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Category: IND AS/IGAAP - Interpretation & Practical Application

Accounting of Sale of Fertilizers and Related Subsidy

Rourkela Core Fertilizers Ltd (RCF), a fertilizer manufacturing company, sells fertilizers to dealers, who in turn sell to farmers. Under the Direct Benefit Transfer (DBT) scheme, the Government of India provides a fertilizer subsidy to RCF. This subsidy is disbursed based on actual sales made by dealers to the end-users—the farmers, for whom the subsidy is actually directed towards. These transactions are validated using Point-of-Sale (POS) devices at dealer location and authenticated through farmer identification, such as Aadhaar, Voter ID, or Kisan Credit Card.

The subsidy rates are notified by the government and are subject to periodic revisions, either retroactively or prospectively. RCF receives the subsidy upon submission of a valid claim supported by appropriate evidence.

There exists an inherent time lag between the sale of fertilizers by RCF to dealers and the subsequent sale by dealers to farmers. Subsidy entitlement is governed by the law in force at the time the dealer sells the fertilizers to the farmer. RCF recognizes revenue from sales when control of goods is transferred to dealers in accordance with Ind AS 115 – Revenue from Contracts with Customers. Based on the contractual terms and interpretation of Ind AS 115, RCF considers the point of dispatch to dealers as the moment of transfer of control and hence a trigger for revenue recognition. Accordingly, RCF recognizes revenue when goods are dispatched to the dealers.

RCF is evaluating appropriate timing for recognition of subsidy income, and is considering the following three alternative approaches. This note discusses the accounting treatment, excluding presentation aspects of the subsidy income.

View 1: Recognize the revenue when goods are dispatched to the customer at which time control is transferred in accordance with Ind AS 115. The subsidy is recognized as a variable consideration in accordance with Ind AS 115.

View 2: Recognise the revenue when goods are dispatched to the customer at which time control is transferred in accordance with Ind AS 115. The subsidy is recognised in accordance with the principles laid out in Ind AS 20 Accounting for Government Grants and Disclosure of Government Assistance. RCF interprets this to mean that the subsidy will be recognised only when the dealer sells the goods to the farmers, which will therefore not coincide with the timing for recognition of revenue on sale of good.

View 3: Recognise the revenue when goods are dispatched to the customer at which time control is transferred in accordance with Ind AS 115. The subsidy is recognised as a grant income in accordance with Ind AS 20. RCF interprets this to mean that the subsidy will be recognized at the time of recognition of the revenue, basis best estimate, which will then be trued up/down in subsequent period if necessary (for e.g., if the subsidy rate is revised).

Accounting Standard References

Ind AS 115 Revenue from Contracts with Customers

“31 An entity shall recognise revenue when (or as) the entity satisfies a performance obligation by transferring a promised good or service (i.e. an asset) to a customer. An asset is transferred when (or as) the customer obtains control of that asset.”

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

“50 If the consideration promised in a contract includes a variable amount, an entity shall estimate the amount of consideration to which the entity will be entitled in exchange for transferring the promised goods or services to a customer.”

“87 After contract inception, the transaction price can change for various reasons, including the resolution of uncertain events or other changes in circumstances that change the amount of consideration to which an entity expects to be entitled in exchange for the promised goods or services.”

“98 An entity shall recognise the following costs as expenses when incurred: (a)…(b)…….. (c) costs that relate to satisfied performance obligations (or partially satisfied performance obligations) in the contract (i.e. costs that relate to past performance); and (d) costs for which an entity cannot distinguish whether the cost relate to unsatisfied performance obligations or to satisfied performance obligations (or partially satisfied performance obligations).”

Ind AS 20 Accounting for Government Grants and Disclosure of Government Assistance

“3. Government grants are assistance by government in the form of transfers of resources to an entity in return for past or future compliance with certain conditions relating to the operating activities of the entity. They exclude those forms of government assistance which cannot reasonably have a value placed upon them and transactions with government which cannot be distinguished from the normal trading transactions of the entity”.

“7 Government grants, including non-monetary grants at fair value, shall not be recognised until there is reasonable assurance that: (a) the entity will comply with the conditions attaching to them; and (b) the grants will be received.”

“12 Government grants shall be recognised in profit or loss on a systematic basis over the periods in which the entity recognises as expenses the related costs for which the grants are intended to compensate.”

Ind AS 2 Inventories

“9 Inventories shall be measured at the lower of cost and net realisable value.

Cost of Inventories

10 The cost of inventories shall comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition.”

“34 When inventories are sold, the carrying amount of those inventories shall be recognised as an expense in the period in which the related revenue is recognised. The amount of any write-down of inventories to net realisable value and all losses of inventories shall be recognised as an expense in the period the write-down or loss occurs. The amount of any reversal of any write-down of inventories, arising from an increase in net realisable value, shall be recognised as a reduction in the amount of inventories recognised as an expense in the period in which the reversal occurs.”

Discussion

View 1: Recognise the revenue when goods are dispatched to the customer at which time control is transferred as per Ind AS 115. The subsidy is recognised as a variable consideration in accordance with Ind AS 115 and its estimated value is included in the transaction price.

Supporting Rationale:

a) Revenue is recognised on transfer of control of the underlying goods (fertilizers) at the time of dispatch in accordance with the contract with the dealers (para 31).

b) The subsidy received by RCF is a subsidy not to RCF but to the farmers. The subsidy received by RCF is a payment by the government on behalf of the farmers. In other words, RCF receives the consideration largely from the farmers (through the dealers) and partly from the government on behalf of the farmers (see para 47).

c) Since the amount to be received from the government may fluctuate, the provisions relating to variable consideration under Ind AS 115 will kick in. On this basis, variable consideration will be estimated using either the expected value method or the most likely amount method under Ind AS 115 whichever the entity expects to better predict the amount of consideration to which it will be entitled. The entity will constraint the amount determined to an extent that it is highly probable that significant reversal of revenue will not happen in subsequent period. In subsequent period, the variable consideration will be trued up basis the amount received from the government (see para 50 and 87).
d) In addition to the subsidy for which variable consideration is to be applied, variable consideration will also be applied for likely goods that may be returned by the dealers. A simple consequence of this is that the subsidy amount is also not recognized on estimated goods that may be returned by the dealers (see para 50 and 87).

e) This view will allow subsidy income on an estimated basis to be recognized in the same period it transfers control of the underlying goods (fertilizers). However, it is likely to require significant estimates which will get updated in subsequent periods. It is possible that this view would result in significant volatility in margins for each reporting period. Additionally, depending on extent of changes in subsidy rate, the matching principle may not be met in its entirety, as the entire cost of manufacture of fertilizers is booked in one period, while a specific portion of the revenue (resulting from changes in subsidy rates on channel stock, which is happening more frequently) is recognized in another period.

Dissenting opinion

The counter view in the extant case is that there is contract between RCF and the dealer, who is the customer. The ultimate customer is the farmer, who is the customer of the dealer and not of RCF. Apparently, neither the contract between RCF and the dealer nor the contract between the dealer and the farmer specifies that any portion of the consideration is payable to RCF by the government (on behalf of the farmer).

Transaction price under Ind AS 115 is defined as consideration that is paid by a customer to the vendor. Since the subsidy is received from the government who is not the customer of RCF, the fertilizer subsidy does not form part of the variable consideration element of the transaction price and is outside the scope of Ind AS 115.

Consequently, view 1 is not acceptable.

View 2: Recognise the revenue when goods are dispatched to the customer at which time control is transferred in accordance with Ind AS 115. The subsidy is recognized in accordance with the principles laid out in Ind AS 20 Accounting for Government Grants and Disclosure of Government Assistance. RCF interprets this to mean that the subsidy will be recognized only when the dealer sells the goods to the farmers, which will therefore not coincide with the timing for recognition of revenue on sale of good. Further, the cost of inventories will be allocated proportionately to the main revenue component and the subsidy element. Since the subsidy revenue is to be recognized in later periods, the proportionate cost of inventories will be carried forward as an asset, and adjusted against the subsidy revenue in subsequent periods.

Supporting Rationale

a) Basis paragraph 3 of Ind AS 20, in the case of RCF, the subsidy received on sale of fertilizers qualifies as a transfer of resources to an entity and hence is a grant under Ind AS 20.

b) The purpose of fertilizer subsidy is to ensure availability of fertilizer at an affordable rate to farmers. Under DBT regime, the Government decides subsidy rate for each season depending on trending of few products like DAP, Urea, MOP and Sulphur which are not having any direct link with cost of production of companies. However, the Government assumes that if above mentioned products are imported today and sold at certain prices, then, the companies require the difference as subsidy to sustain operations. Paragraph 4 of Ind AS 20 reads as, Government assistance takes many forms varying both in the nature of the assistance given and in the conditions which are usually attached to it. The purpose of the assistance may be to encourage an entity to embark on a course of action which it would not normally have taken if the assistance was not provided.

c) DBT regime requires accounting practice which is more aligned to subsidy entitlement under DBT, unlike the earlier scheme where the condition to receive the subsidy was tied to RCF selling the goods, rather than when the goods were ultimately purchased by the farmer. Under DBT regime, subsidy entitlement is final when material is sold to farmer.

d) The volatility on margins would be minimised and matching principle would also be met.

Dissenting View

a) The costs of producing inventories of fertilizers are costs incurred in fulfilling the contract with the customers i.e., dealers, which should be accounted for in accordance with Ind AS 2 and not in accordance with Ind AS 115 (para 9, 10, 34 or Ind AS 2). When such inventories are sold to the dealers, the carrying amount of the same should be expensed in the period in which the related revenue is recognised. No amounts can be recognised or carried forward to be adjusted against subsidy income in future periods.

b) The recognition of subsidy receivable with concurrent recognition of the subsidy income in profit or loss at the time of sale to farmers by the dealers would generally not be appropriate, since the reasonable assurance condition prescribed in paragraph 7 of Ind AS 20 is met when the goods are sold to the dealers, unless proved otherwise. The government is unlikely to renege on its promises and therefore the subsidy income recognition criterion is met at the point in time when the sale to dealers is recognised.

c) Even assuming the reasonable assurance condition that the grant will be received is not met, at the time of sale to dealers, the proportionate cost related to the subsidy cannot be separately treated as an asset. A portion of inventories on goods sold cannot be carried forward (to be adjusted against subsidy income in subsequent periods) and is neither permitted under Ind AS 2 (as discussed above) or Ind AS 20 (see para 12). Neither does Ind AS 115 (see para 98) allows such a cost to be carried forward.

Final recommendation

The correct accounting treatment is set out in View 3 below.

View 3: Recognise the revenue when goods are dispatched to the customer at which time control is transferred in accordance with Ind AS 115. The subsidy is recognized as a grant income in accordance with Ind AS 20. RCF interprets this to mean that the subsidy will be recognised at the time of recognition of the revenue (sale to dealers), basis best estimate, which will then be trued up in subsequent period if necessary (for e.g., if the subsidy rate is revised).

