to defer it over the average life of the subscription agreement. The Government would need to clarify the method of taxation in such cases and consider to defer the tax implications in consonance with the deferral of revenue.

   IFRS provides guidance on accounting treat-ment of service concession agreements. For concession agreements, the contractor recognises certain profit (unrealised) dur-ing the construction phase and the balance during the operations phase when realised e.g., Company incurs cost of Rs.1,000 for construction of road and in consideration for the same has received a right to charge toll of Rs.30 on all vehicles plying on that road for 30 years (after which the road is handed over to the Government body). Under Indian GAAP, Company would capitalise Rs.1,000 as a fixed asset and depreciate it over 30 years.

However under IFRS, Company would need to accrue a notional margin on the construction activity as well and the cost of Rs.1,000 plus 10% margin (assumption) i.e., Rs.1,100 will be accounted as an intangible asset and amor-tised over 30 years. Although the manner of accounting will not result in any change in the total amount of profit or loss from the contract during the concession period (since the notional gain of 10% margin is offset by higher amortisation charge over the concession period), the proportion of the profit or loss over different reporting periods within the concession arrangement may differ.

The Government would need to consider the method of taxation in such cases. In this in-stance, entities may need to recognise profit margins upfront, though they would not have received cash inflows from the customers, thus entities may not have sufficient liquidity to settle tax dues, in case tax is charged based on the net profit reported in the financial statements.

Minimum Alternate Tax (‘MAT’) :

In case companies in India do not have sufficient taxable profits in India, as per the Income-tax Act companies are required to pay MAT as a specified percentage of book profits. Further, the new direct tax code proposes to charge MAT as a specified percentage of the total assets of the company.

Various differences discussed above and in particular the fair value implications and notional gains/ losses would have substantial impact on the reported profits or reported assets by companies.

The Government would need to assess the implications of such impacts on the tax liability arising due to provision of MAT, given that companies may find it difficult to pay tax dues (actual cash outflow) on unrealised gains which have not yet resulted in cash inflows for the company.

Further the proposal to charge MAT as a percentage of asset poses the following challenges for companies converging with IFRS, which need to be considered by tax authorities in formulating appropriate provisions :
   IFRS provides an option to account for its property, plant and equipment and investment properties at fair value at each reporting date. This could also result in increase in tax liability without any cash inflow to the company.

   Under IFRS, companies may need to account for certain embedded leases in normal sale/ purchase transactions e.g., Company has contracted to buy the entire output from suppliers production line and also given a minimum commitment to reimburse the fixed cost including capital cost of the supplier (these arrangements are commonly used as take or pay arrangement), in such cases, companies will need to account the production plant of the supplier as its own plant. This would increase the gross asset base of the Company and the corresponding MAT liability.

The above, being notional accounting aspects would cause significant issues for companies, if these are considered for taxing the entities and result in potential cash outflows.

The taxation model needs to be framed to ensure that companies that are required to follow the IFRS converged standards are not at a disadvantage as compared to other entities that are not required to follow the IFRS converged standards from April 1, 2011.

Matters for consideration by the Government :

Overall the Government will need to consider how to incorporate the implications of IFRS in the tax rules to be applied by companies, such that they do not result in unintended difficulties and adverse cash flow implications for companies.

The options to be considered to manage this transition :

Option 1 — Taxation based on current Indian accounting standards :
Require companies to prepare reconciliation of profit reported/assets reported under IFRS with profits and assets per the current accounting standards. Taxation based on such reconciled profits, assets and book balances. This is also generally followed in many of the European countries where taxation is determined based on the GAAP of the respective countries. For example : Germany, Spain.

Option 2 — Taxation based on IFRS with additional differences between IFRS financial statements and taxable income :

IFRS financial statements as a starting point for taxation. However, tax laws to be modified to identify additional areas where taxation (both current taxation and MAT) will be different from the basis used in the IFRS financial statements. These areas may be limited in number, and would not necessarily cover all differences that arise due to transition from current accounting standards to the IFRS converged standards. Additionally, under Option 2, the Government would need to determine how the one-time adjustments recorded in the books of accounts to transition to IFRS are treated for tax purposes.

It is important to note that the Income-tax Act in India applies to all entities i.e., corporate, partnership firms, trusts, individuals, etc. and IFRS will be applicable from 1st April 2011 only for a limited number of companies covered by Phase 1. If Option 2 is followed, this would result in different IFRS-based taxable models for some entities and a different model for other entities (that are not required to converge with IFRS immediately).

While Option 1 appears to be attractive, it poses challenges relating to maintaining two sets of records — one under IFRS and the other under current accounting standards. The benefits and costs of each of these options may need to be further debated to decide the best option from an Indian perspective.

Nirav Shah

Business Combinations (IFRS 3) — Accounting to reflect the economic substance

Nirav Shah

IFRS and Indirect Taxes : Need for Dual Reporting !

IFRS

The corporate sector is closely monitoring the changes in the
accounting and tax frameworks — Implementation of International Financial
Reporting Standards (IFRS), and Goods and Services Tax (GST).

Interestingly, IFRS (for large entities) and GST
principles/rules apply with effect from a common date i.e., 1 April 2011. While
the changes in the accounting and tax frameworks would have a substantial impact
on the Indian industry, there is a need felt for more clarity on some of these
impact areas. Further, the differences in recognition and measurement principles
under the revised accounting and tax frameworks would lead to additional efforts
of maintaining different accounting records — one for accounting purposes and
the other for tax purposes. This article attempts to illustrate some of the
practical challenges relating to the adoption of IFRS and GST frameworks.

Date on which the tax will be levied :

Under current excise law, the levy of excise duty is at the
point of manufacture of goods. However under GST framework, the levy of tax will
be on ‘sale’ of goods. However, it is unclear today whether the date of levy of
GST will be the date of invoice, date of dispatch of goods or the date on
recognition of revenue as per books of accounts (i.e., depending on the delivery
terms in the sales contract).

If the levy of tax will be on the date of recognition of
revenue in the books of the entity, then the date of levy of GST might differ
depending on whether the entity follows Indian GAAP or IFRS. Under IFRS, apart
from the transfer of risk and rewards to the buyer along with effective control,
IFRS also prescribes an additional condition in relation to the continuing
managerial involvement to the degree usually associated with ownership of goods.
Thus revenue recognition under IFRS might be later than that under Indian GAAP.

If the levy of GST is based on the invoice date or the
dispatch date, then under certain circumstances the timing of revenue
recognition under IFRS may not be the same as the date of levy of GST. This
difference in recognition of revenue under the accounting and taxation
frameworks will need to be periodically reconciled.

Barter sales :

Unlike Indian GAAP, IFRS prescribes specific accounting
guidance on barter transactions. Under IFRS, a barter transaction shall be
recognised as such only when there is an exchange of dissimilar goods. As such
there is no accounting implication in case of exchange of similar goods.

It is widely anticipated that the GST framework shall levy
tax on barter transactions. However, more clarity is awaited on whether GST
would be applicable on exchange of similar goods, even though these are not
recognised as sale for accounting purposes.

Intangible asset model under service concession arrangements
:

Under IFRS, IFRIC 12 provides guidance on accounting by
private sector entities (operators) for public-to-private service concession
arrangements.

In some arrangements, the operator is not awarded a fixed
consideration, but is awarded a right to collect toll fees for a fixed period of
time. Accounting under IFRS for such arrangements is similar to the barter
transactions, whereby the operator renders construction services (and recognises
construction revenue) in lieu of a right to collect toll fees from the users of
the infrastructure facility (i.e., intangible asset which is depreciated over
the concession period). Thus the construction service (revenue) is exchanged for
an intangible asset that provides the operator the right to collect toll
revenue. This accounting treatment is akin to accounting for barter
transactions. The subsequent collection of toll revenue is recognised as
separate revenue, while the depreciation on the intangible asset represents the
cost for the operator.

Currently no indirect taxes are levied on the construction
services provided by the operator under a service concession arrangement. The
indirect tax incidence, if any, is on the collection of toll revenue. It would
be interesting to see whether the GST framework shall also view such service
concession arrangements as barter revenue in line with IFRS accounting. If the
current indirect tax treatment is retained under GST framework, the revenue from
construction and other services needs to be periodically reconciled with the
revenue for accounting purposes.

Branch transfers :

As widely deliberated, GST will also be levied on the stock
transfers from one location of the entity to the other. Like Indian GAAP, IFRS
shall not recognise the branch transfers as revenue of the company. This
difference in recognition of branch transfers under the accounting and taxation
frameworks needs to be periodically reconciled.

Discounts and rebates :

IFRS requires all discounts including cash discounts given by
way of separate credit notes, free goods to the buyer to be reduced from
revenue. Further, the cash discounts and volume rebates need to be recognised on
an estimated basis as at the date of sale. Like the current indirect taxes, GST
is expected to be levied on the transaction value as per the invoice after
deduction of discount as specified on the invoice. This difference in
recognition of discounts under the accounting and taxation frameworks needs to
be periodically reconciled.

Customer loyalty programmes :

Customer loyalty programmes, comprising offering of loyalty
points or award credits, are offered by a diverse range of businesses, such as
supermarkets, retailers, airlines, telecommunication operators, credit card
providers and hotels. Award credits may be linked to individual purchases or
groups of purchases, or to continued custom over a specified period. The
customer can redeem the award credits for free or discounted goods or services.

IFRS requires an entity to recognise the award credits as a
separately identifiable component of revenue and to defer the recognition of
revenue related to the award credits. The revenue attributed to the award
credits takes into account the expected level of redemption. The consideration
received or receivable from the customer is allocated between the current sales
transaction and the award credits by reference to fair values. The component of
the revenue pertaining to award credits is deferred until the redemption of the
award credit against the future sale.Cash flow from operations — in terms of stabil-ity, timing and certainty — if the target does not prepare a cash flow statement merely because it is not mandatorily required to do so, it is no excuse for the FDD team not to carry out this analysis. The FDD team would be well advised to develop the cash flow statement of the business with the aid of two balance sheets and the profit and loss account for the intervening period and to then analyse the same. One lesson that the Enron debacle has taught us is that ‘Cash is king’ and that if one is able track where cash is being generated and where it is deployed, potential accounting ‘juggleries’ tend to get exposed.

Like the current indirect tax treatment, the GST may be levied on the transaction value of the goods. Thus on the initial sale transaction, GST may be levied on the entire sale value, whereas the accounting revenue as per IFRS would be lower to the extent of the fair value of award credits (that is deferred). Subsequently, as the buyer is provided other goods free of charge in lieu of the award credit, GST may not be levied as there is no sale consideration. For accounting purposes, the fair value of the award credit that was deferred on initial recognition will now be recognised as revenue. Thus the accounting revenue would be recognised subsequently, though there would be no revenue for GST purposes.

This difference in recognition of benefits provided under customer loyalty programmes under the accounting and taxation frameworks needs to be periodically reconciled.

Multiple deliverables within a contract :

Oftentimes a contract involves multiple deliverables such as sale of goods, installation services, warranty benefit and maintenance services. For revenue recognition, IFRS requires identification of different revenue components, allocation of the contractual revenue to each component based on their relative fair values and recognition of revenue for each component based on compliance with the revenue recognition criteria for each such component. The timing and amount of revenue recognition may not strictly follow the contractual arrangement.

GST is expected to be levied on the transaction value that is based on the contract. Hence there will be a need for reconciliation between the revenue as per IFRS and revenue as per GST. An entity may be required to maintain this reconciliation on a periodic basis.

Sales on deferred payment terms :

Deferred payment term is a credit term that is higher than the normal credit term. In case of deferred payment term, IFRS requires the sales to be recognised by discounting the future receivables to its present value. The difference between the nominal value and discounted value shall be recognised as interest income over the credit term.

Under the GST framework, if the levy of tax would be on the invoice value, then it might be viewed as if GST is levied on interest income as well (From an accounting perspective under IFRS, the invoice value comprises two parts — Revenue and Interest Income). More clarity is required on the assessable value of goods and services for GST purposes.

Lease deposits received by lessor :

Under IFRS, lease deposits are classified as financial instruments that are measured at fair value on initial recognition. When a lessor provides a leased asset to a lessee on a non-cancellable operating lease, the fair value of interest-free lease deposits is not equal to the nominal value (i.e., face value). The fair value of the lease deposit would be the present value of the future cash flows under the contract discounted at the market interest rate. The difference on initial recognition between the nominal value and the fair value of the lease deposits would be recognised as lease income received in advance. This advance lease income is recognised on straight-line basis over the lease term. Correspondingly the deposit liability would accrete interest expense over the lease term. Thus the lease income as per IFRS would be higher than the contractual lease rent.

Like the practice under current indirect tax laws, GST may be levied on the contractual lease rent without the impact of the notional lease rent on account of interest-free lease deposit. Thus the lessor will need to reconcile the lease revenue between IFRS and GST on a periodic basis. This would have a substantial impact on leasing companies.

Embedded leases :

Under IFRS, there is specific guidance on accounting for certain arrangements which include lease components. If the contract involves use of dedicated assets by a service provider, then such contract needs to be assessed from the perspective of a lease. Determining whether an arrangement is, or contains, a lease shall be based on the substance of the arrangement and requires an assessment of whether : (a) fulfilment of the arrangement is dependent on the use of a specific asset or assets (the asset); and (b) the arrangement conveys a right to use the asset.

For the purpose of applying the requirements of lease accounting, payments and other consideration required by the arrangement shall be separated at the inception of the arrangement into those for the lease and non-lease elements on the basis of their relative fair values.

Further, the entity may need to determine the classification of lease into operating or finance lease. In case of operating lease, the entity needs to recognise the lease component of the non-cancellable arrangement on a straight-line basis. In case of finance lease, the lessor would recognise the sale of the leased assets upfront and interest income over the lease period. The lessor shall recognise the non-lease components based on the accounting guidance from other relevant IFRS standards.

While the accounting for embedded leases could get complicated in practice, the GST is expected to be levied based on the same principles that are currently in existence i.e., transaction values. Thus when an arrangement is classified as a finance lease under IFRS, the earnings would comprise sale of ‘leased’ asset and interest income, whereas it would be taxed as job work charges in the hands of the service provider. The entity needs to periodically reconcile the impact of different measurement principles relating to revenue recognition under IFRS and GST.

Interest-free loan to job worker :

Under IFRS, loans are financial instruments that are initially recognised at fair value. In case of interest-free loans, the loans are initially recognised at fair value by discounting the future cash flows. The discounted value accretes interest expense over the term of the loan. The difference between the nominal value and fair value is recognised as notional job work charges over the tenure of the loan.

Under the current excise valuation rules, where a customer provides an interest-free loan to the job worker and the loan has influenced the price charged, then a notional interest is added to the assessable value of the goods sold by the job worker.

The GST framework so far is silent on the assessable value of goods/services. It would be interesting to see whether the notional interest and the notional job work charges are also to be added to the computation of assessable value for the purpose of levy of tax.

While industry believes that the changes in the accounting and taxation frameworks are steps in the right direction, they are unable to estimate the exact impact on their business. Further, unless some more clarity emerges in the near future, the industry shall face challenges around maintaining an efficient and planned tax structure. Further, some of the apparent transition implications, where the IFRS and tax treatment is relatively clear, indicate maintenance of two sets of records — one for accounting purpose and the other for tax purposes.