Consequently, the correct accounting treatment is summarised below:
a) Ind AS 115 will apply to sale of fertilizers to dealers and Ind AS 20 (para 3) will apply to subsidy income.

b) The Ind AS 115 revenues will be recognised at the time of transfer of control (see para 31 of Ind AS 115) along with entire cost of inventories (see para 34 of Ind AS 2).

c) The subsidy meets the definition of grant under Ind AS 20 since there is transfer of resources (cash subsidy) from the government to RCF in return for past compliance with a condition i.e., sale of fertilizers to the ultimate customer (viz., farmer) at the rate notified by the government and the grant is a revenue related grant (see para 3 of Ind AS 20).

d) RCF should assess, in its own circumstances, the point of time at which the reasonable assurance condition is met, having regard to factors such as, quantity of non-moving channel stock, if any, past experience in receipt of subsidy etc. In the extant case, the subsidy is intended to either reimburse to RCF a portion of cost of production of goods sold or to compensate RCF for loss of revenue arising on account of sales to the dealers at rates not commensurate with the cost of production. In both the situations, the periods in which the subsidy income should be recognised in profit or loss on a systematic basis will be the periods of sale to the dealers, provided the reasonable assurance condition prescribed in paragraph 7 of Ind AS 20 is met.

View 3 offers the most suitable accounting treatment. It establishes a consistent method for recognising revenue and the corresponding subsidy in line with the relevant Indian Accounting Standards, while also requiring adjustments (either upward or downward) to subsidy income when the government announces revised subsidy rates. Although these future subsidy true-ups may introduce volatility, such fluctuations are appropriate as they accurately reflect changes in government subsidy rates in subsequent periods.

Own Use Exception

Ind AS 109 is applicable to commodity contracts / contracts to buy or sell non-financial items that may be settled net. What is the meaning of “net settlement”? In accordance with Ind AS 109, there are various ways in which an entity may be able to net settle a contract to buy or sell a non-financial item. These include:

a) The terms of contract permit either party to settle it net.

b) The contract does not contain any specific terms permitting parties to settle it net. However, the entity has a past practice of settling similar contracts net. For example, net settlement may occur either with the counterparty, or by entering into an offsetting contract or by selling the contract before it is exercised or lapses. Infrequent historical incidences of net settlement in response to events that could not have been foreseen at inception of a contract would not taint an entity’s ability to apply the own-use exception to other contracts; for example, an unplanned break-down in a power plant. However, any regular or foreseeable events leading to net settlements would taint the entity’s ability to apply the own-use exception to other contracts.

c) For similar contracts, the entity has a practice of taking delivery of the underlying and selling it within a short period after delivery to generate a profit from short-term fluctuations in price or dealer’s margin.

d) Non-financial item covered in the contract is readily convertible to cash.

However, it is noted that Ind AS 109 will not apply to all contracts that may be settled net in cash. A contract for purchase or sale of non-financial items will still be scoped out from Ind AS 109, if the entity can demonstrate that the contract was entered into and continue to be held for the receipt / delivery of a non-financial item in accordance with its expected purchase, sale or usage requirements. This is commonly referred to as ‘own use exception’ or ‘normal purchase or sale exception (NPSE)’.
There was always a question around how to apply the own-use exception to renewable energy contracts for which the source for production of the renewable electricity is nature-dependent so that supply cannot be guaranteed at particular times or in particular volumes. Examples of sources include wind-, solar- and hydroelectricity.

Consider the example below.

EXAMPLE

Kleen Co. enters into a power purchase agreement (PPA) with a windmill operator to purchase electricity. Both Kleen and the operator are connected through a common national grid. The PPA obliges Kleen to acquire a 45% fixed share of the wind energy produced by the operator. The price per unit for the energy is fixed in advance and remains stable throughout the contract duration of 25 years. The operator does not guarantee a specific amount of output (energy) but estimates with 80% probability an expected amount. The energy produced is transferred to Kleen through the national grid.

The total energy demand of Kleen by far exceeds both the contracted share of the estimated output and the contracted share of the peak output of the wind park. However, Kleen does not operate its production facilities 24/7 but pauses production during the night times, on weekends and holiday season. There is thus a mismatch between the demand profile of Kleen and the supply profile of the wind park.

Kleen is obliged to acquire the energy of the wind park in the amount (45% of the current production volume) and at the time it is produced. Since Kleen has no feasible option to store the energy, it sells energy that cannot be consumed immediately (e.g., on weekends or overnight) to the spot market and repurchases (at least) the same amount from that market at times when the production facilities are operated. The windmill operator continues to transfer the amounts of energy fed into the grid to the account of Kleen and Kleen has to sell unused amounts from its account to third parties. The process of selling and repurchasing is designed to be an autopilot that acts without the intention of trading to realise profits and has the sole intention to enable the Kleen’s operations. The process of selling and repurchasing is delegated to a service provider.

For the purpose of this discussion, it is assumed that the conditions do not change throughout subsequent periods and that some market transactions become necessary for unused amounts of energy.

Will own-use exception apply in this case, and consequently whether the above PPA is to be treated as a derivative or not?

Kleen has considered aspects relating to whether the PPA is accounted for applying another Ind AS Accounting Standard, for example Ind AS 110 Consolidated Financial Statements, Ind AS 111 Joint Arrangements and / or Ind AS 116 Leases, and believe those do not apply in the extant fact pattern.

RELEVANT REQUIREMENTS OF IND AS 109 FINANCIAL INSTRUMENTS

Paragraph 2.4 of Ind AS 109 states:

This Standard shall be applied to those contracts to buy or sell a non financial item that can be settled net in cash or another financial instrument, or by exchanging financial instruments, as if the contracts were financial instruments, with the exception of contracts that were entered into and continue to be held for the purpose of the receipt or delivery of a non financial item in accordance with the entity’s expected purchase, sale or usage requirements. However, this Standard shall be applied to those contracts that an entity designates as measured at fair value through profit or loss in accordance with paragraph 2.5.

Paragraph 2.6 of Ind AS 109 states:

There are various ways in which a contract to buy or sell a non- financial item can be settled net in cash or another financial instrument or by exchanging financial instruments. These include:

(a) when the terms of the contract permit either party to settle it net in cash or another financial instrument or by exchanging financial instruments;

(b) when the ability to settle net in cash or another financial instrument, or by exchanging financial instruments, is not explicit in the terms of the contract, but the entity has a practice of settling similar contracts net in cash or another financial instrument or by exchanging financial instruments (whether with the counterparty, by entering into offsetting contracts or by selling the contract before its exercise or lapse);

(c) when, for similar contracts, the entity has a practice of taking delivery of the underlying and selling it within a short period after delivery for the purpose of generating a profit from short-term fluctuations in price or dealer’s margin; and

(d) when the non-financial item that is the subject of the contract is readily convertible to cash.

A contract to which (b) or (c) applies is not entered into for the purpose of the receipt or delivery of the non financial item in accordance with the entity’s expected purchase, sale or usage requirements and, accordingly, is within the scope of this Standard. Other contracts to which paragraph 2.4 applies are evaluated to determine whether they were entered into and continue to be held for the purpose of the receipt or delivery of the non financial item in accordance with the entity’s expected purchase, sale or usage requirements and, accordingly, whether they are within the scope of this Standard.

ACCOUNTING FOR THE PPA

On the date of inception of the contract, Kleen regards the sole purpose of the PPA as a contract to buy a non-financial item as it is entered for the purpose of the receipt of energy in accordance with the it’s expected usage requirements as laid out in Ind AS 109.2.4. Kleen does not designate the contract as measured at fair value through profit or loss in accordance with Ind AS 109.2.5. Kleen views the difference in prices (lower prices during night times, on weekends and during holiday season when production is paused vs. higher prices when repurchased on spot markets during peak times) as costs of storage, i.e., it uses the energy spot market as a storage facility. Kleen does not operate as a trading party in the market, the production schedule and the consumption profile dictate spot price transactions.

Kleen further analyses whether the contract can be settled net in cash in accordance with Ind AS 109.2.6.

Kleen is always in a net purchaser position, i.e., it buys more energy from the spot market than it has sold to it based on a monthly view (meaning that for every calendar month, the Kleen has purchased more energy on spot markets than it has sold). The average purchase price exceeds the average sale’s price, so that Kleen incurs expenses for “storing” the energy on sport markets which is part of the fee paid to a service provider involved to sell unused amounts of energy to and repurchase additional demands from the grid/spot markets.

The various views are presented below.

VIEW A

Kleen assesses at the inception of the contract that:

(a) the terms of the contract do not provide for an option to settle net in cash or by exchanging financial instruments.

(b) Kleen has no practice of settling similar contracts net in cash or another financial instrument or by exchanging financial instruments.

(c) Kleen intends to sell unwanted energy out of the contract to the spot market and also intends to purchase at least the same amount of energy at times when it is needed. Kleen uses the spot market as a storage mechanism and does not intend to generate profits from those transactions although it cannot rule out that some transactions will lead to profits or losses. Transactions on the spot market are solely used to store the energy.

(d) Kleen assesses the non-financial item to be readily convertible to cash as there is an active market where unused energy can be sold and purchased at any time.

Kleen concludes that the own-use-exception applies to its contract because it is entered into and continues to be held for the purpose of taking delivery of the non-financial asset (energy) in accordance with the entity’s expected (energy) consumption.

VIEW B

Kleen expects transactions on the spot market already at inception of the contract for the amount of energy it cannot use when it is produced. Under View B this would disqualify the contract from the application of the own-use-exception because the contract was not – in its entirety – being held to the purpose of the receipt of the energy at the specific time of production (Ind AS 109.2.4) but with some anticipated sales transactions.

VIEW C

As Kleen intends to sell unused energy to the spot market, it creates a practice of settling similar contracts on the spot market and therefore the contract is not entered into for the purpose of the receipt of the energy (Ind AS 109.2.6(b)).

VIEW D

Under this View D, the transactions on the spot market may lead to a breach of the requirement set out in Ind AS 109.2.6(c) (generating profit from short term fluctuations in price or dealer’s margin) because Kleen cannot rule out that profit arises from some sales transactions, even though this is not intended.

AMENDMENTS TO IND AS 109

As can be seen above, multiple views were possible. However, Ind AS 109 is now proposed to be amended with respect to contracts referencing nature-dependent electricity that requires an entity to buy and take delivery of the electricity when it is generated. These contractual features expose the entity to the risk that it would be required to buy electricity during a delivery interval in which the entity cannot use the electricity. The entity might also have no practical ability to avoid making sales of unused electricity because the design and operation of the electricity market in which the electricity is transacted under the contract require any amounts of unused electricity to be sold within a specified time. Such sales are not necessarily inconsistent with the contract being held in accordance with the entity’s expected usage requirements. An entity entered into and continues to hold such a contract in accordance with its expected electricity usage requirements if the entity has been, and expects to be, a net purchaser of electricity for the contract period. An entity is a net purchaser of electricity if it buys sufficient electricity to offset the sales of any unused electricity in the same market in which it sold the electricity.

In determining whether an entity is a net purchaser of electricity, the entity shall consider reasonable and supportable information (that is available without undue cost or effort) about its past, current and expected future electricity transactions over a reasonable amount of time. The entity identifies ‘a reasonable amount of time’ by considering the variability in the amount of electricity expected to be generated due to the seasonal cycle of the natural conditions and the variability in the entity’s demand for electricity due to its operating cycle. In determining whether the entity has been a net purchaser, ‘a reasonable amount of time’ shall not exceed 12 months.

An entity shall apply these amendments for annual reporting periods beginning on or after 1st April, 2026. Earlier application is not permitted. Some of the amendments are subject to prospective application and others subject to retrospective application.

Disclosure of Climate Related Uncertainties

There was a strong concern from multiple stakeholders regarding information about the effects of climate-related risks in the financial statements, which either were insufficient or appeared to be inconsistent with information entities provide outside the financial statements, particularly information reported in other general purpose financial reports.

To address these concerns, the International Accounting Standards Board (IASB) collaborated with the International Sustainability Standards Board, and issued an Exposure Draft (ED) proposing eight examples illustrating how an entity applies the requirements in IFRS Accounting Standards to report the effects of climate-related and other uncertainties in its financial statements. The examples mostly focus on climate-related uncertainties, but the principles and requirements illustrated apply equally to other types of uncertainties.

The IASB expects that these illustrative examples will help to improve the reporting of the effects of climate-related and other uncertainties in the financial statements, including by helping to strengthen connections between an entity’s general purpose financial reports.

The IASB decided to focus the examples on requirements: (a) that are among the most relevant for reporting the effects of climate-related and other uncertainties in the financial statements; and (b) that are likely to address the concerns that information about the effects of climate-related risks in the financial statements is insufficient or appears to be inconsistent with information provided in general purpose financial reports outside the financial statements.

The eight examples, illustrate the application of various IFRS standards, to the extent they are related to climate related disclosures.

Paragraph 31 of IAS 1 Presentation of Financial Statements states “An entity shall also consider whether to provide additional disclosures when compliance with the specific requirements in IFRS is insufficient to enable users of financial statements to understand the impact of particular transactions, other events and conditions on the entity’s financial position and financial performance.”

Consider the example below.

The entity is a manufacturer that operates in a capital-intensive industry and is exposed to climate-related transition risks. To manage these risks, the entity has developed a climate-related transition plan. The entity discloses information about the plan in a general-purpose financial report outside the financial statements, including detailed information about how it plans to reduce greenhouse gas emissions over the next 10 years. The entity explains that it plans to reduce these emissions by making future investments in more energy-efficient technology and changing its raw materials and manufacturing methods. The entity discloses no other information about climate-related transition risks in its general-purpose financial reports.

In preparing its financial statements, the entity assesses the effect of its climate-related transition plan on its financial position and financial performance. The entity concludes that its transition plan has no effect on the recognition or measurement of its assets and liabilities and related income and expenses because: (a) the affected manufacturing facilities are nearly fully depreciated; (b) the recoverable amounts of the affected cash-generating units significantly exceed their respective carrying amounts; and (c) the entity has no asset retirement obligations.

The entity also assesses whether specific requirements in IFRS Accounting Standards—such as in IAS 16 Property, Plant and Equipment, IAS 36 Impairment of Assets or IAS 37 Provisions, Contingent Liabilities and Contingent Assets—require it to disclose information about the effect (or lack of effect) of its transition plan on its financial position and financial performance. The entity concludes that they do not.

In applying paragraph 31 of IAS 1 [paragraph 20 of IFRS 18], the entity determines that additional disclosures to enable users of financial statements to understand the effect (or lack of effect) of its transition plan on its financial position and financial performance would provide material information. That is, omitting this information could reasonably be expected to influence decisions primary users of the entity’s financial statements make on the basis of those financial statements.

Without that additional information, the decisions users of the entity’s financial statements make could reasonably be expected to be influenced by a lack of understanding of how the entity’s transition plan has affected the entity’s financial position and financial performance. For example, users of the entity’s financial statements might expect that some of its assets might be impaired because of its plans to change manufacturing methods and invest in more energy-efficient technology.

The entity reaches this conclusion having considered qualitative factors that make the information more likely to influence users’ decision-making, including: (a) the disclosures in its general-purpose financial report outside the financial statements (entity-specific qualitative factor); and (b) the industry in which it operates, which is known to be exposed to climate-related transition risks (external qualitative factor).

Therefore, applying paragraph 31 of IAS 1 [paragraph 20 of IFRS 18], the entity discloses that its transition plan has no effect on its financial position and financial performance and explains why.

Other examples, include, the applicability of materiality judgements on disclosures, the disclosure of assumptions on impairment of assets, under different standards, such as IAS 36, Impairment of Assets, IAS 1, and IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, disclosure about decommission and  restoration provisions, under IAS 37 Provisions, Contingent Liabilities and Contingent Assets and disclosure of disaggregated information under IFRS 18 Presentation and Disclosure in Financial Statements.

There is also an interesting requirement relating to disclosure of credit risks under IFRS 7 Financial Instruments: Disclosures. Entities are exposed to significant credit risks arising from climate change. For e.g., a financial institution may be exposed to significant credit risks from its agriculture focussed lending, because of drought or flood. An entity might disclose: (a) information about the effects of particular risks on its credit risk exposures and credit risk management practices; and (b) information about how these practices relate to the recognition and measurement of expected credit losses.

In determining whether the disclosures are required, and the extent of such disclosures, an entity considers(a) the size of the portfolios affected by climate-related risks relative to the entity’s overall lending portfolio. (b) the significance of the effects of climate-related risks on the entity’s exposure to credit risk compared to other factors affecting that exposure. The effects depend on factors such as loan maturities and the nature, likelihood and magnitude of the climate-related risks. (c) external climate-related qualitative factors—such as climate-related market, economic, regulatory and legal developments—that make the information more likely to influence decisions primary users of the entity’s financial statements make on the basis of the financial statements.

The entity considers what information to provide about the effects of climate-related risks on its exposure to credit risk. This information might include, for example: (a) an explanation of the entity’s credit risk management practices related to climate-related risks and how those practices relate to the recognition and measurement of expected credit losses. The information the entity discloses might include, for example, how climate-related risks affect: (i) the determination of whether the credit risk on these financial instruments has increased significantly since initial recognition; and (ii) the grouping of instruments if expected credit losses are measured on a collective basis.

(b) an explanation of how climate-related risks were incorporated in the inputs, assumptions and estimation techniques used to apply the requirements in Section 5.5 of IFRS 9 Financial Instruments. The information the entity discloses might include: (i) how climate-related risks were incorporated in the inputs used to measure expected credit losses, such as probabilities of default and loss given default; (ii) how forward-looking information about climate-related risks was incorporated into the determination of expected credit losses; and (iii) any changes the entity made during the reporting period to estimation techniques or significant assumptions to reflect climate-related risks and the reasons for those changes.

(c) information about collateral held as security and other credit enhancements, including information about properties held as collateral that are subject to flood risk and whether that risk is insured.

(d) information about concentrations of climate-related risk if this information is not apparent from other disclosures the entity makes.

CONCLUSION

Many entities do not disclose sufficient and relevant information relating to climate related risks and the impact on its financial statements. Mostly, the disclosures if made are boiler plated or are outside the financial statements, which are not subject to any scrutiny. The IASB’s ED is a step in the right direction for ensuring better compliance relating to the disclosure of climate related risks. The ED will be followed by similar requirements in India as well. Hopefully, what will follow is better disclosures and effective compliance. Entities in the meanwhile, should consider the above disclosures, on a voluntary basis, without waiting for the ED to become a standard.

Digital Assurance

The Securities and Exchange Board of India (SEBI) has recently issued a draft circular, dated 3rd February, 2025, requiring digital assurance, of financial statement. The first reaction is that this probably relates to IT-related controls or cyber security. That is not the case. SEBI has separate regulations for the same, e.g., Cyber Security and Cyber Resilience Framework for SEBI-regulated entities.

In the circular relating to digital assurance, SEBI states “As a continuous endeavour to enhance the quality of financial reporting being done by listed companies and in order to provide greater investor protection, it is proposed to mandate a separate report on digital assurance of financial statement. The report will increase transparency, improve disclosure standards and enable better enforcement, and thereby provide greater investor protection and trust in the ecosystem.”

The auditor shall conduct an examination in accordance with the “Technical Guide on Digital Assurance” issued by the Institute of Chartered Accountants of India (ICAI). The report shall be prepared by an auditor (Statutory Auditor or Independent Practitioner) who has subjected himself / herself to the peer review process of the Institute of Chartered Accountants of India and holds a valid certificate issued by the Peer Review Board of the Institute of Chartered Accountants of India.

If SEBI issues the circular, reporting on digital assurance shall be applicable to the Top 100 listed entities by market capitalization from Financial Year 2024-25 onwards i.e. for the period ending on or after 31st March, 2025.

Some examples of external digital information that can be used to corroborate information in the financial statements are the following:

  1. Revenue of an entity can be corroborated with the GST tax portal
  2. Export receivables can be corroborated with the EDPMS report
  3. Import payables can be corroborated with the IDPMS report
  4. Tax deducted at source and advance taxes paid can be corroborated with the traces portal and AIS data
  5. Total contribution to provident fund by employer and employee, can be corroborated with Employee Provident Fund Organization portal
  6. Use of e-way bills to perform a sales cut-off procedure
  7. Traffic data submitted to NHAI can be corroborated with toll revenue.

The ICAIs technical guide was issued some time ago in January 2023. This guide primarily focuses on sources of external audit evidence available and how it can be utilized by the members in their audit procedures. This guide also highlights the importance of reliability and relevance of the source from which the information is being obtained. In addition to using the available source, the members are guided to consider the reliability and relevance of the source and information being used in the audit. This guide also provides various illustrations of available sources of external audit evidence and how they can be used. Some of those examples are given above.

The aforementioned Technical Guide primarily focuses on sources of external audit evidence and information available and how the same can be utilised by the members in their audit procedures. It is noted that the Technical Guide does not require any separate reporting by auditors on these aspects. Further, no responsibility is cast on the management of the listed entity to provide this information obtained from external data repositories to auditors or provide access to such information to auditors. However, rightfully so, SEBI in the draft circular requires management to take responsibility for sharing such information to the auditors of the company.

The ICAI’s stance not to require any separate audit attestation is understandable, because external audit evidence, whether digital or otherwise, is in any case covered under extant auditing standards and audit procedures in the audit of financial statements.

Paragraph 7 of SA 500 requires as under: “When designing and performing audit procedures, the auditor shall consider the relevance and reliability of the information to be used as audit evidence.” Accordingly, the auditor is required to consider the relevance and reliability of information (e.g., information contained in accounting records, information obtained from other sources, information prepared using the work of a management’s expert) which is intended to be used by the auditor as audit evidence.

The reliability of audit evidence is increased when it is obtained from independent sources outside the entity. However, SA 500 rightfully cautions, that there may be exceptions, for e.g., information obtained from an independent external source may not be reliable if the source is not knowledgeable, or a management’s expert may lack objectivity.

According to the Technical Guide, the following factors may be important when considering the relevance and reliability of information obtained from an external information source:

  • The nature and authority of the external information source, including the extent of regulatory oversight (if applicable)
  • The “independence” of the data — is the entity able to influence the information obtained  The competence and reputation of the external information source with respect to the information, including whether, in the auditor’s professional judgement, the information is routinely provided by a source with a track record of providing reliable information
  • The auditor’s past experience with the reliability of the information
  • Market acceptability of the data source
  • Whether the information has been subject to review or verification
  • Whether the information is relevant and suitable for use in the manner in which it is being used, including the age of the information and the nature and strength of the relationship between the information and the entity’s transactions, and, if applicable, the information was developed taking into account the applicable financial reporting framework
  • Alternative information that may contradict the information used
  • The nature and extent of disclaimers or other restrictive language relating to the information obtained
  • Information about the methods used in preparing the information, how the methods are being applied including, where applicable, how models have been used in such application, and the controls over the methods
  • When available, information relevant to considering the appropriateness of assumptions and other data applied by the external information sources in developing the information obtained.