The financial and taxation aspects relating to the IFRS/ GST convergence need to be planned and tested in advance of the implementation date. In view of this, the Industry needs to start their transition process early, preferably now. Global experience has shown that the early adopters are generally more successful in managing the overall IFRS and GST transition. The early-mover advantage not only provides adequate time to carry out required changes, but protects critical decisions being taken within the constraints of time and resources.

Nirav Shah

IFRS impact on fixed assets — More than just a change in name

Accounting for property, plant and equipment

IAS 16 deals with accounting for property plant and equipment; widely referred to as PPE under IFRS. PPE comprises tangible assets held by a company for use in production or supply of goods or services, for rental to others, or for administrative purposes, that are expected to be used for more than one period. PPE is recognised only if it is probable that future economic benefits associated with the asset will flow to an entity and the cost of the asset can be reliably measured. IAS 16 requires PPE to be initially recognised at cost plus ‘directly attributable’ expenses incurred to bring an asset to the location and condition necessary for its ‘intended use’.

In practice there may be situations where the determination of what comprises ‘directly attributable cost’ would involve exercise of judgment.

Directly attributable costs :

At a general level, the concept of directly attributable costs in AS 10 is broadly consistent with what is provided by IAS 16. IAS 16 has provided examples of directly attributable costs. Some of these include :

Installation and assembly cost

Site preparation

Fees paid to professionals e.g. towards legal assistance for title report on land

Cost of employee benefits incurred for acquisition/construction of an asset e.g. share based payments provided to employees who have worked on the construction/acquisition of an asset

Interest and other borrowing costs can be capitalised as part of the cost of a qualifying asset

These costs need to be incremental or external to be considered as directly attributable. For example : if a company is installing a machine in its factory and one of its engineers has been assigned this task on a full time basis then the cost of the engineer including employee benefits during the period of installation should be included in the cost of the machine even though this cost may have been incurred in any event. In any case, the cost of an asset can include expenditure only if an asset is acquired e.g. if a broker is paid fees to identify property, such fees can be added to the cost of property which is acquired since it is directly attributable to the acquisition of property, fees paid for other properties not acquired needs to be expensed.

Care should be taken to ensure that expenses which are in the nature of administrative costs are not capitalised since these cannot be considered as directly attributable to acquisition of an asset. Also, abnormal amounts of material/labour/other costs that maybe incurred while constructing an asset cannot be added to the cost of that asset. These will have to be expensed in the period in which these have been incurred. The determination of what comprises ‘abnormal’ is subjective. For example, if the normal commissioning time for an asset is two weeks but it takes four weeks because a trainee engineer had installed a machine incorrectly or because site management forgot to schedule machine operators for the testing phase, then additional costs incurred as a result of such events should be considered ‘abnormal’ and expensed as incurred. However, the assessment of what is abnormal can be made by considering the level of technical difficulty associated with a project, timelines/estimates made at the time of planning etc. Having said that, there may be circumstances where there might be a delay in the process of constructing an asset due to some unexpected technical difficulties. This delay may give rise to additional costs being incurred which should then be capitalised and not expensed.

As is the case with AS 10, IAS 16 also permits subsequent expenditure to be capitalised only if it is probable that future economic benefits associated with them will flow to the entity and its cost can be reliably measured.

Areas of GAAP difference : AS 10 v. IAS 16 :

The accounting for PPE as required by IAS 16 is similar to accounting for fixed assets as per AS 10 in certain areas, while there are certain important differences such as :

Foreign exchange differences and preoperative expenses capitalised under Indian GAAP

Accounting for decommissioning costs

Depreciation

Component accounting

Revaluation approach for subsequent measurement of PPE

Foreign exchange differences and preoperative expenses capitalised under Indian GAAP :

Under Indian GAAP, (based on principles laid out in the Companies Act 1956), companies have traditionally capitalised foreign exchange differences on monetary items relating to fixed assets as part of the acquisition cost. This has been recently amended by the Accounting Standard Rules 2006. However, prior capitalisation of foreign exchange differences still forms a part of the cost of fixed asset. On adoption of IFRS, companies need to strip out these capitalised exchange differences on the transition date so as to bring the cost of assets in line with IAS 16 and also rework depreciation for future years accordingly.

It is important to note here that as per the recent March 2009 notification issued by the Ministry of Company Affairs, Indian companies have an option to adjust exchange differences arising on reporting of long term foreign currency monetary items to the cost of the fixed asset where they relate to the acquisition of a depreciable capital asset and consequently depreciated over the asset’s balance life. Such an option would not be available under IFRS and hence such capitalisation would also need to be adjusted on transition to IFRS.

The same rule applies to general and administrative overheads relating to start up activities capitalised under Indian GAAP as per Guidance note on expenditure during construction period, until the year 2008. These would also have to be stripped out from the cost of the PPE with a corresponding impact on opening reserves on the transition date.

Decommissioning:

Under IFRS, the cost of an asset also includes the estimated cost of dismantling an asset and restoring the site. For example, consider that the installation and testing of a company’s new chemical plant results in contamination of the ground at the plant. The company will be required to clean up the contamination caused by the installation when the plant is dismantled. Hence it will recognise a provision for restoration, which is capitalised as part of the cost of the asset. Subsequent changes to these estimates due to change in the amount or timing of the expenditure are required to be accounted as change in estimates. Although AS 10 does not provide guidance on accounting for decommissioning costs, Appendix C to AS 29 provides an example of cost of restoring an oil rig at the end of production. Such costs are required to be included as part of the cost of oil rig. The key GAAP differences here are:

IFRS requires recognition of provisions based on constructive obligations also as opposed to only contractual obligations under Indian GAAP

Under IFRS, such provisions need to be recorded based on their discounted values

Depreciation:

Under IFRS,entities will have to estimate depreciation based on the estimated useful life of an asset. This is different from the current practice of using rates prescribed by Schedule XIV to the Companies Act, 1956 as the minimum rates for providing depreciation. IFRS does not prescribe any particular method of calculating depreciation but permits use of the straight line method, diminishing balance method and sum of units method. IAS 16 also requires a review of the estimated useful life of an asset, estimated residual value of an asset and the method of depreciation at each balance sheet date. Although AS 6 also requires estimated useful life ot'” major classes of depreciable assets to be periodically reviewed, given the current practice of using Schedule XIV rates for providing depreciation, this may be an area of focus for preparers and auditors while signing off on financial statements prepared under IFRS. Based on our recent conversion experiences we have noted differences in depreciation because the useful life of major property, plant and machinery is longer than the maximum lives permitted under Schedule XIV. In other cases, companies may not necessarily have estimated useful lives, but may have adopted the Schedule XIV rates, which may not correctly reflect the useful lives (for example, furniture and vehicles being depreciated over inappropriately long lives). In such cases, application of IFRS would result in assessment of useful lives and higher depreciation rates and depreciation charge.

Irrespective of the method of depreciation followed, entities will have to ensure that the cost or revalued amount of an asset is allocated on a systematic basis over the useful life of an asset.

The residual value, the useful life and the depreciation method used must be reviewed at least at each financial year-end. Any changes are accounted for prospectively by adjusting the depreciation charge for current and future periods from the date of the change in estimate. It is noteworthy here that if a change of depreciation method has to be made, the change should be accounted for as a change in accounting estimate, and not as a change in accounting policy, and the depreciation charge for the current and future periods should be adjusted accordingly.

Component accounting:

IAS 16 requires component accounting to be fol-lowed for assets which have individual significant components and for which different rates or methods of depreciation are appropriate. The separate component may be a physical component or non physical component. An example of a physical component is an aircraft engine. An aircraft engine is a significant physical component with a distinctly different useful life. Whilst an aircraft is depreciated over its useful life, its engine is separately depreciated on the basis of estimated flying hours. An example of a non physical component is where major overhaul costs are required to be incurred on a periodic basis. If a ship costing Rs.I00 is acquired with a useful life of 15 years and if it has to be dry-docked after every three years for a major overhaul at a cost of Rs 30 then the cost of ship is split into two components i.e. non physical component of Rs 30 and other components aggregating to Rs 70. The non physical component in this case is depreciated over its useful life of 3 years and the other components will be depreciated over their useful life of 15 years.

Component accounting does not apply only to specific assets like ships or aircrafts. A single plant and machinery comprising of different parts such as melting furnace, grinders, rolling mills, etc. could have different useful lives for these parts and hence need to follow component accounting. Similarly, a building can be broken into different components

like the roof top, basic structure and interior improvements which could have different useful lives. The key here is to assess firstly whether there are different components in one asset and then whether these different components have significantly different useful lives.

In many cases an entity acquires an asset for a fixed sum without knowing the cost of the individual components. In such cases, the cost of individual components should be estimated either by reference to current market prices (if possible), in consultation with the seller or contractor, or using some other reasonable method of approximation.

Generally Indian companies have depreciated all assets within a class using a uniform depreciation rate (for example, a single rate for all plant and machinery). However, useful lives of different types of plant and machinery may be different – and hence the need to use different depreciation rates under IFRS.

Revaluation approach for subsequent measurement of PPE:

PPE can be measured at fair value if its fair value can be reliably measured. If the revaluation approach is chosen then:

All assets in that class of assets (being revalued) will have to be revalued. Class of assets would include assets which are of a similar nature and use in an entity’s operations

Carrying value of assets under the revaluation model should not be materially different from their fair values

Any surplus arising on the revaluation is recognised directly in the revaluation reserve within equity except to the extent that the surplus reverses a previous revaluation deficit on the same asset recognised in profit and loss, in which case the credit to that extent is recognised in profit and loss. Any deficit on revaluation is recognised in profit or loss except to the extent that it reverses a previous revaluation surplus on the same asset, in which case it is taken directly to the revaluation reserve. Therefore, revaluation increases and decreases cannot be offset, even within a class of assets.

Fair value of an asset is its market value and is the highest possible price that could be obtained for that asset without regard to its existing use.

The frequency of revaluations depends upon the volatility of the movements in the fair values of the items of PPE being revalued. Revaluations every year are unnecessary for items of PPE with only insignificant movements in fair value. For items that usually experience significant and volatile movements in fair value, annual revaluations are necessary. It is important that revalued amounts do not differ materially from fair values as at the balance sheet date.

Comparison of the cost model with revaluation model:

Illustration:

Depreciation is charged on a straight line basis over the useful life of the asset. The residual value is Rs. nil

Depreciation charge for the subsequent year 2012 under revaluation model shall be Rs.115 (i.e. the carrying value of Rs.920 amortised over balance period of asset 8 years)

Intangible assets:

IAS 38 deals with accounting for intangible assets. An intangible asset is an identifiable non monetary asset without physical substance. It is identifiable (only) if it is separable or arises from contractual or other legal rights. An intangible asset should be controlled by the entity and should expect to get future economic benefits.

Initial recognition:

Like PPE, an intangible asset is initially measured at cost plus directly attributable expenditure incurred in preparing the asset for its intended use. Expenses incurred in training, initial operating losses should be expensed as incurred.

An entity may either acquire or internally generate an intangible asset. An intangible asset maybe internally generated through research and development. Research costs are required to be expensed as incurred. If an internally generated intangible asset arises from development phase of a project, directly attributable expenses should be capitalised from the date that the entity is able to demonstrate:

The technical feasibility of completing the intangible asset so that it will be available for use or sale;

Its intention to complete the intangible asset and use or sell it;

Its ability to use or sell the intangible asset;

How the intangible asset will generate probable future economic benefits;

The availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset; and

Its ability to measure reliably the expenditure attributable to the intangible asset during its development.

Expenses on internally generated brands,”r’ mastheads, publishing titles, customer lists are ‘not capitalised since such expenditure cannot be distinguished from developing the business as a whole. However, such intangibles are recognised when acquired in a business combination (acquisition). Hence, such internally generated, technology related or customer-related intangibles could form a part of the consolidated books of the acquirer entity although they do not meet the recognition criterion in the separate financial statements of the acquired entity. These principles are set out in IFRS 3 — ‘Accounting for business combinations’ .

There are certain expenses which should be expensed as incurred regardless of whether the criteria for recognition appear to be met:

Internally generated goodwill
Training activities
Start up costs
Advertising and promotional costs
Expenditure on relocating or reorganising part or all of an entity

Principally, there are no differences between IAS 38 and AS 26 relating to the identification and recognition of intangible assets. However, with IFRS 3 in the picture, the recognition of some intangibles in the consolidated financial statements of a group due to fair value accounting for business combinations lead to differences between the two GAAPs.

Subsequent measurement:

The key difference between Indian GAAP and IFRS here is that IFRS recognises that an intangible may have an indefinite useful life and hence need not be amortised. However, the term ‘indefinite’ does not mean ‘infinite’. An intangible asset has an indefinite useful life when, based on an analysis of all the relevant factors (e.g., legal, regulatory, contractual), there is no foreseeable limit to the period over which the asset is expected to generate net cash inflows ‘for the entity.

Under Indian GAAP, an intangible asset has to be amortised over a maximum period of ten years unless a longer period can be justified. However, it does not give the option of not amortising the intangible altogether or considering an indefinite useful life.

An intangible asset with a finite useful life is sub-sequently amortised on a systematic basis over its useful life. Goodwill and intangible assets with an indefinite useful life are measured at cost or revalued amount less accumulated impairment charge. If an intangible asset is not amortised, its useful life must be reviewed at each annual reporting date to determine if the useful life continues to be indefinite.

The method of amortisation used should reflect the pattern of consumption of economic benefits. The method of amortisation used should be reviewed at each annual reporting date and any change in method should be accounted for prospectively as a change in estimate.

Intangible assets may subsequently be measured at fair value only if there is an active market. An active market exists if the items traded are homo-geneous, there are willing buyers and sellers and information on price is available. Under Indian GAAP, revaluation of intangible assets is not permitted. However, in practice, since an active market for intangible assets does not exist for most intangible assets, revaluation would typically not be permitted in the Indian context.

Acquired goodwill and intangible assets with an indefinite useful life will have to be tested annually for impairment or whenever there is a trigger for impairment. In a subsequent article, we will discuss the various impairment monitoring and measurement requirements under IFRS (IAS 36).

Conclusion:

The basic principles of accounting for PPE and intangibles under IFRS are not new to Indian GAAP. Concepts like component accounting and revaluations have been existing in the current Indian accounting framework. However, IFRS gives out clear principles and guidance in these matters. It aims at consistency in application of policies and accounting for PPE based on their composition.

PPE is one area that would need significant efforts and time for computations in order to converge with IFRS.

Nirav Shah

Impact of IFRS on the telecom sector : Dialling a new reporting framework

IFRS

Impact of IFRS on the telecom sector : Dialling a new reporting
framework

As Indian companies get poised to converge with IFRS
commencing April 1, 2011, one of the industries which will witness significant
changes in the financial statements is the telecom industry. This article seeks
to discuss these changes and their related impact in greater detail.

Revenue recognition :

Presently in India, revenue recognition is governed by the
principles outlined in AS-9 ‘Revenue Recognition’. The corresponding standard
under IFRS — IAS 18 ‘Revenue’ along with related IFRICs serve as the required
starting point for developing accounting policies, even if they are not
necessarily specific to the telecom sector. The key changes from the present
accounting practices with respect to revenue recognition are as follows :

Arrangements involving more than one component (Bundled
arrangements) :

Telecom companies often offer customers bundled products,
which involve multiple components such as sale of equipment when the customer
signs up for a service contract. A typical example of this would be the schemes
where companies offer mobile handsets, modems, set top boxes, etc. (either at
full price or subsidised prices or at no separate price) when the customer signs
up for the respective services.

Under IFRS, IAS 18 has detailed guidance for identification
of arrangements having more than one component and their consequent separation
for the purposes of revenue recognition. Due to limited guidance available under
Indian GAAP for the same, entities presently account for such arrangements based
on their legal form and not based on the substance of such transactions.

IAS 18 requires that two or more transactions be considered a
single arrangement “when they are linked in such a way that the commercial
effect cannot be understood without reference to the series of transactions as a
whole.”

Having identified the transactions which are part of a single
arrangement, the standard requires entities to identify the various components
of the arrangement and account for the respective component based on the
applicable revenue recognition criteria.

For the purposes of separation of components the following
criteria is required to be fulfilled :

the component has stand-alone value to the customer, and

the
fair value of the component can be measured reliably.

There is no specific guidance in IAS 18 for allocation of the
overall consideration to the respective components. However, based on the
guidance available in IFRIC 13 revenue could be allocated to components using
either of the following methods :

Relative fair values, or

Fair value of the undelivered components (residual method)

Using the relative fair values, the total consideration is
allocated to the different components based on the ratio of the fair value of
the components relative to each other. Using the residual method, the
undelivered components are measured at fair value and the remainder of the
consideration is allocated to the delivered components.

Telecom companies generally charge less for deliverables in a
bundled arrangement than they charge for each component separately. The relative
fair value method allocates this discount across all separately identifiable
components while the residual method would result in allocation of the discount
to undelivered components.

Customer incentives in the form of free minutes :

Telecom companies generally offer customers bonus talktime
without any additional revenue for the same. Presently under Indian GAAP,
revenue recognition is based on actual utilisation of talktime by the customer
with no revenue being recognised while the bonus talktime is being used. Under
IFRS, revenue recognition per minute is to be adjusted for the impact of the
bonus talktime (after considering the impact of forfeiture).

For example, Telecom T runs a promotion for its prepaid
telecom base. A customer purchasing a standard prepaid card for Rs.50 normally
would receive 100 minutes of calling time. However, during the promotion the
customer receives an additional 20 bonus minutes.

The revenue per minute of airtime is Rs.0.42 (50/120).
Therefore T will recognise revenue of Rs. 0.42 for every minute of airtime used
by the customer assuming that the customer shall use the bonus minutes entirely.

Activation revenue :

Activation revenue is normally collected from customers at
the point of their entry into the network. Accounting practices under Indian
GAAP varies with some companies recognising the activation revenue upfront,
while others recognising it over the expected life of the customer on the
network.

Under IFRS, such revenue is recognised over the expected life
of the customer and is not permitted to be recognised upfront.

Customer loyalty programs :

Telecom companies often offer customer loyalty points for
amounts spent on airtime and a customer can redeem those points for money off
their monthly bill or obtain a handset upgrade. Presently under Indian GAAP, due
to limited guidance telecom companies do not defer any revenue on account of the
loyalty points.

IFRIC 13 provides specific guidance with respect to
accounting for customer loyalty programs with the following features:

Telecom companies grant award credits to a customer as part of a sales
transaction; and

Subject to meeting of other conditions, the customer can redeem the award
credits for free or discounted goods or services in the future.

In addition to loyalty points offered by telecom companies,
IFRIC 13 would cover a wide range of sales incentives that might include, for
example, vouchers, coupons and discounts or renewals.

In summary, IFRIC 13 requires revenue to be deferred to account for an entity’s future obligation in respect of loyalty programs awarded. Recognition of revenue in accordance with IFRIC 13 would require allocation of revenue to award credits. Allocation of revenue is to be based on either relative fair value method or fair value of the award credits (i.e., residual value method). In estimating the fair value credits the telecom company is required to consider the following:

Fair value of the goods and services that can be obtained from the exercise of the award credits, and

The proportion of award credits granted that are expected not to be redeemed i.e., expected forfeitures.

Revenue from award credits is recognised as the telecom company fulfils its obligations to provide the free or discounted goods or services or as the obligation lapses.

Gross v. net presentation of revenue:

IAS 18 provides specific guidance for determination of gross or net presentation of revenue. For example, arrangement with respect to content available for downloads, involve the telecom companies earning a commission based on user access to the content. Typically such arrangements do not result in the telecom companies acquiring content rights. Accordingly, an assessment shall be required to be performed for gross v. net presentation based on the specific features of the arrangements.

Capacity transactions:

Telecom companies often enter into arrangements whereby they convey to other telecom companies ‘the right to use’ equipment, fibres or capacity (bandwidth) for an agreed period of time, in return for a payment or a series of payments. In relation to such capacity transactions, the telecom companies can be either providers (sellers) or customers or both. The capacity sellers usually retain the ownership of the network assets and convey the ‘right to use’ the asset to the customer for an agreed period of time. An agreement that conveys the exclusive right to use is generally referred to as ‘indefeasible right of use’ (IRU) in the telecom industry.

IRU contracts may not be described explicitly as lease contracts, but what matters is the substance of the agreement, which should be evaluated to determine whether the arrangement constitutes a lease. The analysis is based on the requirements of IFRIC 4 and accordingly based on the fulfilment of the following conditions:

Whether the provision of a service depends on the use of one or more specific assets; and

Whether a right of use of these assets is conveyed through the arrangement.

For the purpose of determining whether the arrangement conveys a right of use for specified assets, the telecom companies shall be required to assess whether:

(a) the customer has the ability or right to operate the asset (including to direct how others should operate the asset), and at the same time obtain or control more than an insignificant amount of the asset’s output;

(b) the customer has the ability to control physical access to the asset while obtaining more than an insignificant amount of the asset’s output;

(c) the possibility of another party taking more than an insignificant amount of the asset’s output during the term of the arrangement is remote, and if yes, whether the customer pays a fixed price per unit of output which is not based on market price.

The facts and circumstances of the case would determine whether the customer acquires the right to use interchangeable capacity from an overall physical telecom asset; or whether the customer acquires the right to use a specific portion of the physical asset (for example, a physically identifiable portion of the wavelength) . Generally, rights to use ‘general capacity’ would not qualify as leases. However, rights to use specific telecom assets/portion of telecom assets may qualify as leases.

Property plant and equipment:
Depreciation:

Presently in India, telecom companies depreciate their fixed assets primarily based on the rates prescribed in Schedule XIV of the Companies Act, 1956. However, some companies depreciate certain fixed assets at rates based on the respective useful lives of the assets.

Under IFRS, companies are required to depreciate property plant & equipment based on their useful lives. The revised draft of Schedule XIV prescribes indicative useful lives and unlike its predecessor, is not expected to represent the minimum rates. Accordingly, all companies including the telecom companies will have to charge depreciation based on the useful lives of the related item of property plant and equipment.

Components of cost of property plant and equipment:

Presently, under Indian GAAP, companies capitalise costs which may not be directly attributable to bringing the fixed asset into its present location and condition. E.g., foreign exchange fluctuations related to long-term borrowing with respect to fixed assets are currently permitted to be capitalised under Indian GAAP.

However, under IFRS, only those costs which are directly attributable to bringing the asset into its present location and condition are permitted to be capitalised. Accordingly, items like foreign exchange fluctuation, administrative expenses, etc. shall not be permitted to be capitalised to the cost of property plant and equipment.

Asset retirement obligations:

As per the requirement of AS-29 ‘Provisions, Contingent Liabilities and Contingent Assets’, companies are required to recognise the entire undiscounted value of asset retirement obligation as a part of the cost of the related item of property plant and equipment.

However, under IFRS, IAS 37, the corresponding standard, requires the obligation to be discounted and accordingly, the present value of the asset retirement obligation is required to be included in the cost of the asset.

Deferred credit arrangements:

Telecom companies often have arrangements with creditors for purchase of property plant and equipment requiring payment on deferred terms i.e., on deferred credit terms. Under Indian GAAP, no specific adjustment is required for such arrangements and accordingly the related item of property plant and equipment is capitalised at the gross value of the amount payable to the creditor.

However, under IFRS, since all financial instruments have to be fair valued on initial recognition, the liabilities towards purchase of property plant and equipments (being financial liabilities) are required to be discounted on initial recognition. Accordingly, the related item of property, plant and equipment shall be capitalised at the present value of the amount payable to the creditor at the end of the extended credit period. The unwinding shall be through accrual of interest expense on the discounted liability for each reporting period.

Conclusion:

As the convergence date with IFRS is approaching, telecom entities have to be well prepared to ensure that the transition is smooth. Entities also have to be mindful of the ‘carve-outs’ (areas where accounting treatment under the IFRS converged standards in India may differ from IFRS issued internationally) which are being presently considered by the regulators.

Lastly, telecom companies would need to carefully consider the impact of IFRS convergence on their IT systems. This is especially true for changes impacting revenue recognition, given that revenue recognition in the telecom industry is highly technology-intensive.

Nirav Shah

IFRS 8 : Operating Segments

Background information :

IFRS 8 on ‘Operating Segments’ sets out requirements for disclosure of information about an entity’s operating segments and also about the entity’s products and services, the geographical areas in which it operates, and its major customers.

(1) Core principle :

The core principle of IFRS 8 is that an entity shall disclose such information as to enable users of its financial statements to evaluate the nature and financial effects of the business activities in which it engages and the economic environments in which it operates.

(2) Applicability of IFRS 8 :

IFRS 8 shall apply to the separate/individual/consolidated financial statements of an entity. IFRS 8 is not applicable to all entities. It is applicable only to those companies whose securities are either listed or are in the process of listing in a public market.

(3) Management approach :

(a) Management approach :

IFRS requires segment disclosure based on the components of the entity that management monitors in making decisions about operating matters (the ‘management approach’). Such components (operating segments) are identified on the basis of internal reports that the entity’s Chief Operating Decision Maker (‘CODM’) reviews regularly in allocating resources to segments and in assessing their performance.

The management approach is based on the way in which management organises the segments within the entity for making operating decisions and in assessing performance. Consequently, the segments are evident from the structure of the entity’s internal organisation and the information reported internally to the CODM. The adoption of the management approach results in the disclosure of information for segments in substantially the same manner as they are reported internally (and used by the entity’s CODM) for purposes of evaluating performance and making resource allocation decisions. In that way, financial statements users are able to see the entity ‘through the eyes of management’.

(b) Identifying the CODM :

The term CODM refers to a function, rather than to a specific title. The function of the CODM is to allocate resources to the operating segments of an entity and to assess the operating segments’ performance. The CODM usually is the highest level of management (e.g., CEO or COO), but the function of the CODM may be performed by a group rather than by one person (e.g., a board of directors, an executive committee or a management committee).

For example, an entity has a CEO, a COO and a president. These individuals comprise the executive committee. The responsibility of the executive committee is to assess performance and to make resource allocation decisions related to the individual operations of the entity, and each of these individuals has an equal vote. The executive committee is the CODM because the committee is the highest level of management that performs these functions. The segment financial information provided to and used by the executive committee to make resource allocation decisions and to assess performance is the segment information that would be the basis for disclosure for external financial reporting purposes.

However, the mere existence of an executive committee, management committee or other high-level committee does not necessarily mean that one of those committees constitutes the CODM. Assume the same fact pattern as in the previous example except that the managing director can override decisions made by the executive committee. Because the managing director essentially controls the committee and therefore has control over the operating decisions that the executive committee makes, the managing director will be the CODM for purposes of applying IFRS 8.

(4) Identifying operating segments :

An operating segment is a component of an entity :

(a) that engages in business activities from which it may earn revenues and incur expenses (including revenues and expenses relating to transactions with other components of the same entity),

(b) whose operating results are regularly reviewed by the entity’s CODM to make decisions about resources to be allocated to the segment and assess its performance, and

An operating segment generally has a segment manager. Essentially, the segment manager is directly accountable for the functioning of the operating segment and maintains regular contact with the CODM to discuss operating activities, forecasts and financial results. Like the CODM, a segment manager is a function, rather than a specific title.

(a) Business activity is essential :

A corporate headquarters would carry out some, or all, of the functions in the treasury, legal, accounting, information systems and human resources areas. However, corporate activities generally would not qualify as operating segments under IFRS 8, because typically they are not business activities from which the entity earns revenues.

(b) Multiple segment information reviewed by CODM :

Apart from the core principle as mentioned above, the additional factors that can be considered in determining the appropriate operating segments are as under :

(a) the nature of the business activities of each component;

(b) the existence of managers responsible for the components;

(d) information provided to external financial analysts and on the entity’s website.

Some entities use a ‘matrix’ form of organisation, whereby business components are managed in more than one way. For example, some entities have segment managers who are responsible for geo-graphic regions, and different segment managers who oversee products and services. If the entity generates financial information about its business components based on both geography and products or services (and the CODM reviews both types of
information, and both have segment managers), then the entity determines which set of components constitutes the operating segments by reference to the core principle to IFRS 8 as mentioned above.

For example, an entity has six business components (A, B, C, D, E and F). Three of these business components (A, B and C) are located in India and each manufactures and sells a different product to customers in India. The CEO (who is the CODM) assesses performance, makes operating decisions and allocates resources to these business components based on financial information presented on a product-line basis. The entity also has three business components in the U.S. (D, E and F), which are organised to mirror the India operations (i.e., each manufactures and sells its products to customers located in the U.S.). However, the CODM assesses performance, makes operating decisions and allocates resources based on the financial information presented for the U.S. as a whole. The entity’s presi-dent of the U.S. operations is responsible for assessing performance, making operating decisions and allocating resources to the business components within the U.S. The entity’s president of the U.S. operations also is directly accountable to the CODM. The entity therefore has four operating segments: Segments A, B and C, which are determined on a product-line basis, and Segment U.S., which consists of business components D, E and F and is determined on a geographic basis. There is no requirement to disaggregate information for segment reporting purposes if it is not provided to the CODM in a disaggregated form on a regular basis.

Further, determination of the industry in which a business component of an entity operates generally is not decisive for purposes of identifying properly all of the operating segments under IFRS 8. For example, an entity historically reported that it had one industry segment (mining), but presented financial information in its MD&A and press releases on the following business components: gold, copper and coal. The entity determines that the CODM does, in fact, make resource allocation decisions based on the financial performance of each of these three business components. Accordingly, each of the three business components is an operating segment under IFRS 8, despite the fact that they all are in the mining industry.

c) Discrete and sufficient financial information :

In order to assess performance and to make resource allocation decisions, the CODM must have financial information about the business component. This information must be sufficiently detailed to allow the CODM to assess performance and to make resource allocation decisions. For example, an entity’s CODM receives revenue information for three different services delivered by segment A (Segment A is one of the five operating units of the entity). However, its operating expenses are reported to the CODM on a combined basis for the entire segment. Because a measure of profit or loss by service is not presented, the CODM might not have enough information to assess the performance or make resource (capital) allocation decisions regarding the individual services. Thus Segment A, in aggregate, is likely to be one operating segment, as opposed to the three individual services delivered by the Segment A.

5) Aggregation of segments :

Two or more operating segments may be aggregated into a single operating segment if

a) aggregation is consistent with the core principle of IFRS 8,

b) the segments have similar economic characteristics, and

c) the segments are similar in each of the following respects :

the nature of the products and services;

the nature of the production processes;

the type or class of customer for their products and services;

the methods used to distribute their products or provide their services; and

if applicable, the nature of the regulatory environment, for example, banking, insurance or public utilities.