The technical guide emphasises that, the information obtained by the auditor from external sources may reveal inconsistencies with the information obtained by the auditor from other sources (e.g., accounting records, information obtained during the course of audit, etc.). This would help the auditor in performing necessary modifications or additional procedures to resolve the matter. Thus, audit evidence obtained from external sources plays a vital role in the audit process.

SEBI has invited comments and suggestions, by 24th February, 2025. The author submits as follows:

1. There are numerous auditing standards that require an appropriate use of internal and external audit evidence, in the audit of financial statements, to ensure that they are true and fair. The implementation of these standards and the conduct of appropriate audit procedures are also verified by various peer reviewers, including the NFRA reviewers. Therefore, a separate audit report to certify the same is unwarranted and is an extra burden on the auditors.

Precisely for this reason, the Technical Guide of the ICAI does not require any separate audit report. What may be more appropriate under the circumstances, is that the auditors include a summary work paper in their audit file, which will document all the external evidences that they used to audit the financial statements. This in the normal course will be subjected to a review by various peer reviewers.

2.   If the above recommendation is not acceptable to SEBI, they should require the report to be issued by the company’s statutory auditor. It would be incorrect and inappropriate for an independent practitioner to certify the report, as they do not have the same level of knowledge about the client as the statutory auditor. A statutory auditorconducts regular audits, reviews financial statements, and has a deep understanding of a company’s internal controls, compliance framework, and financial history. On the other hand, an independent practitioner, who is engaged for a specific task, lacks this extensive familiarity. For instance, if a company has complex revenue recognition policies, the statutory auditor—being well-versed in past accounting treatments—can provide a more informed certification than an external practitioner with limited exposure to the company’s financial intricacies.

Suppose a company’s revenue figures in its financial statements need to be verified against GST (Goods and Services Tax) returns. The statutory auditor, having audited the company’s financials and tax reconciliations over time, is aware of any past discrepancies, discount or adjustments for returns, or specific reporting nuances, such as aggregating the multiple branches. An independent practitioner, however, would only be reviewing the data at a surface level and may not be aware of historical issues such as classification errors, past rectifications, or timing differences in revenue recognition.

3. The original purpose of digital assurance was to obtain more certification by statutory auditors on various non-GAAP measures in offer documents, which a merchant banker may not be competent, since they are not involved in the audit of financial statements; and may not have a deep understanding of clients databases and controls. Take for example, in the case of Swiggy, there are several non-GAAP measures that are used, such as adjusted EBITDA, quick commerce gross revenue, food delivery gross revenue, etc. Without opining on the relevance of these measures, it is not out of bounds for the statutory auditors to comfort such numbers.

In the offer document, Swiggy also provides industry and market-related data, basis the Redseer Report. Here the merchant banker’s basis their in-house experts or hired consultants should feel comfortable that the source is authoritative, and that it is fairly represented in the offer document, without any cherry-picking of information that suits the issuer, and avoiding those that are adversarial.

Likewise, there could be detailed cost-related data, where comforting by a cost accountant or cost auditor may be appropriate. A geoscientist may be more competent to certify mineral reserves. Information related to attrition rate for services company can be comforted by the statutory auditors, however, since there could be multiple ways of computing the same, the basis of measurement should be clarified by ICAI, so that there is consistency in calculations.

Whilst the merchant bankers are overall responsible for the information contained in the offer document, they should be supported by various professionals. Some of these professionals can be sourced as consultants or employed by the merchant bankers. Information that is closely associated with financial systems and related databases, should be comforted by the statutory auditors. SEBI should ensure that all stakeholders have a collaborative and cooperative approach in this matter, so that the end result is a solid offer document that can form a strong basis for evaluating a company.

Presentation and Disclosure in Financial Statements

WHAT IS THE ISSUE?

ICAI has issued an exposure draft (ED) — Ind AS 118, ‘Presentation and Disclosure in Financial Statements’ — in response to concerns about the comparability and transparency of entities’ performance reporting. The new requirements introduced in Ind AS 118 will help to achieve comparability of the financial performance of similar entities, especially related to how ‘operating profit or loss’ is defined and the presentation of the income statement. Additionally, the new disclosures required for some management-defined performance measures will also enhance transparency.

It will not affect how companies measure their financial performance and the overall profit figure.

KEY CHANGES

1. Structure of the statement of profit or loss

Ind AS 118 introduces a defined structure for the statement of profit or loss. The goal of the defined structure is to reduce diversity in the reporting of the statement of profit and loss, helping users of financial statements to understand the information and to make better comparisons between companies. The structure is composed of categories and required subtotals.

Categories: Items in the statement of profit or loss will need to be classified into one of five categories: operating, investing, financing, income taxes, and discontinued operations. Ind AS 118 provides general guidance for entities to classify the items among these categories — the three main categories are:

OPERATING CATEGORY

The operating category is the default or residual category for income and expenses that are not classified in other categories and:

  •  includes all income and expenses arising from a company’s operations, regardless of whether they are volatile or unusual in some way. Operating profit provides a complete picture of a company’s operations for the period.
  •  includes, but is not limited to, income and expenses from a company’s main business activities. Income and expenses from other business activities, such as income and expenses from additional activities, are also classified in the operating category, if those income and expenses do not meet the requirements to be classified in any of the other categories.

Ind AS 118 requires a company to present expenses in the operating category in a way that provides the most useful structured summary of its expenses. To do so, a company will present in the operating category expenses classified based on: a) their nature — that is, the economic resources consumed to accomplish the company’s activities, for example, raw materials, salaries, advertising costs; or b) their function — that is, the activity to which the consumed resource relates, for example, cost of sales, distribution costs, administrative expenses.

It requires companies to classify expenses in a way that provides the most useful information to investors, considering, for example: a) what line items provide the most useful information about the important components or drivers of the company’s profitability; and b) what line items most closely represent the way the company is managed and how management reports internally.

Some companies might decide that classifying some expenses by nature and other expenses by function, provides the most useful structured summary of their expenses. The standard also requires companies that present expenses classified by function to disclose the amount of depreciation, amortisation, employee benefits, impairment losses and write-downs of inventories included in each line item in the operating category of profit or loss. Allowing presentation of expenses by function is a significant change and improvement of current Ind AS 1 Presentation of Financial Statements.

INVESTING CATEGORY

This category typically includes:

  •  results of associates and joint ventures;
  •  results of cash and cash equivalents; and
  •  assets that generate a return individually and largely independently of other resources, for example, a company might collect rentals from an investment property or dividends from shares in other companies.

FINANCING CATEGORY

This category includes:

  •  all income and expenses from liabilities that involve only the raising of finance (such as typical bank borrowing); and
  •  interest expense and the effects of changes in interest rates from other liabilities (such as unwinding of the discount on a pension liability).

An entity is required to assess whether it has a specified main business activity that is a main business activity of investing in particular types of assets; or providing financing to customers, for example, insurers and banks. Income and expenses that would otherwise be classified in the investing or financing categories by most companies would form part of the operating result for such companies. Ind AS 118 therefore requires these income and expenses to be classified in the operating category.

Required subtotals:Ind AS 118 requires entities to present specified totals and subtotals: the main change relates to the mandatory inclusion of ‘Operating profit or loss’. The other required subtotal is ‘Profit or loss before financing and income taxes’, with some exceptions.

2. Disclosures related to the statement of profit or loss

Ind AS 118 introduces specific disclosure requirements related to the statement of profit or loss:

Management-defined Performance Measures (‘MPMs’):

This is a subtotal of income and expenses other than those specifically excluded by the Standard or required to be disclosed or presented by Ind ASs, that a company uses in public communications outside financial statements to communicate to investors management’s view of an aspect of the financial performance of the company as a whole. For example, measures that adjust a total or subtotal specified in Ind ASs, such as adjusted profit or loss, are management-defined performance measures.

Other measures (such as free cash flow or customer retention rate) are not management-defined performance measures. For the purpose of identifying MPMs, public communications outside the financial statements include management commentary, press releases, and investor presentations. It does not include oral communications, written transcripts of oral communications, or social media posts.

The standard requires an entity to provide disclosures for all MPMs in a single note, including:

  •  reconciliation between the measure and the most directly comparable subtotal listed in Ind AS 118 or total or subtotal specifically required by Ind ASs, including the income tax effect and the effect on non-controlling interests for each item disclosed in the reconciliation;
  •  a description of how the measure communicates management’s view and how the measure is calculated;
  •  an explanation of any changes in the company’s MPMs or in how it calculates its MPMs; and
  •  a statement that the measure reflects management’s view of an aspect of financial performance of the company as a whole and is not necessarily comparable to measures sharing similar labels or descriptions provided by other companies.

3. Enhanced requirements for aggregation & disaggregation of information

Ind AS 118 requires companies to aggregate or disaggregate information about individual transactions and other events into the information presented in the primary financial statements and disclosed in the notes.

The Standard requires companies to ensure that: a) items are aggregated based on shared characteristics and disaggregated based on characteristics that are not shared; b) items are aggregated or disaggregated such that the primary financial statements and the notes fulfil their roles; and c) the aggregation and disaggregation of items does not obscure material information.

Companies will be specifically required to disaggregate information whenever the resulting information is material. If a company does not present such information in the primary financial statements, it will disclose the information in the notes. To help companies apply the principles, Ind AS 118 provides guidance on grouping items and labelling aggregated items, including which characteristics to consider when assessing whether items have similar or dissimilar characteristics.

The guidance on aggregation and disaggregation has changed compared to Ind AS 1 Presentation of Financial Statements. This will require entities to reconsider their chart of accounts to evaluate whether their existing presentation is still appropriate or whether improvements can be made to the way in which line items are grouped and described in the primary financial statements. In addition, changes in the structure of the statement of profit or loss and additional disclosure requirements might require an entity to make significant changes to its systems, charts of accounts, mappings, investor presentations, etc. The level of operational change required by the new standard should not be underestimated, and entities should start thinking about the operational challenges as soon as possible.

EFFECTIVE DATE

It is proposed that an entity shall apply this Standard for annual reporting periods beginning on or after 1st April, 2027 and when this Standard applies, Ind AS 1 Presentation of Financial Statements, will be withdrawn.

Proposed Amendments to IAS 37 Provisions, Contingent Liabilities and Contingent Assets

IASB has published an Exposure Draft (ED), to make certain changes to IAS 37 Provisions, Contingent Liabilities and Contingent Assets. Similar changes should be anticipated for Ind AS standards as well. In this article we discuss some of the important changes and an example of how the ED relates to climate commitments, with a simple example.

The IASB’s proposed amendments aim to clarify the requirements for the present obligation criterion, and to change the timing of the recognition of some provisions, in particular, levies. The IASB has proposed to update the definition of a liability to match the 2018 Conceptual Framework for Financial Reporting (Conceptual Framework). The updated wording would replace the current requirement for an obligating event with three distinct conditions: obligation, transfer and past-event.

The proposed amendments include separate sections of requirements to support each of the conditions. The proposed amendments would also replace the requirements in IFRIC 21 Levies, which would be withdrawn. The accounting for levies would be aligned with the general requirements for provisions. However, new requirements are proposed for levies when they are triggered only after two or more specific actions (or events) or once a specific threshold is exceeded.

Entities would need to recognise a provision after the first action or event if they have no practical ability to avoid the second event. The proposed amendments would supersede the requirements in IFRIC 6 Liabilities arising from Participating in a Specific Market — Waste Electrical and Electronic Equipment, which would be withdrawn. The proposed amendments would clarify the requirements for restructuring provisions in order to eliminate potentially misleading terminology. Nevertheless, they are not intended to change the outcome of applying the requirements for restructuring provisions.

Change in definition of provision

Existing provision Proposed Amendment

A provision is a liability of uncertain timing or amount.

 

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.

 

An obligating event is an event that creates a legal or constructive obligation that results in an entity having no realistic alternative to settling that obligation.

A liability is a present obligation of the entity resource to transfer an economic resource as a result of past events.

The following paragraphs have been added.

Paragraph 14A

The first criterion for recognising a provision is that an entity has a present obligation (legal or constructive) to transfer an economic resource as a result of a past event.

 

This criterion (the present obligation recognition criterion) comprises three conditions: (a) an obligation condition — the entity has an obligation (paragraphs 14B —14H); (b) a transfer condition — the nature of the entity’s obligation is to transfer an economic resource (paragraphs 14I–14L); and (c) a past-event condition — the entity’s obligation is a present obligation that exists as a result of a past event (paragraphs 14M–14U).
Obligating condition

 

Paragraph 14B

The first condition for meeting the present obligation recognition criterion is that the entity has an obligation. An entity has an obligation if:

 

(a) a mechanism is in place that imposes a responsibility on the entity if it obtains specific economic benefits or takes a specific action; (b) the entity owes that responsibility to another party; and (c) the entity has no practical ability to avoid discharging the responsibility if it obtains the specific economic benefits or takes the specific action.
Paragraph 14C reiterates the obligation can be legal or constructive.
Paragraph 14D

The economic benefits the entity obtains could be, for example, cash, goods or services. The action the entity takes could be, for example, operating in a specific market, causing environmental damage or other harm to another party, owning specific assets on a specific date, or constructing an asset that will need to be decommissioned at the end of its useful life.
Paragraph 14E (this is derived from the current standard)

An obligation is always owed to another party. It is not necessary for an entity to know the identity of the party to whom the obligation is owed. The other party could be a person or another entity, a group of people or other entities, or society at large
Paragraph 14F

An entity has no practical ability to avoid discharging a responsibility:

(a) in the case of a legal obligation, if: (i) the other party has a legal right to act against the entity if the entity fails to discharge the responsibility — for example, to ask a court to enforce settlement, charge the entity a financial penalty or restrict the entity’s access to economic benefits; and (ii) as a result of that right, the economic consequences for the entity of not discharging the responsibility are expected to be significantly worse than the costs of discharging it; or

 

(b) in the case of a constructive obligation, if the entity’s pattern of past practice, published policy or sufficiently specific current statement creates valid expectations in other parties that the entity will discharge the responsibility
14G (this is derived from current standard)

If details of a proposed new law have yet to be finalised, an obligation arises only when the legislation is virtually certain to be enacted as drafted. In this Standard, such an obligation is treated as a legal obligation. Variations in circumstances surrounding enactment make it impossible to specify a single event that would make the enactment of a law virtually certain. In many cases it will be impossible to be virtually certain of the enactment of a law until it is enacted

 
14H (this is derived from current standard)

An obligation requires an entity to have no practical ability to avoid discharging a responsibility. Therefore, a management or board decision does not give rise to a constructive obligation at the end of the reporting period unless the decision has been communicated before the end of the reporting period to those affected by it in a sufficiently specific manner to create a valid expectation in those affected that the entity will discharge its responsibility.

 
Transfer condition

 

14I

The second condition for meeting the present obligation recognition criterion is that the nature of the entity’s obligation is to transfer an economic resource. To meet this condition, the obligation must have the potential to require the entity to transfer an economic resource to another party.

 

14J

For that potential to exist, it does not need to be certain, or even likely, that the entity will be required to transfer an economic resource — the transfer may, for example, be required only if a specified uncertain future event occurs.

 

14K

Consequently, the probability of a transfer does not affect whether an obligation meets the present obligation recognition criterion — an obligation can meet that criterion even if the probability is low. However, the probability of a transfer could affect: (a) whether the obligation meets one of the other criteria for recognising a provision — a provision is recognised only if it is probable (more likely than not) that the entity will be required to transfer an economic resource to settle the obligation (see paragraphs 14(b) and 23); and (b) whether the entity discloses a contingent liability if the obligation does not meet all the criteria for recognising a provision (see paragraph 23).

 

14L

An obligation to exchange economic resources with another party is not an obligation to transfer an economic resource to that party unless the terms of the exchange are unfavourable to the entity. Accordingly, the obligations arising under an executory contract — for example, a contract to receive goods in exchange for paying cash — are not obligations to transfer an economic resource unless the contract is onerous.
Past-event condition

14M

The third condition for meeting the present obligation recognition criterion is that the entity’s obligation is a present obligation that exists as a result of a past event.

 

14N

An entity’s obligation becomes a present obligation that exists as a result of a past event when the entity: (a) has obtained specific economic benefits or taken a specific action, as described in paragraphs 14B and 14D; and(b) as a consequence of having obtained those benefits or taken that action, will or may have to transfer an economic resource it would not otherwise have had to transfer.
14O

If the economic benefits are obtained, or the action is taken, over time, the past-event condition is met, and the resulting present obligation accumulates, over that time.

 
14P

In some situations, an entity has an obligation to transfer an economic resource only if a measure of its activity in a period (the assessment period) exceeds a specific threshold. In such situations, the action that meets the past event condition is the activity that contributes to the total activity on which the amount of the transfer is assessed. At any date within the assessment period, the present obligation is a portion of the total expected obligation for the assessment period. It is the portion attributable to the activity carried out to date. The entity recognises a provision if the recognition criteria in paragraphs 14(b) and 14(c) are met — that is, if: (a) it is probable that the entity’s activity will exceed the threshold and the entity will be required to transfer an economic resource (see paragraph 14(b)); and (b) a reliable estimate can be made of the amount of the obligation (see paragraph 14(c)).
14Q

In some situations, an entity has an obligation to transfer an economic resource only if it takes two (or more) separate actions, and the requirement to transfer an economic resource is a consequence of taking both (or all) these actions. In such situations, the past-event condition is met when the entity has taken the first action (or any of the actions) and has no practical ability to avoid taking the second action (or all the remaining actions).
14R

A decision to prepare an entity’s financial statements on a going concern basis implies that the entity has no practical ability to avoid taking an action it could avoid only by liquidating the entity or by ceasing to trade.

 
Interactions between the obligation and past-event conditions

 

14S

The enactment of a new law is not in itself sufficient to create a present legal obligation for an entity. A present legal obligation arises only if, as a consequence of obtaining the economic benefits or of taking the action to which the law applies, the entity will or may have to transfer an economic resource it would not otherwise have had to transfer (see paragraph 14N).

 

14T

Similarly, having an established pattern of past practice, publishing a policy or making a statement is not in itself sufficient to create a present constructive obligation for an entity. A present constructive obligation arises only if, as a consequence of obtaining the economic benefits or of taking the action to which the practice, policy or statement applies, the entity will or may have to transfer an economic resource it would not otherwise have had to transfer (see paragraph 14N).

 

14U

[Derives from former paragraph 21] An action of the entity that does not give rise to a present obligation immediately might do so at a later date,

because a mechanism is introduced that imposes new responsibilities on the entity — a new law might be enacted, an existing law might be changed or the entity might establish a pattern of practice, publish a policy or make a statement that gives rise to a constructive obligation. For example, if an entity causes environmental damage, it might have no obligation to remedy the damage at the time of causing it. However, the  causing of the damage will be the past event that has created a present obligation if, at a later date, a new law requires the existing damage to be rectified, or if the entity accepts responsibility for rectification in a way that creates a constructive obligation.

 

Example 15 — Climate-related commitments

In 20X0 an entity that manufactures household products publicly states its commitments: (a) to gradually reduce its annual greenhouse gas emissions, reducing them by at least 60 per cent of their current level by 20X9; and (b) to offset its remaining annual emissions in 20X9 and in later years by buying carbon credits and retiring them from the carbon market.

To support its statement, the entity publishes a transition plan setting out how it will gradually modify its manufacturing methods between 20X1 and 20X9 to achieve the 60 per cent reduction in its annual emissions by 20X9. The modifications will involve investing in more energy-efficient processes, buying energy from renewable sources and replacing petroleum-based product ingredients and packaging materials with lower-carbon alternatives.

Management is confident that the entity can make all these modifications and continue to sell its products at a profit. In addition to publishing the transition plan, the entity takes several other actions that publicly affirm its commitments. Having considered all the facts and circumstances of the entity’s commitments — including the actions it has taken to affirm them — management judges that the entity’s statement has created a valid expectation in society at large that the entity will fulfil the commitments, and hence that it has no practical ability to avoid doing so (paragraph 14F(b)).

The entity is preparing financial statements for the year ended 31st December, 20X0. Present obligation to transfer an economic resource as a result of a past event three conditions specified in paragraph 14A of IAS 37 are not all met:

Obligation condition Met

The entity’s public statement of its commitments imposes on the entity responsibilities: (a) to operate in the future in a way that reduces its annual greenhouse gas emissions; and (b) to offset its remaining emissions if it emits greenhouse gases in 20X9 and later years (paragraph 14B(a)). The entity owes those responsibilities to society at large (paragraph 14B(b)). The entity has no practical ability to avoid discharging its responsibilities (paragraph 14B(c)). The obligations meet the definition of a constructive obligation (paragraph 10).
Transfer condition Not met Obligation to reduce emissions

The entity’s obligation to operate in the future in a way that reduces its greenhouse gas emissions is not an obligation to transfer an economic resource. Although the entity will incur expenditure in changing the way it operates, it will receive other economic resources — for example, property, plant and equipment, energy, product ingredients or packaging materials — in exchange, and will be able to use these resources to manufacture products it can sell at a profit (paragraph 14L).
Transfer condition Met Obligation to offset remaining emissions

The entity’s obligation to offset its remaining annual greenhouse gas emissions in 20X9 and later years is an obligation to transfer an economic resource. The entity will be required to buy and retire carbon credits without receiving any economic resources in exchange (paragraph 14I).
Past event condition Not met Obligation to offset remaining emissions

The entity has not yet taken the action (emitting gases in 20X9 or in a later year) as a consequence of  which it will have to buy and retire carbon credits it would not otherwise have had to buy or retire (paragraph 14N).

Conclusion — No provision is recognised at 31st December, 20X0.

If the entity emits greenhouse gases in 20X9 and in later years, it will incur a present obligation to offset these past emissions when it emits the gases. If, at that time, the entity has not settled the present obligation and it is probable that it will have to transfer an economic resource to do so, the entity will recognise a provision for the best estimate of the expenditure required.