6) Reportable segments :

a) Quantitative thresholds :

An entity shall report separately information about an operating segment that meets any of the following quantitative thresholds :

a) Its reported revenue, including both sales to external customers and inter-segment sales or transfers, is 10% or more of the combined revenue, internal and external, of all operating segments.

b) The absolute amount of its reported profit or loss is 10% or more of the greater, in absolute amount, of

the combined reported profit of all operating segments that did not report a loss and
the combined reported loss of all operating segments that reported a loss.

c) Its assets are 10% or more of the combined assets of all operating segments.

Operating segments that do not meet any of the quantitative thresholds may be considered reportable, and separately disclosed, if management believes that information about the segment would be useful to users of the financial statements or more reportable segments need to be identified until at least 75% of the entity’s revenue is included in reportable segments.

The term ‘combined’ in each of the three tests as mentioned above means the total amounts for all operating segments before the elimination of intra-group transactions and balances (i.e., not the entity’s financial statement amounts). It does not include reconciling items and activities that do not meet the definition of an operating segment under IFRS 8 (e.g., corporate activities).

b) Use of different accounting policies for segment reporting :

The measures of the segment amounts are based on the amounts reported to the CODM. As a result, the entity can measure the segment amounts based on segment accounting policies that may be different from the entity’s accounting policy for preparation of financial statements. In such cases, the entity measures the segment amounts based on segment accounting policies and provides additional disclosure reconciling the segment amounts to the entity’s financial statements.

c) Measures for profits, assets or liabilities :

The segment information is based on the actual measure of segment profit or loss that is used by the CODM for purposes of evaluating each reportable segment. Adjustments and eliminations made in preparing the entity’s financial statements, as well as allocations of revenue, expenses, gains or losses, are included in the reported segment profit or loss only if these items are included in the segment profit or loss measure used by the CODM. Additionally, the allocation of amounts included in the measure of segment profit or loss must be on a reasonable basis.

d) Use of multiple measures of profits, assets or liabilities for different segments :

If the CODM uses more than one measure of a segment’s profit or loss, or more than one measure of a segment’s assets or the segment’s liabilities, then the measure disclosed in reporting segment profit or loss, or segment assets or liabilities, should be the measure that management believes is determined in accordance with the measurement principle most consistent with the corresponding amounts in the entity’s financial statements.

For instance, the CODM receives and uses the operating profit, operating profit less corporate charges and operating profit less corporate charges and an allocated cost of capital measures of segment profit or loss for each of the operating segments, the measure of segment profit or loss used to report segment profit or loss should be operating profit because this measure is most consistent with the corresponding amounts in the entity’s financial statements.

e) Operating segments below quantitative thresholds :

An entity is allowed to combine information about two or more such operating segments that do not meet the quantitative thresholds (as discussed above) to produce a reportable segment only if the operating segments have similar economic characteristics and share a majority (but need not be all) of the aggregation criteria listed in point 5 above.

If the total of external revenue reported by operating segments constitutes less than 75% of total consolidated revenue, then additional operating segments are identified as reportable segments (even if they do not meet the quantitative threshold criteria) until at least 75% of the total consolidated revenue is included in reportable segments.

Information about other business activities and operating segments that are not reportable shall be combined and disclosed in an ‘all other segments’ category separately from other reconciling items. The sources of the revenue included in the ‘all other segments’ category shall be described.

7. Change in reportable segments :

a) Operating segment becomes reportable segment only in current period :

If an operating segment is identified as a reportable segment in the current period in accordance with the quantitative thresholds, segment data for a prior period presented for comparative purposes shall be restated to reflect the newly reportable segment as a separate segment, even if that segment did not satisfy the criteria for reportability in the prior period, unless the necessary information is not available and the cost to develop it would be excessive.

b) Operating segment was reportable segment in previous period but does not meet quantitative thresholds in current period :

An operating segment that historically has been a reportable segment might not exceed any of the quantitative thresholds in the current period. In this situation if management expects it to be a reportable segment in the future, then the entity should continue to treat that operating segment as a reportable segment in order to maintain the inter-period comparability of segment information.

c) Change in composition of operating segments :

If an entity changes the structure of its internal organisation in a manner that causes the composition of its reportable segments to change, the corresponding information for earlier periods, including interim periods, shall be restated unless the information is not available and the cost to develop it would be excessive. Following a change in the composition of its reportable segments, an entity shall disclose whether it has restated the corresponding items of segment information for earlier periods.

The entity shall disclose segment information for the current period on both the old basis and the new basis of segmentation, unless the necessary information is not available and the cost to develop it would be excessive.

8) Disclosure of segment information :

a) Disclosures :

An entity shall disclose the following for each period for which a statement of comprehensive income is presented :

general information as described in point b below

information about reported segment profit or loss, including specified revenues and expenses included in reported segment profit or loss, segment assets, segment liabilities (refer point c below) and the basis of measurement (refer point d below) and

reconciliations of the totals of segment revenues, reported segment profit or loss, segment assets, segment liabilities and other material segment items to corresponding entity amounts. Reconciliations of the amounts in the statement of financial position for reportable segments to the amounts in the entity’s statement of financial position are required for each date at which a statement of financial position is presented. (refer point e below).

b) General information :

IFRS 8 requires an entity shall disclose the following general information about its segments :

factors used to identify the entity’s reportable segments, including the basis of organisation (for example, whether management has chosen to organise the entity around differences in products and services, geographical areas, regulatory environments, or a combination of factors and whether operating segments have been aggregated), and

types of products and services from which each reportable segment derives its revenues.

c) Information about profit or loss, assets and liabilities : Segment profit or loss disclosures :

IFRS 8 requires an entity to report a measure of profit or loss and total assets for each reportable segment, and a measure of liabilities for each reportable segment if such an amount is provided regularly to the CODM. It also requires that an entity disclose the following about each reportable segment if the specified amounts are included in the measure of segment profit or loss reviewed by the CODM or are otherwise provided regularly to the CODM, even if not included in that measure of segment profit or loss :

revenues from external customers;

revenues from transactions with other operating segments of the same entity;

interest revenue;

interest expense;

depreciation and amortisation;

material items of income and expense disclosed in accordance with paragraph 97 of IAS 1 Presentation of Financial Statements (as revised in 2007);

the entity’s interest in the profit or loss of associates and joint ventures accounted for by the equity method;

income tax expense or income; and

material non-cash items other than depreciation and amortisation.

If the amounts specified above are inherent in the measure of segment profit or loss used by the CODM, then those amounts are required to be disclosed even if they are not provided explicitly to the CODM.

Segment asset disclosures :

IFRS 8 requires an entity to disclose the following about each reportable segment if the specified amounts are included in the measure of segment assets reviewed by the CODM or are otherwise regularly provided to the CODM, even if not included in the measure of segment assets :

the amount of investment in associates and joint ventures accounted for by the equity method, and

the amounts of additions to non-current assets (i.e. PPE and Intangible assets) other than financial instruments, deferred tax assets, post-employment benefit assets and rights arising under insurance contracts.

d) Disclosure of measurement basis :

IFRS 8 requires an entity to provide an explanation of the measurements of segment profit or loss, segment assets and segment liabilities for each reportable segment. At a minimum, an entity shall disclose the following :

the basis of accounting for any transactions between reportable segments;

the nature of any differences between the measurements used for segments reporting (i.e. for profits or losses, assets and liabilities) and the entity’s financial statements (if not apparent from the reconciliations as required under point e below). Those differences could include accounting policies and policies for allocation of common items of income, expenses, assets and liabilities that are necessary for an understanding of the reported segment information.

the nature of any changes from prior periods in the measurement methods used to determine re-ported segment profit or loss and the effect, if any, of those changes on the measure of segment profit or loss.

the nature and effect of any asymmetrical allocations to reportable segments. For example, an entity might allocate depreciation expense to a segment without allocating the related depreciable asset to that segment.

e) Reconciliation disclosures :

IFRS 8 requires an entity to provide reconciliations of all of the following :

the total of the reportable segments’ revenues to the entity’s revenue.

the total of the reportable segments’ measures of profit or loss to the entity’s profit or loss before tax and discontinued operations. However, if an entity allocates to reportable segments items such as tax expense (tax income), the entity may reconcile the total of the segments’ measures of profit or loss to the entity’s profit or loss after those items.

the total of the reportable segments’ assets to the entity’s assets

the total of the reportable segments’ liabilities to the entity’s liabilities

the total of the reportable segments’ amounts for every other material item of information disclosed to the corresponding amount for the entity.

All material reconciling items shall be separately identified and described. For example, the amount of each material adjustment needed to reconcile reportable segment profit or loss to the entity’s profit or loss arising from different accounting policies shall be separately identified and described.

9) Entity-wide disclosures :

Entity-wide disclosures about products and services (refer point a below), geographic areas (including country of domicile and individual foreign countries, if material) (refer point b below) and major customers (refer point c below) for the entity as a whole are required, regardless of whether the information is used by the CODM in assessing segment performance. These disclosures apply to all entities subject to IFRS 8, including entities that have only one reportable segment. However, information required by the entity-wide disclosures need not be repeated if it is included already in the segment disclosures.

a) Information about products and services :

There might be situations in which additional disclosures of external revenue from products and services are necessary on an entity-wide basis when those revenues are not evident from the operating segment disclosures (including situations in which the operating segment disclosures are determined by products and services). For example, an entity might not be organised on the basis of related products and services, and therefore its individual reportable segments include revenues from a broad range of essentially different products and services. In this situation supplemental disclosure of revenues by groups of similar products and services is required, unless the necessary information is not available and the cost to develop it would be excessive. In this case that fact is disclosed.

b) Information about geographical areas :

An entity is required to report the following geo-graphical information :

1. revenues from external customers :

attributed to the entity’s country of domicile and

attributed to all foreign countries in total from which the entity derives revenues. If revenues from external customers attributed to an individual foreign country are material, those revenues shall be disclosed separately. An entity shall disclose the basis for attributing revenues from external customers to individual countries.

2. non-current assets other than financial instruments, deferred tax assets, post-employment benefit assets, and rights arising under insurance contracts :

located in the entity’s country of domicile and

located in all foreign countries in total in which the entity holds assets. If assets in an individual foreign country are material, those assets shall be disclosed separately.

c) Information about major customers :

Revenue from individual external customers that represents 10% or more of an entity’s total revenue must be disclosed. Specifically, the total amount by significant customer and the identity of the segment that includes the revenue must be disclosed. However, IFRS 8 does not require the identity of the customer or the amount of revenues that each segment reports from that customer to be disclosed.

d) Measure of segment profits, assets and liabilities for entity-wide disclosures :

The entity-wide disclosures should be based on the same financial information that is used to produce the entity’s financial statements (i.e., not based on the management approach). Accordingly, the revenue reported for these disclosures should equal the entity’s total revenue. Further, if the necessary information is not available and the cost to develop it would be excessive, that fact shall be disclosed.

10) Issues on first-time adoption :

There is no specific first-time adoption exemption within IFRS 1 for presentation of segment information. However, the reportable segments which, in the past, were identified based on management’s assessment of dominant source and nature of entity’s risks and returns, shall now be identified based on the manner in which the entity’s Chief Operating Decision Maker (‘CODM’) reviews the business components regularly in allocating resources to segments and in assessing their performance.

11) Summary of key differences compared to AS 17 :

Conclusion :

The management needs to reassess the identified business segments based on the manner in which the entity’s Chief Operating Decision Maker (‘CODM’) reviews the business regularly in allocating resources to segments and in assessing their performance.

Is this move to a management approach a good thing ? There is some risk that moving to a management approach may reduce comparability between entities because entity-specific measures override ‘normal’ measurement requirements. But this risk will be offset by the user understanding how does the management assess their own performance and see the business ‘through the eyes of the management’.

Nirav Shah

IFRS – Is it a smooth drive for auto companies?

IFRS

IFRS – Is it a smooth drive for auto companies?

Notwithstanding the recent representation by a leading
industry body to defer the implementation of IFRS in India, the automotive
industry is watching closely, as the events unfold on the roadmap for IFRS
transition in India. Several phase 1 auto companies that are in the advanced
stage of IFRS transition realise that some of the IFRS related changes could
have a significant impact on the financial and business parameters. This article
attempts to highlight some of the key IFRS impact areas for the auto industry in
relation to (a) Revenue recognition; (b) Property, plant and equipment, (c)
capital structure and (d) group structure.

Revenue recognition

Timing of recognition of revenues

Currently under Indian GAAP (hereafter referred to as IGAAP),
many auto companies recognise revenues on dispatch of the product for sale from
the production unit, which coincides with transfer of legal title of goods.
However, as per IFRS, revenue can be recognised only when significant risk and
rewards are transferred to the buyer and the seller does not retain managerial
involvement or effective control over the goods sold.

For example, for domestic sales, if the company bears the
risk of damage/loss to vehicles before it reaches the dealer/customer, then
revenue recognition may need to be deferred till delivery.

In the auto sector, a significant proportion of revenue comes
from month-end billings. There is a possibility that revenues from such
month-end billing may get deferred to the next quarter or fiscal year when the
revenue recognition criteria are met. This may result in a one-time impact (but
will be balanced out on an ongoing basis) on the company’s financials due to the
IFRS transition. Companies may have to align their internal processes so that
they can fulfill the revenue recognition criteria as prescribed under IFRS.

Customer incentives and discounts

Auto companies offer a range of dealer discounts and
incentives (including free service coupons to ultimate customers) to boost their
sales. Under IGAAP, the majority of such discounts and incentives are recognised
as sales promotion expenses, while the sales are reported gross of such
incentives. Under IFRS, all forms of discounts and incentives to the dealers are
recognised as a reduction of revenue. As such, revenues are presented net of
related discounts/incentives. Though such IFRS adjustment may not have an impact
on the profits for the year, they do impact the revenues and key ratios related
to revenue (for example, gross profit margins).

Warranties

Auto companies usually offer two types of warranties (i)
initial warranty that is bundled along with every vehicle sold without any
additional cost and (ii) extended warranty (commencing after expiry of initial
warranty) that is offered to the customer as per their choice and for a price.

Under IGAAP, as the initial warranty is not identified as a
separate element of the contract, sales are recorded for the full amount at the
time of the delivery of the vehicle. Correspondingly, a provision (calculated at
the amount of expected undiscounted cost to be incurred on meeting the warranty
obligation) is recognised upfront. Under IFRS, similar accounting treatment is
required for ‘normal’ warranties, except that the provision is required to be
discounted.

In case of ‘extended’ warranties, the contract contains
multiple elements i.e. sale of vehicles and sale of extended warranty. Under
IGAAP, there is no specific guidance on accounting for multiple elements in a
contract, and practice varies. Under IFRS, the price attributable to the
extended warranty is required to be deferred and recognised in income statement
over the extended warranty period.

The revenue attributable to the extended warranty may be
calculated based on the relative fair value method (relative fair values of sale
of vehicle and the extended warranty) or the residual fair value method (the
fair value of extended warranty is deferred).

Property, plant and equipment

Component approach for depreciation

Currently, most companies apply schedule XIV rates for
providing depreciation on assets. As such, the entire depreciable amount (i.e.
cost less residual value) is depreciated over the useful life estimated under
Schedule XIV to the Companies Act, 1956. Any replacement of significant
component is generally charged to profits as repairs cost.