Although the entity does not recognise a provision for its constructive obligations at 31st December, 20X0, the actions it plans to take to fulfil the obligations could affect the amounts at which it measures its other assets and liabilities (for example, its property, plant and equipment), and the information it discloses about them, as required by various IFRS Accounting Standards.

As can be seen from the above example, the ED provides much more clarity on whether a provision is required and in a very methodical and step-by-step manner. Similar changes can be expected under Ind AS.

Segment Disclosures under Ind AS 108

Recently the IFRS Interpretations Committee (IFRIC) clarified on a few issues relating to segment disclosures required under Ind AS 108 Operating Segments.

An entity is required to report a measure of total assets and liabilities for each reportable segment, if such amounts are regularly provided to the chief operating decision maker (CODM). Further specific disclosures are required, of certain items, for each reportable segment, if those amounts are included in the measurement of the segment profit or loss, reviewed by the CODM or if those items are regularly provided to the CODM, even if those items were not included in measuring the segment profit or loss.

Paragraph 23 of Ind AS 108 which sets out the above requirement is reproduced below:

An entity shall report a measure of profit or loss for each reportable segment. An entity shall report a measure of total assets and liabilities for each reportable segment if such amounts are regularly provided to the chief operating decision maker. An entity shall also disclose the following about each reportable segment if the specified amounts are included in the measure of segment profit or loss reviewed by the chief operating decision maker, or are otherwise regularly provided to the chief operating decision maker, even if not included in that measure of segment profit or loss:

a) revenues from external customers;

b) revenues from transactions with other operating
segments of the same entity;

c) interest revenue;

d) interest expense;

e) depreciation and amortisation;

f) material items of income and expense disclosed in accordance with paragraph 97 of Ind AS 1, Presentation of Financial Statements;

g) the entity’s interest in the profit or loss of associates and joint ventures accounted for by the equity method;

h) income tax expense or income; and

i) material non-cash items other than depreciation and amortisation.

An entity shall report interest revenue separately from interest expense for each reportable segment unless a majority of the segment’s revenues are from interest and the chief operating decision maker relies primarily on net interest revenue to assess the performance of the segment and make decisions about resources to be allocated to the segment. In that situation, an entity may report that segment’s interest revenue net of its interest expense and disclose that it has done so.

IFRIC reiterated that paragraph 23 of Ind AS 108 requires an entity to disclose the specified amounts for each reportable segment when those amounts are:

  • included in the measure of segment profit or loss reviewed by the CODM, even if they are not separately provided to or reviewed by the CODM, or
  • regularly provided to the CODM, even if they are not included in the measure of segment profit or loss.

The other clarification provided was with respect to materiality in the context of segment disclosures.

Before we jump to the issue, let us first quote certain important paragraphs under Ind AS 1 Presentation of Financial Statements:

PARAGRAPH 7: MATERIALITY

Information is material if omitting, misstating or obscuring it could reasonably be expected to influence decisions that the primary users of general purpose financial statements make on the basis of those financial statements, which provide financial information about a specific reporting entity.

Materiality depends on the nature or magnitude of information, or both. An entity assesses whether information, either individually or in combination with other information, is material in the context of its financial statements taken as a whole.

Information is obscured if it is communicated in a way that would have a similar effect for primary users of financial statements to omitting or misstating that information. The following are examples of circumstances that may result in material information being obscured: (a) information regarding a material item, transaction or other event is disclosed in the financial statements but the language used is vague or unclear; (b) information regarding a material item, transaction or other event is scattered throughout the financial statements; (c) dissimilar items, transactions or other events are inappropriately aggregated;(d) similar items, transactions or other events are inappropriately disaggregated; and (e) the understandability of the financial statements is reduced as a result of material information being hidden by immaterial information to the extent that a primary user is unable to determine what information is material.

Assessing whether information could reasonably be expected to influence decisions made by the primary users of a specific reporting entity’s general purpose financial statements requires an entity to consider the characteristics of those users while also considering the entity’s own circumstances.

PARAGRAPHS 30–31: AGGREGATION

30. Financial statements result from processing large numbers of transactions or other events that are aggregated into classes according to their nature or function. The final stage in the process of aggregation and classification is the presentation of condensed and classified data, which form line items in the financial statements. If a line item is not individually material, it is aggregated with other items either in those statements or in the notes. An item that is not sufficiently material to warrant separate presentation in those statements may warrant separate presentation in the notes.

30A When applying this and other Ind ASs an entity shall decide, taking into consideration all relevant facts and circumstances, how it aggregates information in the financial statements, which include the notes. An entity shall not reduce the understandability of its financial statements by obscuring material information with immaterial information or by aggregating material items that have different natures or functions.

31 Some Ind ASs specify information that is required to be included in the financial statements, which include the notes. An entity need not provide a specific disclosure required by an Ind AS if the information resulting from that disclosure is not material except when required by law. This is the case even if the Ind AS contains a list of specific requirements or describes them as minimum requirements. An entity shall also consider whether to provide additional disclosures when compliance with the specific requirements in Ind AS is insufficient to enable users of financial statements to understand the impact of particular transactions, other events and conditions on the entity’s financial position and financial performance.

PARAGRAPH 97: DISCLOSURE REQUIREMENTS

97 When items of income or expense are material, an entity shall disclose their nature and amount separately.

A question arises as to the meaning of ‘material items of income and expense’ in the context of paragraph 97 of Ind AS 1 as referenced in paragraph 23(f) of Ind AS 108.

MATERIAL ITEMS OF INCOME AND EXPENSE

Paragraph 23(f) of Ind AS 108 sets out one of the required ‘specified amounts’, namely, ‘material items of income and expense disclosed in accordance with paragraph 97 of Ind AS 1’. Paragraph 97 of Ind AS 1 states that ‘when items of income or expense are material, an entity shall disclose their nature and amount separately’.

Definition of ‘Material’

Paragraph 7 of Ind AS 1 defines ‘material’ and states ‘information is material if omitting, misstating or obscuring it could reasonably be expected to influence decisions that the primary users of general purpose financial reports make on the basis of those financial statements, which provide financial information about a specific reporting entity’.

Paragraph 7 of Ind AS 1 also states that ‘materiality depends on the nature or magnitude of information, or both. An entity assesses whether information, either individually or in combination with other information, is material in the context of its financial statements taken as a whole’.

Aggregation of information

Paragraphs 30–31 of Ind AS 1 provide requirements about how an entity aggregates information in the financial statements, which include the notes. Paragraph 30A of Ind AS 1 states that ‘an entity shall not reduce the understandability of its financial statements by obscuring material information with immaterial information or by aggregating material items that have different natures or functions’.

Applying paragraph 23(f) of Ind AS 108 – material items of income and expense

IFRIC clarified that, when Ind AS 1 refers to materiality, it is in the context of ‘information’ being material. An entity applies judgement in considering whether disclosing, or not disclosing, information in the financial statements could reasonably be expected to influence decisions users of financial statements make on the basis of those financial statements.

IFRIC clarified, in applying paragraph 23(f) of Ind AS 108 by disclosing, for each reportable segment, material items of income and expense disclosed in accordance with paragraph 97 of Ind AS 1, an entity:

a) applies paragraph 7 of Ind AS 1 and assesses whether information about an item of income and expense is material in the context of its financial statements taken as a whole;

b) applies the requirements in paragraphs 30–31 of Ind AS 1 in considering how to aggregate information in its financial statements

c) considers the nature or magnitude of information—in other words, qualitative or quantitative factors — or both, in assessing whether information about an item of income and expense is material; and

d) considers circumstances including, but not limited to, those in paragraph 98 of Ind AS 1.

Furthermore, paragraph 23(f) of Ind AS 108 does not require an entity to disclose by reportable segment each item of income and expense presented in its statement of profit or loss or disclosed in the notes. In determining information to disclose for each reportable segment, an entity applies judgement and considers the core principle of Ind AS 108 — which requires an entity to disclose information 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.

Accounting for Coaching Fees

Educational institutions receive fees from students for an entire financial year, though the coaching is imparted over an academic year, which may be shorter, let’s say, 10 months, followed by a two-month vacation. An interesting question arises, whether the student fees are recognised equally over 10 months or 12 months. It appears there are mixed practices on how the fees are recognised. Whilst the fact pattern discussed herein relates to coaching or tuition fees, similar question arises in numerous other service industries, for example, sports and broadcasting services or provision of maintenance services in IT and construction industries. Both the views are discussed herein, followed by author’s view on the more appropriate view.

QUERY

With respect to an educational institution:

(a) Students attend the educational institution  for approximately 10 months of the year (academic  year) and have a summer break of approximately two months;

(b) During the summer break, the school’s academic staff take a four-week holiday and use the rest of the time:

(i) to wrap-up the school year just ended (for example, marking tests and issuing certificates); and

(ii) to prepare for the next school year (for example, administering re-sit exams for students who failed in the previous school year and developing schedules and teaching materials); and

(c) during the four-week period in which academic staff are on holiday:

(i) the academic staff continue to be employed by, and receive salary from, the educational institution but they provide no teaching services and do not undertake other activities relating to the provision of educational services;

(ii) non-academic staff of the educational institution provides some administrative support, for example, responding to email enquiries and requests for past records; and

(iii) the educational institution continues to receive and pay for services such as IT services and cleaning.

What should be the period over which the educational institution recognises revenue — that is, evenly over the academic year (10 months), evenly over the financial year (12 months) or a different period?

RESPONSE

Accounting Standard References

(These are provided in Annexure 1)

DISCUSSION

There are two differing views on the matter:
(View 1) General education revenue should be recognised over an academic year that starts and ends on dates determined by the school calendar (approximately 10 months).

Revenue from general education services should be recognised in accordance with Ind AS 115 Revenue from Contracts with Customers, paragraph 2, which requires an entity to “recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.” In the case under consideration, the promised service to be transferred to customers is the general education, and the consideration to which the entity expects to be entitled in exchange for this service is the tuition fees receivable from students. Ind AS 115, para. 31, states that “An entity shall recognize revenue when (or as) the entity satisfies a performance obligation by transferring a promised good or service to a customer.” Since the general education service is transferred over school semesters, related revenues should be recognised over that period (i.e., 10 months), as required by paragraphs 35–37.

The educational institution does not transfer to customers a significant good or service that is distinct or that can be integrated with other services as required by Ind AS 115 that are directly related to the contracted general education services during the summer vacation. The fact that a student remains enrolled in the school during the summer vacation or that a school maintains student files during that vacation does not constitute a performance.

The entity does not deliver during the summer vacation significant education services closely related to the general education service promised and delivered during the academic year. Further, an entity satisfies its promise to transfer the education service during the academic year independently of the services delivered during the summer vacation (if any); no part of the transaction price should be allocated to the vacation.

For the obligation of an entity to administer a re-sit exam for a student who fails in final exams, it is a rare case and is de minimis relative to the education service arrangement as a whole, and it may be ignored. Alternatively, an entity should be able to estimate the number of those students based on historical information and can allocate a portion of the transaction price received from contracts in respect of those students who are required to re-sit examinations, in proportion to its efforts to satisfy the performance obligation of administering the re-sit exam, normally at the beginning of the next school year.

The delivery of the general education service necessitates preparation activities before students coming back from their vacation and starting the school year (for example, preparation of classrooms and development of school schedules and work papers at the beginning of the school year). It, also, necessitates closing activities of the school year (for example, examination paper marking, determining results and preparing academic certificates). Hence, these activities can be seen as an integral part of the performance obligation (general education service) stated in the contract that is satisfied during the academic year. Consequently, they are not distinct and should not be treated as separate performance obligations.

Since the academic staff is contracted only to deliver the general education service over the school year, their remuneration during their vacation should be considered as a cost to be charged to the same period in which revenue from the related general education service is recognised (i.e., over the academic year, i.e., 10 months).

(View 2) General education revenue should be recognised on a straight line basis over the financial year, including the summer vacation after related academic year (12 months).

Para. 16 of Ind AS 115 requires an entity to recognise the consideration received from a customer as a liability until one of the events in paragraph 15 occurs; i.e., the contract has been terminated or the entity has no remaining obligations to the customer. In the case under consideration, the contract with the customer has not been terminated at the end of the school year. In addition, the contractual relationship and provided services are not restricted to teaching activities that are carried out inside classrooms and concluded at the end of the academic year. Rather, they include following services that are provided after the end of the academic year (throughout the financial year):

(a) Marking examinations
(b) Administering re-sit exams,
(c) Issuing certificates and announcing results
(d) Delivering certificates
(e) Delivering student (customer) files when requested

An entity is obligated to provide to customers above services throughout the financial year, not just by the end of the academic year. Hence, the contractual relationship and obligations of the entity towards a customer exist during the whole financial year. Para. 27(a) defines a good or service that is promised to a customer as a good or service that “the customer can benefit from on its own or…”. In the case under consideration, the assumption that the provided service is restricted to teaching activities that are concluded by the end of the academic year and the customer can benefit from such service on its own is not correct since the customer needs to receive, among other services, certificates and files which are delivered after the end of the academic year and throughout the whole financial year.

Applying paras. 29–30, the provided service is not restricted to teaching activities and it is inseparable from other services (certificates, examinations, etc.). Consequently, requirement in para. 30 applies (the entity accounts for all the goods or services promised in a contract as a single performance obligation).

Applying paras. 31–33 that require an entity to recognise revenue when the customer obtains control of the asset, the customer in the general education industry should receive the academic certificate and student files and move on to the following grade in the same or another educational institution, failing which the customer would not be able to obtain the service (control) in full.

In accordance with para. 33 that explains the use of an asset by and the transfer of benefits to a customer, to obtain benefits from the asset in the case under consideration, the student (customer) should receive the academic certificate and student file to deliver them to another education entity or use them in joining the labour market or enrolling in a university.

For all reasons above, teaching activities are not separable from subsequent services (certificates and files) and, consequently, teaching activities alone, without such services, do not enable the customer to obtain control of the asset.

CONCLUSION

Both Views 1 and 2 appear to be based on certain arguments that may find support in the standard. However, View 1 appears to be a more appropriate view, keeping in mind that the main service provided in the contract is the coaching of the students, and other things, such as correcting the papers, and providing a mark sheet, are incidental to the coaching services provided. Therefore, the author supports View 1 only.

ANNEXURE 1

Paragraph 2
…the core principle of this Standard is that an entity shall recognise revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.

Paragraph 15
…the entity shall recognise the consideration received as revenue only when either of the following events has occurred: (a) the entity has no remaining obligations to transfer goods or services to the customer and all, or substantially all, of the consideration promised by the customer has been received by the entity and is non-refundable; or (b) the contract has been terminated and the consideration received from the customer is non-refundable.

Paragraph 16
An entity shall recognise the consideration received from a customer as a liability until one of the events in paragraph 15 occurs….

Paragraph 27
A good or service that is promised to a customer is distinct if both of the following criteria are met: (a) the customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer (i.e., the good or service is capable of being distinct); and (b) the entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract (i.e., the good or service is distinct within the context of the contract).

Paragraph 29
Factors that indicate that an entity’s promise to transfer a good or service to a customer is separately identifiable (in accordance with paragraph 27(b) include, but are not limited to, the following: (a) the entity does not provide a significant service of integrating the good or service with other goods or services promised in the contract into a bundle of goods or services that represent the combined output for which the customer has contracted. In other words, the entity is not using the good or service as an input to produce or deliver the combined output specified by the customer; (b) the good or service does not significantly modify or customise another good or service promised in the contract; (c) the good or service is not highly dependent on, or highly interrelated with, other goods or services promised in the contract. For example, the fact that a customer could decide to not purchase the good or service without significantly affecting the other promised goods or services in the contract might indicate that the good or service is not highly dependent on, or highly interrelated with, those other promised goods or services.

Paragraph 30
If a promised good or service is not distinct, an entity shall combine that good or service with other promised goods or services until it identifies a bundle of goods or services that is distinct. In some cases, that would result in the entity accounting for all the goods or services promised in a contract as a single performance obligation.

Paragraph 31
An entity shall recognise revenue when (or as) the entity satisfies a performance obligation by transferring a promised good or service (i.e., an asset) to a customer. An asset is transferred when (or as) the customer obtains control of that asset.

Paragraph 33
…Control of an asset refers to the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset. Control includes the ability to prevent other entities from directing the use of, and obtaining the benefits from, an asset. The benefits of an asset are the potential cash flows (inflows or savings in outflows) that can be obtained directly or indirectly in many ways, such as by:

(a) using the asset to produce goods or provide services (including public services); (b) using the asset to enhance the value of other assets; ….

Paragraph 35
An entity transfers control of a good or service over time and, therefore, satisfies a performance obligation and recognises revenue over time if one of the following criteria is met: (a) the customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs (see paragraphs B3–B4); (b) the entity’s performance creates or enhances an asset (for example, work in progress) that the customer controls as the asset is created or enhanced (see paragraph B5); (c) or the entity’s performance does not create an asset with an alternative use to the entity (see paragraph 36) and the entity has an enforceable right to payment for performance completed to date (see paragraph 37).

Paragraph 36
An asset created by an entity’s performance does not have an alternative use to an entity if the entity is either restricted contractually from readily directing the asset for another use during the creation or enhancement of that asset or limited practically from readily directing the asset in its completed state for another use. The assessment of whether an asset has an alternative use to the entity is made at contract inception. After contract inception, an entity shall not update the assessment of the alternative use of an asset unless the parties to the contract approve a contract modification that substantively changes the performance obligation. Paragraphs B6–B8 provide guidance for assessing whether an asset has an alternative use to an entity.

Paragraph 37
An entity shall consider the terms of the contract, as well as any laws that apply to the contract, when evaluating whether it has an enforceable right to payment for performance completed to date in accordance with paragraph 35(c). The right to payment for performance completed to date does not need to be for a fixed amount. However, at all times throughout the duration of the contract, the entity must be entitled to an amount that at least compensates the entity for performance completed to date if the contract is terminated by the customer or another party for reasons other than the entity’s failure to perform as promised. Paragraphs B9–B13 provide guidance for assessing the existence and enforceability of a right to payment and whether an entity’s right to payment would entitle the entity to be paid for its performance completed to date.

Contingent Features and SPPI Test

IASB has amended IFRS 9 and IFRS 7 with respect to contingent features, which will take effect from reporting periods beginning on or after 1st January, 2026. We can expect similar amendments in Ind AS in the near term, probably taking effect from 1st April, 2026. The amendments provide some leeway, such that the SPPI test will be considered met even if there are contingent features in an instrument, that alter the contractual cash flows. The amendments were introduced to provide some relief in situations where contractual cash flows are altered because of reduction in carbon emissions. The amendments will apply to all contingent features including those relating to carbon emissions. In this article, the author has provided the existing requirements and the amendments in a very simplified question and answer format.

FINANCIAL ASSETS AND AMORTISED COST

Which are the financial assets that can be classified under the ‘amortised cost’ category?

A ‘debt instrument’ can be measured at the amortised cost if both the following conditions are met:

(a) The asset is held within a business model whose objective is to hold assets for collecting contractual cash flows, and

(b) Contractual terms of the asset give rise on specified dates to cash flows that are solely payments of principal and interest (SPPI) on the principal amount outstanding.

Financial assets included within this category are initially recognised at fair value plus transaction costs that are directly attributable to the acquisition of the financial asset and subsequently measured at amortised cost. The following diagram explains the classification requirements.

FVTOCI is Fair Value through Other Comprehensive Income.

FVTPL is Fair Value through Profit and Loss.

CONTRACTUAL CASH FLOWS

ANALYSIS — SPPI TEST

After assessing the business model, the entity should assess whether the asset’s contractual cash flows represent solely payments of principal and interest (SPPI). This test is also referred to as the ‘SPPI’ test.

What is the relevance of SPPI test for deciding classification of financial assets?

SPPI test is required to decide whether an instrument structured as ‘debt instrument’ actually has the ‘basic loan features’. Ind AS 109 allows amortisation or FVTOCI measurement categories only for the debt instruments which satisfy the SPPI test. All other debt instruments need to be classified as at FVTPL, irrespective of the business model.

The SPPI is designed to weed out financial assets on which the application of the effective interest rate (EIR) method either is not viable from a pure mechanical standpoint or does not provide decision useful information. Since the EIR is a mechanism to allocate interest over time, Ind AS 109 allows measurements requiring the use of this methodology only for the instruments having low variability such as traditional unleveraged loans and receivables and ‘plain vanilla’ debt instruments. Thus, the SPPI test is based on the premise that contractual cash flows should give the holder a return which is in line with a ‘basic lending arrangement’.

Are the terms ‘principal’ and ‘interest’ defined for SPPI test?

Ind AS 109 provides the following definitions to help management in making a preliminary assessment of whether contractual cash flows represent SPPI:

Principal: is the fair value of the financial asset at initial recognition. However, that principal amount may change over the life of the financial asset, e.g., if there are repayments of principal.

Interest: Is typically the compensation for the time value of money and credit risk. However, interest can also include consideration for other basic lending risks (for example, liquidity risk) and costs (for example, servicing or administrative costs) associated with holding the financial asset for a period of time, as well as a profit margin.

Consider that contractual provisions of a debt instrument contain clauses which may modify the cash flows of an instrument. How should an entity assess the impact of modifications? Does it mean that SPPI test will not be met?

Ind AS 109 requires that if contractual provisions of an instrument contain elements that modify the time value of money, the entity should compare the financial asset under assessment to a standard/ benchmark instrument without any modification in the time value of money. If cash flows of the two instruments are significantly different, the instrument under assessment fails the SPPI test. If the cash flows of the two instruments are not significantly different, the instrument with modified cash flows will also meet the SPPI test.

The standard clarifies that it will be not necessary for an entity to perform a detailed quantitative assessment if it is clear with little or no analysis that cash flows of the instrument under assessment and those of the benchmark instrument are or are not significantly different.

The standard does not provide any specific guidance or bright-lines to be used for deciding whether cash flows of two instruments are ‘significantly different’. This will require entities to exercise judgment. For example, less than 5 per cent difference in cash flows in each reporting period as well as cumulatively over the life of the asset may not be significant. However, 20 per cent difference either in a reporting period or cumulatively over the life of the asset is likely to be significant.