Under IFRS, companies would be required to depreciate an
asset over its useful life, which may be different from industry benchmarks.
Further, if the asset includes a component, that can be readily identifiable; is
of significant value in relation to the asset; and has a significantly different
useful life; IFRS requires to treat such components as akin to separate assets.
Such components are depreciated over the component’s useful life and the
replacement of such a component is treated as akin to replacement of an asset
(i.e. disposal and fresh purchase).

As depreciation under IFRS may undergo a change, a
corresponding impact may also arise on valuation of inventories.

Contracts with suppliers

Automobile companies maintain vendor parks where suppliers
are in close proximity to the main plant to supply components used in the
manufacture of vehicles. Most of these vendors exclusively serve the plant, and
the automobile company enters into take-or-pay arrangements (such as a minimum
procurement guarantee or a per unit fee along with a fixed annual fee), whereby
the vendor will recover their capital costs irrespective of the actual off-take
from the company. In substance, under IFRS, maintaining exclusive assets against
fixed recoveries of capital costs make it a lease arrangement where the auto
companies are deemed to have taken the vendor’s assets on lease. Under IGAAP,
such contracts are not construed as a lease. Once the arrangement is classified
as a lease, it is further classified as an operating or financial lease
depending on the terms.

If the arrangement contains a financial lease, the fair value
of the asset is recognised on the automobile company’s balance sheet, increasing
its asset base and debt levels, while the impact on the income statement will be
in the form of depreciation on the leased asset and interest payment for the
lease. Under IGAAP, such expenditure would be recognised as part of operating
expenses. This treatment would have a positive impact on the EBITDA of the
company.

From the perspective of inventory valuation for the auto company, the entire payments may be construed as the cost of inventories under IGAAP. However, under IFRS, as charge to the income statement over a period of time would be in the form of depreciation on the leased assets and interest on lease obligation, the interest component may not be considered as cost of inventories.

Intangibles with indefinite useful lives

IGAAP requires all intangibles to be amortised over their useful life, though there is a rebuttable presumption that the useful life of an intangible asset will not be greater than ten years. Under IFRS, there is an additional category of intangible asset i.e. intangible assets with indefinite useful life. The term ‘indefinite’ here does not denote ‘infinite’; instead it denotes a useful life that is relatively long and is not certain eg: brands if they meet certain conditions as detailed in the standard. Such intangible assets are not amortised; rather they are tested for impairment atleast once annually.

Capital structure and borrowing costs
Sales tax deferral loan

Auto companies that have set up plants in certain notified areas are eligible to collect sales tax from customers and are required to pay the same after a few years without any interest charge, based on their total investment in the region. Under IGAAP, such interest-free loans are recognised at the amount collected throughout the tenure of the loan.

Under IFRS, such loans would be considered as financial liabilities and hence recognised at the present value of future cash flows. The difference between the nominal value (i.e., the amount collected from customers) and the present value of the loan would be recognised as a deferred government grant. The difference between the present value and the nominal value of the loan would be recognised as reduction in the value of the underlying fixed assets, or as a deferred income over the depreciable life of the underlying asset.

Borrowing costs

The borrowing costs under IGAAP are primarily determined based on the coupon rates on the financial instrument. As such, the borrowing costs in most cases represent an actual and separately earmarked cash outflow.

Under IFRS, the borrowing cost also includes the effects of routine non-lending transactions that also comprise a financing element. Consider, for instance, the above mentioned sales tax deferral loan. As stated above, the loan liability, which is initially calculated at the present value of future cash flows, shall subsequently be measured at amortised cost and the effects of unwinding of the discount would be recognised as borrowing costs.

Further, if the borrowing cost is attributable to the construction of a qualifying asset as defined under IAS 23, then such effects of unwinding of the loan liability shall also be capitalised to the carrying value of qualifying asset though there is no separate payment of interest made on the loan.

Securitisations

Stringent conditions for securitisation of loans will impact the financing arms of auto companies. Under IGAAP, an entity may de-recognise its assignments of loans and advances with credit enhancements as a ‘sale’ transaction.

Under IFRS, the assessment of retention or transfer of risks and rewards is a critical criterion to determine if de-recognition is appropriate. Legal transfer is not sufficient criteria to achieve ‘sale’ accounting.

Qualitative factors such as credit enhancement facilities provided by the originator to the special purpose trust or to a counterparty in the case of a direct assignment will also have to be evaluated to assess if the de-recognition criteria is met.

This may result in grossing-up of the balance sheet for ‘sold’ assets and related debt (sale proceeds). This, in turn, may impact debt equity ratios.

Group structure
Joint arrangements Under IFRS, consolidation is based on the control (both direct and indirect) over the entity rather than ownership. This may result in consolidation of some current JVs and associates and de-consolidation of certain JVs and subsidiaries based on contractual arrangements.

In the auto industry, the partnerships between Indian and foreign auto companies, where the Indian company may hold a majority stake but has shared control with the foreign company, may be impacted under IFRS eg: veto power with the foreign partner for approval of annual budgets and operating plans etc.

Based on the above guidance, if the consolidated entity is classified as an associate or a joint venture, the company would not be able to disclose the entire revenue of the investee in its consolidated financial statements.

Special Purpose Entity (SPE)

IFRS provides indicators to determine whether an entity controls an SPE, including an assessment of an entity’s exposure to the majority of risks and rewards of ownership of the SPE. Therefore, if the ‘control’ criteria over the SPE are met, the entity will be required to consolidate the SPE in its financial statements, even though it may have no legal ownership of the equity shares of the SPE.

In the automotive sector, the entity operates through a wide network of auto component manufacturers that work on an auto-pilot mechanism or are funded by the automotive company. Such arrangements need to be assessed for SPEs. If such entities are classified as SPEs and meet certain criterias, the SPEs are consolidated with the entity. Thus, all the assets and liabilities of these SPEs are recognised in the entity’s consolidated financial statements, thereby affecting key ratios of the entity. IGAAP does not provide for such guidance.

The financial and non-financial aspects relating to IFRS convergence need to be planned and tested in advance of the implementation date. Global experience has shown that the early adopters are generally more successful in managing the overall IFRS transition. The early-mover advantage not only provides adequate time to carry out required changes, but protects critical decisions being taken within the constraints of time and resources.

Nirav Shah

IFRS 9: Financial Instruments: The new “Avatar”

IFRS

1. Background information

The IASB has undertaken a project to replace the existing IAS
39 on Financial
Instruments: Recognition and Measurement
in order to improve the usefulness of financial statements for users by
simplifying the classification and measurement requirements for financial
instruments. The accounting standard on financial instruments is large and
complex; hence the International Accounting Standard Board (‘IASB’ or ‘the
Board’) has decided to replace the IAS 39 in three phases:

Classification and
measurement of financial instruments:
IFRS 9 was published in November 2009. This standard is currently applicable
for financial assets only. The Exposure draft (ED) on financial liabilities is
expected in 2010.

Impairment of
financial assets:
The IASB has issued an ED in November 2009

Hedge Accounting:
An ED is expected in the first quarter of 2010

Apart from the above, the IASB has also issued an exposure
draft relating to Derecognition and Fair Value Measurements that would either be
part of, or relevant to, accounting for financial instruments.

IFRS 9 currently is applicable only to financial assets
(accordingly, this article covers only financial assets within the scope of IFRS
9). Financial liabilities are currently removed from the scope of IFRS 9 due to
concerns raised on entity’s own credit risk in liability measurement. IASB needs
more time for deliberation and exploring alternative approaches to account for
financial liabilities.

2. Scope and recognition principle for financial assets

The objective of IFRS 9 is not to dramatically change the
accounting for financial instruments, but to simplify the accounting. Hence, the
standard has not modified the scope of financial assets under IAS 39.

3. Measurement principle for financial assets

3.1. Initial measurement

Like IAS 39, all financial assets under IFRS 9 shall be
initially recorded at fair value plus, in case of assets not classified as ‘fair
value through profit or loss’ (FVTPL), transaction costs directly attributable
to its acquisition.

3.2. Subsequent measurement

Like IAS 39, IFRS 9 has retained the ‘mixed model approach’
whereby, at inception, the financial assets are categorized into those that will
be subsequently remeasured at (a) amortised cost or (b) fair value. Thus IFRS 9
has eliminated the three categories of financial assets viz loans and
receivables, held to maturity (HTM) and available for sale, while the FVTPL
category is retained.

4. Principles for classification of financial assets

4.1. Classification criterion

An entity shall classify financial assets (as subsequently
measured) at either amortised cost or fair value on the basis of both (a) the
entity’s business model for managing the financial assets; and (b) the
contractual cash flow characteristics of the financial asset. The standard aims
at aligning the accounting in line with how management deploys assets in its
business, while also considering its characteristics.

4.2. Amortised Cost

Unlike IAS 39, the revised standard has laid down specific
criteria for classification of financial assets at amortised cost. A financial
asset shall be measured at amortised cost if the following two conditions are
met:

(a) the asset is held within a business model whose objective
is to hold assets in order to collect contractual cash flows.

(b) the contractual terms of the financial asset give rise on
specified dates to cash flows that are solely payments of principal and interest
on the principal amount outstanding.

If both the above criteria for amortised cost accounting are
not met, then it is measured at fair value.

4.3. Business Model

The Board clarified that an entity’s business model does not
relate to a choice (i.e. it is not a voluntary designation) but rather, it is a
matter of fact that can be observed by the way an entity is managed and
information is provided to its management. IFRS 9 requires the key managerial
personnel (as defined in IAS 24 on Related Party Disclosures) to determine the
objective of the business model. The entity’s business model is not determined
at the level of every instrument, but is determined at a higher level. An entity
may also have more than one business model for managing financial assets. For
example, a bank’s retail banking division may hold its loan assets and manage
the same in order to collect contractual cash flows while its investment banking
business has the objective to realise fair value changes through the sale of
loan assets prior to their maturity.

4.4. Cash flow characteristics

For amortised cost measurement, the cash flows from financial asset should represent solely payments of principal and interest on the principal amount outstanding on specified dates. Interest here means the consideration for the time value of money and for the credit risk associated with the principal amount outstanding during a particular period of time.

Leverage is not consistent with the ‘solely payments of principal and interest’ criterion. Leverage is described as increasing the variability of the contractual cash flows such that they do not have the economic characteristics of interest. The standard lists

freestanding swaps, options and forwards as instruments that contain leverage.
Examples

The following are examples when both the above conditions are met and hence the financial asset is subsequently remeasured at amortised cost:

A bond with variable interest rate and an interest cap;

A fixed interest rate loan;

Zero coupon bond;

Variable interest loans including an element of fixed credit spread which is determined at inception e.g. LIBOR + 300 bps;

Purchase of impaired / discounted loans which are then held to collect the contractual cash flows.

On the other hand, an investment in a convertible loan note would not qualify for amortised cost measurement because of the inclusion of the conversion option which is not deemed to represent payment of principal and interest. Similarly, an inverse floating interest loan which has an inverse relationship to market rates does not represent consideration for the time value of money and credit risk.

4.5. Impact of sale of financial assets on business model

Under IAS 39, subject to certain exemptions, if the entity sells / reclassifies held-to-maturity assets before maturity, tainting provisions under paragraph 9 to IAS 39 shall apply. Under IFRS 9, not all of the assets in a portfolio have to be held to maturity in order for the objective of the business model to qualify as holding assets to collect contractual cash flows. A sale of financial asset may not preclude subse-quent measurement at amortised cost if, for example, a financial asset is sold as per entity’s investment policy when the credit rating of the financial asset declined below certain threshold or a financial asset is sold to fund capital expenditures. The standard does not give any bright line or indicator as to what frequency of anticipated sales would preclude an amortised cost classification.

IAS 39 prescribed very limited circumstances under which sale of financial assets within HTM category were permitted without attracting tainting provisions. Under IFRS 9, portfolio of financial assets continue to be measured at amortised cost as long as the sale of financial assets is infrequent in number. Thus the scope for permitted sales of financial assets is much wider for the reporting entities.

4.6. Contractually linked instruments especially for securitisation transactions

An entity may have prioritised payments to holders of multiple ‘contractually linked’ instruments that create concentrations of risk e.g. the tranches of securitised debt. The complexity arises because the junior tranches provide credit protection to the more senior tranches and the characteristics of the tranches depend on the underlying instruments held. The holder should ‘look through’ the structure until the underlying pool of instruments that are creating (rather than passing through) the cash flows are identified for assessment for solely pay-ments of principal and interest, instruments which reduce cash flow variability and exposure to credit risk. Determining whether a tranche has a lower credit risk than that of the underlying instruments should, in many cases, be straightforward. The most senior tranches will qualify, while the most junior tranches will not. For the tranches in between, the entity may have to evalu-ate on a quantitative basis. E.g. Tranches with underlying instruments where the interest rate is linked to a commodity index would not have contractual cash flows that are solely payments of principal and interest.

When it is impracticable to assess the underlying pool of instruments, the test is deemed to fail and the tranche must be measured at FVTPL.

In practice, significant management judgement shall be required for classifying a financial asset where sale of some of these assets is anticipated. In such cases, management needs to determine whether the particular activity involves one business model with some infrequent sale of assets, or whether there are two business models where one is held for collecting contractual cash flows while the other could be sold in future. However, an entity that actively manages a portfolio in order to realise fair value changes, or a portfolio that is managed and whose performance is evaluated on a fair value basis, does not hold the asset under a business model to collect contrac-tual cash flows. Such instruments would not qualify for amortised cost measurement; hence the portfolio would be subsequently remeasured at fair value every reporting date.

5. Option to designate financial asset at FVTPL

Like IAS 39, an entity can choose to designate a financial asset which otherwise would qualify for amortised cost accounting as measured at FVTPL only if it eliminates or significantly reduces a recognition or measurement inconsistency that otherwise would arise from measuring financial assets or liabilities, or recognising gains or losses on them, on a different basis. The election is available only on initial recognition of the asset and is irrevocable.

For instance, an entity may have issued foreign currency convertible bonds (FCCB) that is measured at fair value in entirety. These funds were utilised in investment of fixed rate bonds and met the amortised cost criteria in accordance with IFRS 9. This would lead to accounting mismatch as the liability is mea-sured at fair value while the asset is measured at amortised cost. This accounting mismatch can be significantly reduced by designating the financial asset at fair value through profit or loss as per IFRS 9.

IAS 39 also permitted an entity to designate a financial asset at FVTPL in two other scenarios.

IAS 39 permitted designating financial asset at FVTPL if the portfolio consists assets managed on a fair value basis. For instance, an entity may hold a portfolio of debt securities. The entity manages the portfolio to maximise its returns (i.e. interest and fair value changes) and evaluates its performance on that basis. In such a case, IAS 39 permitted the entity to designate the portfolio as FVTPL.

As discussed above, these assets cannot qualify for amortised cost measurement under IFRS 9 and therefore are required to be measured at fair value.

a) IAS 39 permitted hybrid instruments (containing an embedded derivative and the host contract) to be designated as FVTPL. Under IFRS 9, hybrid instrument as a whole is assessed for classification as amortised cost or FVTPL. If not classified as at amortised cost, entire instrument is measured at fair value through profit or loss. Point 9.4 below explains the difference in the accounting treatment under IAS 39 and IFRS 9 with an example.

Option to designate investment in equity shares at fair value through other comprehensive income (FVOCI)

6.1. Initial designation

The standard allows an entity, at initial recognition only, to elect to present changes in fair value of an investment in an equity instrument (not held for trading) in ‘Other comprehensive income’ (‘OCI’). The election is irrevocable and can be made on an instrument-by-instrument basis. However, investments in associates and joint ventures for venture capital organizations, mutual funds, unit trusts are not permitted such an option on account of equity accounting or proportional consolidation.

6.2. Subsequent measurement of equity instruments

IFRS 9 requires all investments in equity instruments (including unquoted equity instruments) to be measured at fair value. IFRS 9 permits cost to be an appropriate estimate of fair value of unquoted equity instruments in very limited circumstances.

6.3. Accounting implications on profit or loss

The amounts recognised in OCI are not recycled to profit or loss on disposal of the investment. However, dividend income on these investments continues to be recogn-ised in profit or loss, unless the dividend clearly represents a repayment of part of cost of the investment. Under IFRS 9, no separate impairment loss is to be recognised in profit or loss even if the equity invest-ment is designated as FVOCI.

7. Reclassifications

7.1. Change in business model

Classification of financial instruments is determined on initial recognition. Subsequent reclassification is prohibited. However, when an entity changes its business model in a way that is significant to its operations, a re-assessment is required of whether the initial classification remains appropriate. The standard expects such changes to be very infrequent and demonstrable to external parties.

7.2. New carrying value

If a financial asset is reclassified from fair value measurement to amortised cost measurement, then the fair value at the reclassification date becomes the new carrying amount. Conversely, if a financial asset is reclassified from amortised cost measurement to fair value measurement, then the fair value at the reclassification date becomes the new carrying amount and the difference between amortised cost and fair value is recognised in profit or loss.

7.3. Reclassification date

The reclassification date is the first day of the next reporting period. The reason that the reclassification date is different from the actual date of change in business model is that the IASB did not want to allow entities to choose a reclassification date to achieve an accounting result. Thus, from the date of change in business model until the reclassification date, financial assets continue to be accounted as if the business model has not changed.

8. Embedded derivatives

8.1. Embedded derivatives on financial asset host

Under IAS 39, embedded derivatives on financial assets hosts are assessed whether they need to be accounted separately. If the embedded derivative is separated from the host contract, the embedded derivative is measured at fair value while the host could be measured at amortised cost. IFRS 9 requires an entity to assess whether the hybrid instrument (i.e. host with embedded derivative) being a financial asset within the scope of the standard meets the criteria provided in the standard for amortised cost measurement. If the amortised cost measurement criteria are fulfilled, the entire hybrid instrument is measured at amortised cost (Refer 9.4 below). Else, the entire hybrid instrument is measured at fair value (Refer 9.3 below). However, in both cases, the embedded derivative is not separated.

8.2. Embedded derivatives on non-financial asset host

IFRS 9 does not change the accounting prescribed under IAS 39 for embedded derivatives with host contracts that are not financial assets within the scope of the standard. E.g. rights under leases, insurance contacts, financial liabilities and other non-financial assets

9. Examples for classification under IFRS 9 and IAS 39

9.1. Investment in quoted as well as unquoted equity instruments

Under IAS 39, the investments shall be classified as Available-for-sale (AFS), unless held for trading, and measured at fair value every reporting date. The fair value changes shall be recognised in OCI. The entity may also have recorded the unquoted equity instrument at cost based on the exemption given in IAS 39.

Under IFRS 9, the investment does not meet the criteria for amortised cost measurement. Hence they will be measured at fair value at every reporting date. The fair value changes shall be recognised in profit or loss, unless the entity elects to recognise the same in OCI.

9.2. Investment in quoted debt securities

Under IAS 39, an investment in a debt instrument quoted in active market is not permitted to be classified as loans and receivable category. Hence, these investments shall be classified as Available for sale unless there is a stated intent and ability to hold the instrument to maturity (in which case, the instrument would be classified as Held to Maturity and measured at amortised cost)

Under IFRS 9, if the objective of the business model is to collect solely principal and interest on the principal, then the instrument shall be subsequently measured at amortised cost. Thus, the fact that the debt instrument is quoted in active market has no impact on classification of financial asset.

9.3. Investment in Convertible bonds (at the option of investor)

Under IAS 39, the presence of the con-version feature that is exercisable by the investor precludes classification as HTM category. Such convertible bonds are clas-sified as AFS by the investor. Further, the embedded conversion option shall have to be separately accounted for.

Under IFRS 9, the conversion option shall preclude the amortised cost measurement as the investment shall not be considered to collect solely principal and interest. The entire instrument shall be classified at fair value through profit or loss (FVTPL) with fair value changes reported in income state-ment.

9.4. Prepayment options with reasonable additional compensation for early termination

Under IAS 39, if a debt instrument has a prepayment option that permits the holder to redeem the debt instrument for an amount that is approximately equal on each exercise date to the amortised cost of the debt instrument, such option is deemed to be closely related to the host and does not require separation.

IFRS 9 does not preclude amortised cost classification for a financial asset with a prepayment option when the prepayment amount substantially represents unpaid amounts of principal and interest, including reasonable additional compensation for early termination. Thus, in some cases, amortised cost accounting may be possible for the entire hybrid contract under IFRS 9, while separation of prepayment option may be required under IAS 39.

9.5. Term extending options

Under IAS 39, term extending option is an embedded derivative. The embedded derivative does not require separation if the rate of interest for the extended period approximates to the market rate of interest at the time of obtaining extension. Else, the derivative would require separation.

Under IFRS 9, amortised cost classification

for a term extension option is not precluded if the instrument is held under a business model whose objective is to collect contractual cash flows. Thus in such cases, the entire hybrid instrument shall be carried at amortised cost.

Summary of key differences between IAS 39 and IFRS 9

Particulars

IAS 39

IFRS 9

Categories of

There are four categories of financial

There are two categories of
financial assets:

financial assets

assets:
(a) Held-to-maturity; (b) Loans

(a) Fair value through profit or loss and

and
receivables, (c) Available for sale,

(b)
Amortised cost

(d) Fair value through profit or loss.

Embedded
de-

Under
IAS 39, the embedded derivative

Under
IFRS 9, the hybrid instrument shall

rivatives
on a

is
assessed whether it is closely related

be assessed for amortised
cost classification

financial asset

to the
host contract. If closely related,

in its
entirety. If the amortised cost clas-

the
embedded derivative is accounted

sification criteria are met, the entire instru–

separately
from the host contract at

ment is
measured at amortised cost. Else,

fair
value.

the
entire hybrid instrument is measured

at fair
value.

Equity
instru-

All
equity instruments that are classi-

All instruments, other than those classified

ments

fied as AFS securities are subsequently

as
amortised cost, shall be classified as

measured
at fair value with changes

FVTPL.
However, in case of investment in

recognised
in OCI. On disposal of

equity
instruments, an entity has an option

AFS
securities, the fair value changes

to
designate individual equity instruments

recognised
in OCI are recycled to the

as
FVOCI. In such case, the fair value

income
statement.

changes
are recognised in OCI. However,

these
fair value changes are not recycled

to the
income statement on disposal.

Designation
of

Apart
from accounting mismatch, IAS

IFRS 9
provides an option to designate any

financial assets

39 permits designating financial assets

financial asset at FVTPL only to eliminate

as
FVTPL

as at
FVTPL in two other scenarios: (a)

or
substantially reduce accounting mis-

the portfolio
of assets is managed on

match. As discussed above, the classifica–

a fair
value basis and performance is

tion in case of a portfolio of financial
assets

evaluated
on that basis; or (b) it is a

managed
on fair value bases and a hybrid

hybrid
instrument

instrument
(i.e. embedded derivative on a

financial asset) shall be
classified as FVTPL

(without
providing any option).

The standard is effective for annual periods beginning on or after 1 January 2013. Early application is permitted.

The standard has given certain transitionary provisions which provide guidance on how companies who are currently following IAS 39 principles can transition to IFRS 9 within the period when the standard is issued and the effective date of application referred above.

The transitionary provision also provides guidance on classification and measurement of financial as-sets existing on the date of initial application of IFRS 9.

Nirav Shah

IFRS reconstructs the accounting for Public Private Partnerships (‘PPP’)

IFRS

In India, many infrastructure contracts are executed on BOT
(build, operate and transfer) terms under which a company enters into a
contractual agreement with the government or any quasi-government agency to
construct an asset (for example, a road) and to operate it for a specified time
period, before transferring the asset back to the government at the end of the
contracted term.

BOT arrangements are common in areas such as roads, bridges,
airports and power plants. Under such arrangements, there are mainly two types
of contracts : (1) a fixed annuity-based contract under which the operator
company builds the infrastructure asset and gets annuity from the grantor (i.e.,
government body); and (2) a usage based (i.e., toll-based) contract under
which the operator builds the infrastructure asset and collects toll from users.

Under existing Indian GAAP (‘IGAAP’), companies recognise the
infrastructure asset as their own fixed asset, and depreciate it over the
concession period. The amount received from the government and the users of the
infrastructure asset is recognised as income over the period of the concession.
The accounting treatment for such contracts will change under International
Financial Reporting Standards (‘IFRS’). IFRIC 12 (IFRICs are interpretations to
IFRS) on Service Concession Arrangements provides guidance on accounting for
such
arrangements.

Scope of IFRIC 12 :

IFRIC 12 applies to public-to-private service concession
arrangements in which the grantor controls and/or regulates the services
provided and the price, and controls any significant residual interest in the
infrastructure.

Whether or not an arrangement is within the scope of IFRIC 12
will affect the nature of the assets that the operator recognises. For example,
for an arrangement that is within the scope of IFRIC 12, the operator does not
recognise public service infrastructure as its property, plant and equipment (PPE).

Public-to-private service concession arrangements :

While IFRIC 12 does not define public-to-private service
concession arrangements, it does describe the typical features of such
arrangements. Typically a public-to-private service concession arrangement
within the scope of IFRIC 12 will involve most of the following :

(a) Infrastructure is used to deliver public services :

IFRIC 12 states that a feature of public-to-private
arrangements is the public service nature of the obligation undertaken by the
operator.

(b) A contractual arrangement between the grantor and
the operator :

This is the agreement, often termed as concession
agreement, under which the grantor specifies the services that the operator is
to provide and which governs the basis upon which the operator will be
remunerated.

(c) Supply of services by the operator :

These services may include the construction/upgrade of the
infrastructure and the operation and maintenance of that infrastructure.

(d) Payment of the operator over the term of the
arrangement :

In many cases the operator will receive no payment during
the initial construction/upgrade phase. Instead, the operator will be paid by
the grantor directly or will charge users during the period that the
infrastructure is available for use.

(e) Return of the infrastructure to the grantor at the
end of the arrangement :

For example, even if the operator has legal title to the
infrastructure during the term of the arrangement, then legal title may
transfer to the grantor at the end of the arrangement, often for no additional
consideration. In most such arrangements in India, legal title does not pass
on to the operator even during the concession period.

Public-to-private service concession arrangements within the
scope of IFRIC 12 :

The scope of IFRIC 12 is defined by reference to control of
the infrastructure. An arrangement is within the scope of IFRIC 12 if :

(a) the grantor controls what services the operator must
provide with the infrastructure (control of services);

(b) the grantor controls to whom it must provide them
(control of services);

(d) the grantor controls through ownership, beneficial
entitlement or otherwise, any significant residual interest in the
infrastructure at the end of the term of the arrangement (control of the
residual interest).

Control of services :

The grantor may control the services to be provided by the
operator in a number of ways. For example, the services may be specified through
the terms of the concession agreement and/or a licence agreement and/or some
other form of regulation. All of these forms of control are consistent with the
scope criteria of IFRIC 12. Furthermore, the degree of specification of the
services may vary in practice. In some cases the grantor will specify the
services to be provided in detail and by reference to specific tasks to be
undertaken by the operator. In other cases the grantor will specify the services
that the infrastructure should have the capacity to deliver.

Control of pricing :

The grantor may control or regulate the pricing of the
services to be provided using the infrastructure in a variety of ways. The
criterion in IFRIC 12 is generally satisfied when the service concession
involves explicit and substantive control or regulation of prices.

In some cases, particularly when the grantor pays the
operator directly, prices (or a price formula) may be set out in the concession
agreement. In other cases prices may be re-set periodically by the grantor, or
the grantor may give the operator discretion to set unit prices but set a
maximum level of revenue or profits that the operator may retain. All of these
forms of arrangement are consistent with the control criteria in IFRIC 12.

Control of residual interest :

The simplest way in which the grantor may control the residual interest is for the concession agreement to require the operator to return all concession assets to the grantor, or to transfer the infrastructure to a new operator, at the end of the arrangement for no consideration. Such a requirement is a common feature of service concession arrangements involving concession assets with long useful lives, such as road and rail infra-structure. However, other forms of arrangement also are within the scope criteria of IFRIC 12.

‘Whole-of-life’ arrangements, that is, arrangements for which the residual interest in the infrastructure is not significant, are within the scope of IFRIC 12 if the other scope criteria are met.

Accounting for public service infrastructure cost and related revenue:
Accounting for construction/upgrade of infra-structure:
Under IGAAP, the operator recognises the infra-structure as its PPE. However for arrangements within the scope of IFRIC 12 under IFRS, the operator does not recognise public service infrastructure as its PPE, as the operator does not control the public service infrastructure. The control require-ment is determinative irrespective of the extent to which the operator bears the risks and rewards of ownership of the infrastructure.

IFRIC 12 characterises operators as ‘service providers’, who should recognise revenue in accordance with the stage of completion of the services as measured by reference to the fair value of the consideration receivable. This is irrespective of whether the sale consideration is guaranteed by the grantor or is variable based on the usage of infrastructure asset.

Accounting for sale consideration:

The operator recognises consideration received or receivable for providing construction/upgrade services as a financial asset and/or as an intangible asset depending upon the assessment of demand risk.

The operator recognises a financial asset to the extent that it has an unconditional right to receive cash from the grantor irrespective of the usage of the infrastructure.
The operator recognises an intangible asset to the extent that it has a right to charge fees for usage of the infrastructure.

Assessment of demand risk:

The grantor bears the demand risk to the extent it guarantees certain minimum sale consideration irrespective of the usage of the asset. To the extent the grantor bears the demand risk, the operator recognises a financial asset.

Where an arrangement does not guarantee sales consideration and the consideration is linked to the usage of the infrastructure, the demand risk rests with the operator. In such cases, the operator recognises an intangible asset. Even in cases where the arrangement provides a cap on total consideration to be collected from users but does not guarantee minimum sales consideration, the operator shall recognise an intangible asset.

Impact of borrowing costs:

Under IGAAP, borrowing costs incurred during the construction phase are capitalised as part of qualifying fixed assets. Under IFRS, the treatment of borrowing costs differs depending on whether the arrangement qualifies under the financial asset model or the intangible asset model (as discussed above) . In the intangible asset model, the borrowing costs are required to be capitalised to the intangible asset. However, in the financial asset model, the borrowing costs are charged to profits, as financial assets cannot be qualifying assets under borrowing cost standard (i.e., IAS 23).

Recognition and measurement of revenue:

We look at the recognition and measurement of revenue under both the above scenarios — financial asset model and intangible asset model.

Financial asset model:

When the demand risk is with the grantor (i.e., the grantor guarantees the collections that will be recovered over the concession arrangement), the arrangement is said to contain deferred payment terms where the construction revenue is recognised at fair value. It is subsequently measured at amortised cost; i.e., the amount initially recognised plus the cumulative interest on that amount cal-culated using the effective interest method minus repayments. Thus, the overall consideration is broken down into revenue and interest income.

Intangible asset model:

For arrangements where the operator earns revenue purely from collection of tolls that are not guaranteed by the grantor, the right to collect the toll revenue is obtained as a consideration for rendering construction services to the grantor. For accounting purposes, these transactions are treated as barter arrangements. Thus, for such infrastructure projects, companies are required to recognise construction revenue (corresponding amount is debited to the intangible asset i.e., right to collect toll revenue from users) during the course of the construction period; and the toll revenue is recognised separately on collection. The intangible asset is amortised to the income statement over its useful life.

As such, the total amount of revenue recognised over the term of the arrangement is greater than the cash flows received during the period.

Subsequent measurement of financial asset:

The operator accounts for any financial asset it recognizes in accordance with the financial instruments standards (i.e., IAS 39) . There are no exemptions from these standards for operators. As such, the operator is required to classify the financial asset as a loan or receivable, available-for-sale, or at fair value through profit or loss if so designated. Generally, such assets are recorded as loans and receivables.

Subsequent measurement of intangible asset:

IAS 38 allows intangible assets to be measured using either the cost model or the revaluation model. The revaluation model is permitted to be used only if there is an active market for that asset. In most cases there will be no active market for intangible assets recognised under service concession arrangements, and therefore the cost model will be used.

Under the cost model the intangible asset is measured at its cost less any accumulated amortisation and any accumulated impairment losses. The depreciation is based on the asset’s economic useful life, which is generally the concession period.

Financial statement impact for operators on transition to IFRS:
Construction phase of the arrangement:

Under IGAAP, the operator recognises the cost of construction of infrastructure as part of its fixed assets. The fixed assets are depreciated over its useful life (usually over the concession period). Under IFRS, the costs incurred during the construction phase are recognised in income statement as construction

costs (along with the corresponding construction revenue). As the construction cost is recognised upfront in income statement, there would be no impact of depreciation in future years. Thus cost recognised in income statement during initial years is higher under IFRS as compared to IGAAP. Further under IGAAP, no revenue is recognised during the course of the construction phase of the concession arrangement. Under IFRS, revenue is recognised during the course of construction activities (in line with construction cost, based on percentage of completion method). Thus, companies will recognise higher revenues and costs (and higher profits) during the construction period.

Operation revenue:

Under IGAAP, revenue is recognised during the operations phase based on the terms of the concession arrangement. Under IFRS, revenue is recognised depending on whether the concession arrangement falls into financial asset model or intangible asset model. When the operator recognises an intangible asset during the construction phase (i.e., it receives a right to collect fees that are contingent upon the extent of use of the public service), it recognises operation revenue as it is earned i.e., the toll collection is recognised as revenue. Thus there is no impact of IFRS transition on revenue recognition during operations phase. The intangible asset recognised during the construction phase is amortised to income statement over the term of the concession arrangement. Further unlike IGAAP where the fixed asset is capitalised at cost, IFRS requires capitalisation of the intangible asset based on the fair value of construction services. Thus in most cases, the carrying value of intangible asset and related depreciation/amortisation would be higher under IFRS.

When the operator recognises a financial asset during the construction phase (i.e., it receives an unconditional right to receive cash that is not dependent upon the extent of use of the public service), a portion of payments received during the operation phase is allocated to reduce this financial asset (including related imputed interest income. Thus revenue recognition during the operations phase is severely impacted, as a portion of the revenues currently recognized during the operations phase would be adjusted as a recovery of the financial asset.

The table alongside provides a summary impact of the service concession arrangements on transition to IFRS.

Impact of IFRS beyond accounting:

Indian Industry is cautious of the financial statement impact on account of transition to IFRS. However, contrary to the general belief, the impact of transition to IFRS is not restricted to impact on profits and equity.

Financial budget:

On account of transition to IFRS, the financial budgets and performance matrices would undergo a change. Consider, for instance, revenue recognition under financial asset model where the construction revenue is recognised during the course of the construction phase and only interest income/operations revenue recognised during the term of the concession arrangement. This may impact key performance indicators which form a basis on incentive payments to senior employees and also bank covenants (asset cover age ratio, etc.).

Communication with stakeholders:

Management would need to keep stakeholders informed on the change in profitability due to transition related issues.

Contractual impact:

Certain grantors charge companies a certain revenue share every year (which is a percentage of the reported revenues). In case of PPP arrangements accounted under the intangible asset model, total reported revenue is much higher than cash flows earned (as explained above), since the revenue reported during the construction phase is notional. This may lead to higher leakage of regulatory dues which are based on reported revenues.

Similarly, even in the case of a financial asset model, acceleration of revenue recognition (during the construction period) would result in acceleration of contractual cash payments for revenue share (even though the revenues reported have not been realized in cash).

Taxes:

There is a need felt for more clarity on taxation matters vis-à-vis IFRS transition, especially around GST and MAT.

Regulatory:

It remains to be seen whether the statutory financial statements that will now be prepared under IFRS will be accepted for the purposes of filing business plans with banks for borrowing purposes and with RBI/FIPB for investment purposes.

Redefining the systems, processes and data points:

Capturing information under IFRS at a transaction level would pose a significant challenge, atleast in the initial years. The biggest hindrance will be faced on reconfiguration of IT systems, where the investment of time, cost, resources and complexity should not be underestimated. Further, the entity needs to be relook at the process of collecting additional data required under IFRS and make consequential amendment to the internal controls.

While industry believes that the change in the accounting framework is a step in the right direction, they are in the process of estimating the exact impact on their business. The financial and non-financial aspects relating to the IFRS convergence need to be planned and tested in advance of the implementation date. Global experience has shown that the early adopters are generally more successful in managing the overall IFRS transition. The ear-ly-mover advantage not only provides adequate time to carry out required changes, but protects critical decisions being taken within the constraints of time and resources.

succession, survivorship, inheritance, purchase, partition, mortgage, gift, lease, etc., in any land, then he must give a notice of the same to the Talathi within three months of such event.

The Talathi would then enter such changes in a Register of Mutations which would alter the original record of rights.

5.4 Any person buying land especially in a rural or semi-urban area would be well advised to do a thorough title search by checking the Record of Rights, Register of Mutations, etc., which would show whether or not the land in question is an agricultural land, who is the owner, what important developments have taken place in respect of the land, etc.

5.5 In the next Article we shall look at the process for converting an agricultural land into a non-agricultural land.

Nirav Shah

IFRS — Closer to economic substance of the transaction

IFRS

One of the important aspects of convergence is that financial
reporting will be better aligned to the true economic substance of a
transaction. ‘Substance over form’ is one of the most important principles on
which International Financial Reporting Standards (‘IFRS’) are based. Detailed
Implementation Guidance (IG) and Basis of Conclusion (BC) for the accounting
treatment prescribed in the respective standards explain the underling economic
rationale for such treatment, which acts as a guide in implementation of the
intent behind the standards.

In general, Indian GAAP also tends to be principle focussed.
However, there are a number of areas where accounting guidance deviates from the
underlying economic substance (e.g., accounting for business
combinations, service concession arrangements or multiple element deliverables)
or in other situations tends to be prescriptive in nature (e.g.,
accounting for loan impairment losses by a bank, accounting for depreciation on
property, plant and equipments based on minimum rates prescribed). Similarly,
accounting is often governed by the terms of the legal contract.

This article highlights some of the important areas where the
accounting under IFRS is closer to the economic substance of the transactions as
compared to Indian GAAP.

Revenue arrangements with multiple deliverables (IAS 18) :

IAS 18 requires, in certain circumstances, to apply the
recognition criteria to each separately identifiable component of a single
transaction in order to reflect the underlying substance of the transaction.
Thus, under IFRS, multiple deliverable transactions (e.g., product sales
and subsequent servicing) are viewed from the perspective of the customer. What
does customer believe that he is buying ? If the customer believes that he is
buying a single product, the recognition criteria should be applied to the
transaction as a whole. Conversely, if the customer believes that there are a
number of elements to the transaction, then the revenue recognition criteria is
applied to each element separately.

Similarly, in certain cases the standard requires the
recognition criteria to be applied to two or more transactions together when
they are linked in such a way that the commercial effect cannot be understood
without reference to the series of transactions as a whole. Once again, the
focus is on the substance and the economic rationale for the transactions.

Example

Entity A sells software with an annual maintenance service
for a total consideration of Rs.1000. Entity A also provides similar annual
maintenance service to other customers at a consideration of Rs.200. In this
case, the sale of the software and maintenance contract would be regarded as
separate components. Revenue from the sale of the software Rs.800 (1000 — 200)
will be recognised when the software is delivered and other revenue recognition
principles are met, and revenue from rendering of maintenance services will be
recognised on a straight-line basis over one year. Now consider a situation
where the same contract is structured in a different manner and the sales
contract itself provides that the ‘price’ of the software is Rs.900 and the
price of the annual maintenance service is Rs.100. Typical practice under Indian
GAAP is to recognise revenue of Rs.900 upfront and recognise only Rs.100 as the
revenue over the maintenance period. Thus, what gets accounted is the legal form
of the contract and not the true economic substance of the sale transaction.
However under IFRS these two transactions will be linked together and each
component i.e., sale of software and annual maintenance service will be
accounted at its fair value i.e., Rs.800 and Rs.200 irrespective of the
values denominated in the contract, thereby reflecting the true economic
substance.

Consolidation based on control (IAS 27, IAS 28 and IAS 31) :

Definition of control under Indian GAAP is different from the
definition under IFRS. Indian GAAP permits consolidation based on the
ownership of majority of voting power or the ability to control the
composition of Board of Directors. Thus, under Indian GAAP it is possible for
two entities to have ‘control’ over one investee company and both companies will
need to account the investee as a subsidiary.

The definition of control under IFRS has two parts, both of
which need to be met in order to conclude that one entity controls another :

(a) ‘the power to govern the financial and operating
policies of an entity’

(b) so as to obtain benefits from its activities.

Under IFRS, rights of each shareholder need to be carefully
evaluated by examining the shareholder’s agreement to determine the entity,
which has control, for consolidation. For example, an entity may own more than
50% of the voting rights in another entity and accordingly is able to
consolidate that entity with itself, currently under Indian GAAP. However due to
certain veto rights given to minority shareholders contractually, it may not be
in a position to unilaterally control that entity, and therefore may not be able
to consolidate that entity under IFRS as a subsidiary.

Example :

Two companies A and B come together to form a company X in
which company A holds 75% with 3 directors on the board of company X and company
B holds 25% with 2 directors on the board of company X. By virtue of majority
holding, company A consolidates Company X as a subsidiary under Indian GAAP. The
Articles of Association of company X states that for certain decisions, a
unanimous approval of the board of directors is required. These decisions
include approving the annual and semi-annual budgets of the company and
selection and appointment of senior management personnel. In such a case, under IFRS, company A does not control company
X, instead it shares joint control over it along with company B. Hence it shall
not consolidate company X as a subsidiary but account for it as a joint venture
arrangement. However, under Indian GAAP, A would continue to consolidate X,
though it does not have control over the operations, which do not reflect the
true economic substance of the transaction.

Acquisition method of accounting for business combinations (IFRS 3) :

Business combinations are the acquisitions of controlling stakes in entities and businesses like mergers, acquisition of a subsidiary or purchase of net assets of a division. Indian GAAP has limited guidance on the first-time accounting for such transactions and allows the pooling of interests method or the purchase method of accounting; IFRS recognises only the acquisition method for accounting for these transactions. Hence under IFRS, all business combinations are accounted for at fair value as on the acquisition date (excluding the specific scope ex-emptions given in the standard). This process involves the identification of intangibles subsumed within goodwill like customer relationships, favourable leases; fair valuation of contingent liabilities, contingent consideration and all other acquired assets and liabilities whether recognised or unrecognised in the acquiree’s balance sheet.

The objective of this accounting is to ensure that all items where the acquirer saw value and hence paid for it, are brought onto the books of accounts at their fair values. This would ensure appropriate reflection of the factors that affected the negotiation process of the transaction in the financial statements and bring accounting closer to the economic attributes inherent in the business combination.

Initial recognition of financial assets and liabilities at fair value (IAS 39) :

Under IFRS, initial recognition of all financial assets and liabilities is mandatorily required at its fair value. This helps in reflecting the true substance of a particular transaction. Consider the following situations:

Low interest loans given to subsidiary: Under Indian GAAP these are accounted at transaction value, however, under IFRS these are recorded at the fair value and the initial loss is considered as an investment in the subsidiary and the subsidiary accounts for it as a capital contribution. In the subsequent years the unwinding of the initial fair value loss is treated as an interest income by the parent and interest expense by the subsidiary.

Low interest loans given to employees: Under Indian GAAP these are accounted at transaction value, however, under IFRS these are recorded at the fair value and the initial loss is accounted as an employee cost based on the loan terms, thereby reflecting the true intent of compensating the employees in the financial statements.

Interest-free security deposit for leased premises: Under Indian GAAP these are accounted at transaction value, however, under IFRS these are recorded at the fair value and the initial loss is accounted as a prepaid rent, which is amortised over the lease period, thereby reflecting the true operating expense (rental expenditure) in the financial statements.

Sales tax deferral schemes: Under Indian GAAP these are accounted at transaction value, however, under IFRS these are recorded at the fair value and the initial gain is accounted as a government grant, which is deferred over the grant period, thereby reflecting the true operating results of the company each year.

Contracts denominated in ‘third currencies’ (IAS 39) :

Sale or purchase contracts in the ordinary course of business may include payment terms denominated in a third currency i.e., a currency which is not the currency of either of the contracting parties. In such circumstances, the foreign currency element in the contract should be accounted for separately from the underlying contract, unless the payments required under the contract are denominated in one of the following currencies:

the currency’ in which the price of the related goods or service being delivered under the contract is routinely denominated in commercial transactions around the world; and

the currency that is commonly used in contracts to purchase or sell non-financial items in the economic environment in which the transaction takes place.

‘Routinely denominated’, as noted under the first bullet above, should be interpreted narrowly, so that an oil transaction denominated in U.S. dollars is one of the few transactions that qualifies for this exemption.

The separation of foreign currency derivatives would reflect the true risks that the entity has indirectly exposed itself to, on entering into the host contract. Such an embedded derivative is carried at fair value through profit and loss account.

Example:

An Indian entity contracts to lease an aircraft from a US entity for 12 months with prices denominated in Euros. Since Euro is not the functional currency of either of the contracting parties, both the seller and the buyer are indirectly exposing themselves to fluctuations of a foreign currency by way of the underlying contract to lease the aircraft. This would be considered an embedded derivative which requires separation and would be carried at fair value in the financial statements of both the contracting parties until the settlement of the underlying contract i.e., every month the fluctuation in exchange rates attributable to unpaid lease rentals will be recognised in the income statement (like accounting for a notional forward cover to buy Euros for the remaining period) and the monthly lease payments will be recorded based on the INR/ Euro exchange rate on the contract date.

Hence although the host contract would not specify the existence of a derivative; looking at the transaction in substance would result in the identification of an embedded foreign currency derivative (notional forward) and reflect the foreign currency risk that the entity is indirectly exposed to due to the arrangement. The ultimate reporting in the financial statement would result accounting for lease rentals at a fixed rate on the contract date (which is the real commercial transaction) and all other fluctuations in the exchange rate from the contract date to the monthly payment dates will be classified as a foreign exchange gain/loss.

Embedded lease contract (IFRIC 4) :

Companies sometimes enter into normal business transactions that share many features of a lease (lease is defined in paragraph 4 of IAS 17 Leases as ‘an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time’).

Unlike Indian GAAP, under IFRS, all arrangements meeting the definition of a lease should be accounted for in accordance with IAS 17 regardless of whether they take the legal form of a lease. This determination is based on the assessment of whether:

i) the fulfillment of the arrangement (commercial transaction) is dependent on the use of a specific asset or assets; and

ii) the arrangement conveys a right to use the asset.

Examples of such transactions include:

outsourcing arrangements,

take or pay contracts in which purchasers make specified payments regardless of whether they take delivery of the contracted products or services.

Example:

Company A enters in a purchase contract with company B to purchase 1,000 units of C every month @ Rs.25 per unit. Product C can be manufactured on a specific machine M by company B. In case of shortfall every month, company B will compensate company A Rs.10 per unit of short-fall and entire output from machine M is availed by company A.

Under Indian GAAP, the above transaction is accounted as a normal purchase transaction @ Rs. 25 per unit. In case there is a shortfall, the payment amount is expensed as a penalty.

Under IFRS, this transaction is broken into its two constituents i.e.,

1) Lease of machine M given that company A is in substance paying a fixed amount of Rs 10 per unit to company A towards availability of machine for company A

2) Processing charges for manufacture of product C

Service concessions arrangement (IFRIC 12) :

IFRS contains specific guidance on public-to-private service concession arrangements under IFRIC 12. It applies to arrangements, wherein the public entity (referred to as grantor) is able to control the use of the infrastructure by specifying the nature of service, the recipient of the service and the price to be charged, and to retain significant residual interest in the infrastructure. In such cases, infrastructure is not recognised as property, plant and equipment of the private entity (referred to as operator) as the arrangement does not convey the use of the public service infrastructure to the operator. The operator, in turn, recognises and measures revenue in accordance with IAS 11 or IAS 18 for the service it performs i.e., construction, up gradation, operation, etc. The operator recognises the consideration receivable based on its nature as a financial asset or intangible asset or partly a financial asset and partly as intangible, based on the specific terms of the arrangement.

Under Indian GAAP, there is no specific guidance and this has resulted in varied practices. Generally, the operator capitalises the infrastructure cost in its books as fixed asset and revenue is recognised as services are rendered with the infrastructure. This asset is depreciated in accordance with the company’s depreciation policy or over the period of the service concession arrangement. Thus the revenue is not recognised as and when the efforts are expended and increases the volatility in the income statement with losses in initial period of a service concession arrangement and higher margins in the later period, which may not reflect the correct economic activity for a given period.

Example:

A grantor awards a concession to an operator to build and operate a new road. The grantor transfers to the operator the land on which the road is to be constructed, together with adjacent land that the operator may redevelop or sell at its discretion. Construction is expected to take 5 years, after which the operator will operate the road for 25 years. During these 25 years the operator has a contractual obligation to perform routine maintenance on the road and to resurface it as necessary, which is expected to be three times. At the end of the arrangement the road will revert to the grantor. The road is to be used by the general public. Toll for use of the road is set annually by the grantor. This arrangement is a public-to-private arrangement as the road is constructed pursuant to general transport policy and is to be used by the public. This would fall under the scope of IFRIC 12. Accordingly the operator will not recognise the road as property, plant and ‘ equipment; however he will recognise an intangible asset for the right to operate the road and collect toll from it.

Deferred taxes on unrealised profits of joint ventures/associates (IAS 12) :

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

For example:

Parent company P consolidates undistributed profits of Rs.100 crores of associate company A in its consolidated financial statements. The dividend distribution tax rate in A’s jurisdiction is 15% and dividend received is exempt from tax in the hands of P. In this case, P should recognise a deferred tax liability of Rs.15 crores (at a rate of 15% on Rs.100 crares) in its consolidated financial statements which will ensure a correct presentation of the net worth to the shareholders.

Presentation of financial statements:

In India, Schedule VI of the Companies Act, 1956, which prescribes a detailed format for preparation and disclosure of financial statements, lays great emphasis on quantitative information such as quantitative details of sales, COGS, production capacities, amount of transactions with related parties, CIF value of imports and income and expenditure in foreign currency, etc. Contrary to the same, IFRS if more focussed on qualitative information for the stakeholders such as terms of related party transactions, risk management policies, currency exposure for the Company with sensitivity analysis, etc. To more correctly report the liquidity position of the Company, IFRS requires disclosure of all assets/ liabilities, whether they are current or non-current. Presently under Indian GAAP even long-term deposits and advances are disclosed under current assets,loans and advances, thereby not disclosing the true liquidity profile of the entity.

Conclusion:

IFRS aims to present financial statements which are a reflection of the business and economic environment in which a company operates. The standard-setters strive to formulate principles which would help a company in applying judgment and reaching the ultimate goal of accounting which is closer to the economic value of transactions. This is clearly evident in the above discussions of accounting for business combinations, consolidation, embedded leases, embedded derivatives, etc. However, to achieve this goal, it is important that the principles are applied in their true spirit and in the manner in which they are intended.

Convergence brings a new perspective for Indian companies from the traditional Indian GAAP. It challenges them to look beyond the legal language of arrangements, shifting the focus to the substance of arrangements. Indian companies need to be prepared to face this new age of accounting and keep up with the evolving changes that are taking place in IFRS itself.

Nirav Shah

Practical Insights into Accounting for change in Ownership Interest in a Subsidiary under IND AS

The business combination and consolidation principles as discussed under Ind AS-103 (Business combinations) and Ind AS-27 (Consolidated and Separate Financial Statements) provide elaborate guidance on different arrangements between shareholders that lead to change in ownership interest. Such a change in ownership interest may alter the existing control conclusion (i.e., that lead to an investor obtaining or losing control over an investee) or that may not alter the existing control conclusion. In this article, we focus on the guidance provided under Ind AS on such transactions between shareholders, sharing our perspectives on the accounting for such arrangements.

There could be mainly four scenarios for change in ownership interest over an investee, where the change in ownership interest in the investee leads to:

(1)   dilution of ownership interest that leads to loss of control over a subsidiary;
(2)   dilution of ownership interest, but the control over a subsidiary is retained;
(3)   acquisition of additional ownership interest in an existing subsidiary; and
(4)   acquiring control over the investee that is not a subsidiary at the time of acquisition.

Scenario 2 and 3 as mentioned above relate to dilution of existing interest and acquisition of additional interest, respectively, that does not change the control conclusion i.e., the investee would be classified as a subsidiary before and after the change in ownership interest. As the accounting principles for such transactions are common, we shall combine the scenario 2 and scenario 3 for the purpose of this discussion.

The accounting for change in ownership interest in an investee that is not classified as a subsidiary, associate or joint venture in accordance with Ind AS shall be accounted based on guidance provided under the Ind AS-32 and Ind AS- 39 relating to financial instruments and is beyond the discussion under this article.

Let us consider each of the above scenarios.

Dilution leading to loss of control

Dilution and loss of control

The dilution of ownership interest in a subsidiary may be in the nature of absolute change or a relative change in ownership interest and takes various forms such as:

— the parent selling all or part of its ownership interest in its subsidiary;
— the subsidiary issues shares to third parties, thereby reducing the parent’s ownership interest in the subsidiary.

Such a dilution may lead to loss of control over the subsidiary. However, sometimes the loss of control may not involve change in ownership interest (absolute or relative), but may be effected

through contractual arrangements, such as:

— a contractual agreement that gave control of the subsidiary to the parent expires; or

— substantive participating rights are granted to other parties.

Accounting for loss of control

When a parent loses control of a subsidiary, broadly the following steps are involved in accounting for the loss of control over a subsidiary, whereby the parent:

— de-recognises the assets (including any good-will) and liabilities of the subsidiary at their carrying amounts in the consolidated financial statements at the date when control is lost;

— de-recognises the carrying amount of any non-controlling interests (NCI) in the subsidiary in the consolidated financial statements at the date when control is lost (including any components of other comprehensive income attributable to them);

— recognises the fair value of the consideration received, if any, from the transaction, event or circumstances that resulted in the loss of control;

— recognises any investment retained in the former subsidiary at its fair value at the date when control is lost;

— reclassifies to profit or loss (or transfers directly to retained earnings if required in accordance with other Ind AS) gain or loss previously recognised in other comprehensive income (OCI); and

— recognises any resulting difference as a gain or loss in profit or loss attributable to the parent.

Based on the above broad steps, there is a two-fold impact for the loss of control in the profit or loss account (i) reclassification of amounts accumulated in the OCI; (ii) loss or gain due to loss of control over subsidiary.

Reclassification from OCI to profit or loss

The amounts accumulated in OCI are transferred to profit or loss account as on losing control, components of other comprehensive income related to the subsidiary’s assets and liabilities are accounted for on the same basis as would be required if the individual assets and liabilities had been disposed of directly.

Loss or gain due to loss of control

If the loss of control is pursuant to sale of all of the parent’s investment in the former subsidiary, then the loss or gain would only comprise of loss or gain on sale of subsidiary.

However, if the parent retains some or all of its investment in the former subsidiary after losing control (i.e., a non-controlling interest), then such investments would be measured at its fair value as at the date of losing control and the impact would be recognised as part of loss or gain in profit or loss account. In such a case, the loss or gain due to loss of control would comprise of two elements i.e.,

— loss or profit on disposal of subsidiary; and

— loss or gain on remeasurement of investments to the extent retained at the time of losing control.

Illustration
The above principles can be explained with the help of the following example:

— Company A owns 60% of the shares in Company B.

— On 1 April 2010 A disposes of a 20% interest in B for cash of Rs. 200 and loses control over B.

— The fair value of the remaining 40% (i.e., 60 – 20) investment is determined to be Rs. 400.

— At the date that A disposes of a 20% interest in B, the carrying amount of the net assets of B is Rs. 875.

— Before allocation to NCI, the OCI included foreign currency translation reserve (FCTR) of Rs. 50 and available-for-sale revaluation reserve (AFS reserve) of Rs. 100 relating to the subsidiary.

— The amount of NCI in the consolidated financial statements of A on 1 April 2010 is Rs. 350. The carrying amount of NCI includes an amount of Rs. 20 and Rs. 40 relating to NCI’s share (i.e., 40%) in the FCTR and AFS reserve, respectively.

A shall record the following entry to reflect its loss of control over B at 1st April 2010:

The 165 recognised in profit or loss comprises:

— the increase in the fair value of the retained 40% investment of Rs. 50 [400 – (875 x 40%)];

— the gain on the disposal of the 20% interest of Rs. 25 [200 – (875 x 20%)],

— the reclassification adjustments for transfer from OCI of Rs. 90 (30 + 60).

The remaining interest of 40% represents the cost on initial recognition of that investment and the subsequent accounting for the said investment would be as per Ind AS-28 (Investment in Associates) or Ind AS-39 (Financial Instruments: Recognition and Measurement), depending upon whether the investee qualifies as an associate.

Change in ownership interest while retaining control

After a parent has obtained control of a subsidiary, it may change its ownership interest in that subsidiary without losing control. This can happen, for example, through the parent buying shares from, or selling shares to, the NCI or through the subsidiary issuing new shares or reacquiring its shares.

Transactions that result in changes in ownership interests while retaining control are accounted for as transactions with equity holders in their capacity as equity holders. As a result, no gain or loss on such changes is recognised in profit or loss; instead it is recognised in equity. Also, no change in the carrying amounts of assets (including goodwill) or liabilities is recognised as a result of such transactions. This approach is consistent with NCI being a component of equity.

The interests of the parent and NCI in the subsidiary are adjusted to reflect the relative change in their interests in the subsidiary’s equity. Any difference between the amount by which NCI are adjusted and the fair value of the consideration paid or received is recognised directly in equity. Similar principles also apply when a subsidiary issues new shares and the ownership interests change due to that issuance.

Broadly, the following steps are involved in accounting for such transactions:

— Calculate the amount of adjustment required in NCI

— Recognise the difference between the adjustment to NCI and consideration, in equity. Illustrations:

The above principles can be explained with the help of the following examples:

Illustration 1: Subsidiary issues fresh shares leading to change in relative interest

— Company B has 100 ordinary shares outstanding and the carrying amount of its equity (net assets) is Rs. 100. S has no other comprehensive income.

— Company A owns 90% of B, i.e., 90 shares.

— B issues 20 new ordinary shares to a third party for Rs. 40 in cash, as a result of which B’s net assets increase to Rs. 140;

— A’s ownership interest in B reduces from 90% to 75% (A now owns 90 shares out of 120 issued); and

— NCI in B increase from Rs. 10 (100 x 10%) to Rs. 35 (140 x 25%).

Company A records the following entry in its consolidated financial statements to recognise the increase in NCI in B arising from the issue of shares as follows:

Illustration 2: Purchase of additional interest from NCI

— Company A acquired 80% of Company B in a business combination several years ago. A sub-sequently purchases an additional 10% interest in B from third parties for Rs. 300;

— The carrying value of B’s net assets, NCI and parent’s share of equity was Rs. 1000, Rs. 200 and Rs. 800, respectively.

Consequent to the additional purchase of 10% interest in B, the NCI shall adjusted by Rs. 100 for the 10% interest and the difference between the consideration paid (i.e., Rs. 300) and the adjustment to NCI (i.e., Rs. 100) shall be recognised in equity.

Illustration 3: Sale of interest

— Company A acquired 80% of Company B in a business combination several years ago. A subsequently sells a 20% interest in S for Rs. 300, but retains control of B.

— The carrying value of B’s net assets, NCI and parent’s share of equity was Rs. 1000, Rs. 200 and Rs. 800, respectively.

Consequent to the sale of 20% interest in B, the NCI shall be adjusted (i.e., increase) by Rs. 200 for the 20% interest and the difference between the consideration received (i.e., Rs. 300) and the adjustment to NCI (i.e. difference of Rs. 100) shall be recognised in equity.

Acquisition control over the investee that is not a subsidiary at the time of acquisition

The fourth scenario discussed above is in relation to acquisition of shares in an investee resulting in the investor acquiring control over the investee. Such transactions are covered within Ind AS-103 (Business Combinations) to the extent the investee constitutes a business. If the investee does not constitute a business, then the accounting should be in line with the other applicable Ind ASs. We will cover these in subsequent articles.

Summary

Overall, the implementation of the above guidance would involve exercise of judgment as the accounting for change in ownership interest is dependent on whether the control conclusion has changed. In case the change in ownership interest leads to:

— gaining control over an investee that constitutes a business, then such arrangements are recognised as business combinations as per Ind AS-103;

— losing of control over an existing subsidiary, then any profit or loss on change of ownership (including fair value movements of retained interest) is recognised as part of profit or loss; and

— any change in absolute or relative interest that does not change the control conclusion in case of a subsidiary, is recognised in equity.

Nirav Shah

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

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

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

Key differences and implications:

Concept of de facto control:

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

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

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

Accounting for joint ventures:

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

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

Accounting for associates:

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

Deferred taxes on consolidation:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Uniform accounting policies:

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

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

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

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

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

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

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

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

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

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

Conclusion:

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

Nirav Shah

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