Is an entity required to consider all features of the instruments while performing SPPI test?

In performing SPPI test, an entity can ignore de minimis features and non-genuine features.

The de minimis threshold is about magnitude of modification. To be considered de minimis, the impact of feature on the cash flows needs to be de minimis in each reporting period as well as cumulatively over the life of the asset. For example, a feature will not be considered de minimis if it could lead to a significant increase in cash flows in one period and a significant decrease in another period and the amounts offset each other on a cumulative basis. Similarly, if the impact of the feature on the cash flows of each individual period is always de minimis but its cumulative effect over time is more than de minimis; such a feature cannot be considered de minimis.

Ind AS 109 does not specify whether an entity should perform qualitative or quantitative analysis to determine whether a feature is de minimis. The author believes that in most cases, an entity should be able to conclude this without a quantitative analysis.

If a ₹10 million loan contains an early repayment clause which, if exercised, requires repayment of outstanding principal and interest plus ₹100, the additional ₹100 would have only a de minimis impact to cash flows in all circumstances. It is clearly trivial and negligible.

When assessing if a feature is de minimis an entity is not permitted to take into account the probability that the future event will occur, unless the contingent feature is not genuine. De minimis must be assessed at the individual financial asset level and not at some higher level, for example at a portfolio or entity level, because what is not de minimis at the financial instrument level may be de minimis at the portfolio level. Additionally, the assessment should be made by reference to all the cash flows of an instrument (principal and interest).

Non-genuine features are contingent features. A contingent feature is not genuine if it affects the instrument’s contractual cash flows only on the occurrence of an event that is extremely rare, highly abnormal and very unlikely to occur. This implies that although a non-genuine feature can potentially lead to cash flows to significant changes in cash flows, its existence in the contract provisions will not fail the SPPI test. Disregarding non-genuine features also means that classification requirements cannot be overridden by introducing a contractual non-genuine cash flow characteristic to achieve a specific accounting outcome. A clause should not be considered ‘not genuine’ just because historically the relevant event has not occurred. If a clause is ‘not genuine’ the fair value and pricing of the instrument would also be expected to be the same regardless of whether or not the clause is included.

A contract issued at par permits the issuer to repay the debt instrument, or the holder to put the debt instrument back to the issuer before maturity at par, when the BSE 100 index reaches a specific level. When the contingent event takes place, it results in a pre-payment that represents unpaid amounts of principal and interest on the principal amount outstanding. Does this always pass the SPPI test?

Yes. The contingent event (the BSE100 index reaching a specific level) changes the timing of the cash flows, but it still results in the redemption of the debt for an amount equal to par plus accrued interest. Therefore, it will always pass the SPPI test, because the cash flows still represent solely payments of principal and interest on the principal amount outstanding. If, on the other hand, the debt instrument was issued at a discount, but it is repayable at par, this may represent compensation to the issuer for the BSE 100 achieving the target level, which is inconsistent with SPPI.

Ve Co borrows ₹100 million from a bank. The borrowing agreement permits the bank to demand early repayment if Ve’s credit rating falls by more than two notches compared with the credit rating at origination. Is the SPPI test met in this case?

The contingent feature within the early repayment term is consistent with a return of principal and interest on the principal outstanding because the contingent event is directly linked to the credit risk of the borrower, i.e. the prepayment option is designed to provide the lender with the protection from the adverse changes in credit quality of the borrower. The credit risk of the borrower is a risk that is reflected in a basic lending arrangement. Therefore, SPPI test is met.

IFRS 9 AND IFRS 7 AMENDMENTS

The amendments introduce an additional test for financial assets with contingent features to meet SPPI test if contingent feature does not change in basic lending risks or costs, e.g. the interest rate on a loan is adjusted by a specified amount if the borrower achieves a contractually specified reduction in carbon emissions. Under this example, returns have changed due to a contingent event and credit risks (lending risk) of borrower will remain unchanged.

While the amendments may allow certain financial assets with contingent features to meet the SPPI criterion, companies may need to perform additional work to prove this. Judgement will be required in determining whether the new test is met.

IASB has introduced following additional SPPI test:

IASB has prescribed corresponding additional disclosures for financial instruments with a contingent feature that is not measured at fair value through profit and loss:

  • a qualitative description of the nature of the contingent event
  • quantitative information about the range of possible changes to contractual cash flows that could result from those contractual terms
  • the gross carrying amount of financial assets and the amortised cost of financial liabilities subject to those contractual terms.

Date of Capitalisation of Property, Plant and Equipment

The date of capitalisation is very significant in the case of property, plant and equipment. This is the date on which the assessment of useful life and residual value is made, and depreciation commences. Other than in accounting, it has tremendous significance with respect to determining depreciation for tax purposes as well. Consider a simple situation, Mr X purchased a car but is unable to drive it, because he does not yet have a driving license. It takes him a year, to get a driving license, after which he starts running the car, which was lying idle till then. The question is whether the depreciation should commence on date of purchase of the car or the date when Mr X starts running the car. This article deals with this basic and other related questions.

QUERY

Energy Limited (Energy) has one engine that is part of a bigger machine and is being used to produce energy for the plant. Energy has a stand-by engine which is a backup to the first engine. The stand-by engine will be put to use only if the first engine fails or is otherwise rendered out of service. Though the stand-by engine is necessary to ensure continuity of production in the event of failure of the first engine; it is less likely that it will ever be put to use or used immediately on the date of its purchase. The useful life of the bigger machine is 50 years, and the first engine is 20 years. The useful life of the stand-by engine is likely to be much greater than 20 years, even after factoring technological obsolescence, because it will remain mostly idle — let’s say 25 years. Both the engines are of the same type and cost ₹2,50,000 each.

Further, assume, though the first engine was expected to be used for 20 years, it could be used only for 15 years due to some exceptional incident. After 15 years, the first engine was replaced with the stand-by engine.

Further, the first engine had no significant value and would have to be scrapped (the scrap value is ignored because it is immaterial). Energy uses the Straight-Line Method (SLM) of depreciation. The exceptional incident does not warrant any review or change in the useful life of the stand-by engine.

With these simple facts, Energy has the following questions?

1. What is the date of capitalisation of the stand-by engine and when does the depreciation commence? Should the depreciation commence when the first engine fails and the stand-by engine is installed and used within the bigger machine?

2. How is the first engine accounted for and depreciated?

3. How is the replacement of the first engine with the stand-by engine accounted for at the end of 15 years?

RESPONSE

Accounting Standard References in Ind AS 16 Property, Plant and Equipment

Definitions

Property, plant and equipment are tangible items that:

(a) are held for use in the production or supply of goods or services, for rental to others, or for administrative purposes; and (b) are expected to be used during more than one period.

Useful life is: (a) the period over which an asset is expected to be available for use by an entity; or (b) the number of production or similar units expected to be obtained from the asset by an entity.

Paragraph 8

Spare parts and servicing equipment are usually carried as inventory and recognised in profit or loss as consumed. However, major spare parts, stand-by equipment and servicing equipment qualify as property, plant and equipment when an entity expects to use them for more than one period.

Paragraph 13

Parts of some items of property, plant and equipment may require replacement at regular intervals. For example, a furnace may require relining after a specified number of hours of use, or aircraft interiors such as seats and galleys may require replacement several times during the life of the airframe. Items of property, plant and equipment may also be acquired to make a less frequently recurring replacement, such as replacing the interior walls of a building, or to make a non-recurring replacement. Under the recognition principle in paragraph 7, an entity recognises in the carrying amount of an item of property, plant and equipment the cost of replacing part of such an item when that cost is incurred if the recognition criteria are met. The carrying amount of those parts that are replaced is derecognised in accordance with the derecognition provisions of this Standard.

Paragraph 55

Depreciation of an asset begins when it is available for use, ie when it is in the location and condition necessary for it to be capable of operating in the manner intended by management. Depreciation of an asset ceases at the earlier of the date that the asset is classified as held for sale (or included in a disposal group that is classified as held for sale) in accordance with Ind AS 105 and the date that the asset is derecognised. Therefore, depreciation does not cease when the asset becomes idle or is retired from active use unless the asset is fully depreciated. However, under usage methods of depreciation the depreciation charge can be zero while there is no production.

Analysis and Conclusions

It may be noted that both the first engine and the stand- by engine are equipment in their own right. Since both the engines are used to generate electricity (as part of a bigger machine) and have a useful life beyond more than one accounting period, they will be classified as property, plant and equipment in accordance with the definition of property, plant and equipment and paragraph 8 enumerated above.

For the purposes of depreciation, both the first engine and stand-by engine are treated as separate equipment as suggested in paragraph 13 of the Standard and will be depreciated as per their respective useful life. A point to be noted is that though the first engine and the stand- by engine are the same, they have different useful lives depending on the purpose and how they are used.

Now let us proceed to answer the questions raised.

Ind AS 16 defines property, plant and equipment as tangible items that: (i) are held for use in the production or supply of goods or services, for rental to others, or for administrative purposes, and (ii) are expected to be used during more than one period. However, it is not necessary that their use should be regular. Therefore, stand-by engine should be capitalised and depreciated from the date it becomes available for use (i.e., when it is in the location and condition necessary for it to be capable of being operated in the manner intended by the management).

In this case, intended use of the standby-engine is to act as back-up for the first engine. Hence, the company should start depreciating stand-by engine from the day it is ready for the use as back-up. The company cannot postpone the commencement of depreciation till the date stand-by engine is actually put to use for producing energy. Since the stand-by engine is available for use immediately, its depreciation should start from the date of purchase itself.

The stand-by engine will be depreciated over its useful life which is 25 years starting from the date of purchase. Therefore, each year it will be depreciated by ₹10,000 (250,000/25), starting from the date of purchase. This is in accordance with paragraph 55 of the Standard enumerated above.

The first engine will be depreciated over its useful life, i.e., 20 years, which works out to ₹12,500 (250,000/20) each year. A point to be noted is that though the first engine and the stand-by engine are the same, they have different useful lives and will be depreciated according to their respective useful lives.

From the facts as stated in the case, the first engine is replaced by the stand-by engine at the end of 15 years, due to some exceptional situation. The written down value of the first engine at the end of 15 years is ₹62,500 (250,000 less 12,500 * 15 years). In accordance with paragraph 13 of the Standard, this amount will be derecognised and debited to the profit or loss account.

The stand-by engine will continue to be depreciated at ₹10,000 each year, assuming there is no change in the assumption regarding its useful life.

Ind AS 2023 Amendments – Ind AS 1 Presentation of Financial Statements

DISCLOSURE OF ACCOUNTING POLICY INFORMATION

Ind AS 1 Presentation of Financial Statements is amended to require disclosure of material accounting policy information, instead of disclosure of significant accounting policies. Because ‘significant’ is not defined in Ind AS Standards, entities can have difficulty assessing whether an accounting policy is ‘significant’ and understanding the difference, if any, between ‘significant’ and ‘material’ accounting policies. Because ‘material’ is defined in Ind AS Standards and is well understood by stakeholders, the standard setters decided to require entities to disclose their material accounting policy information instead of their significant accounting policies.

Accounting policy information is material if, when considered together with other information included in an entity’s financial statements, it can reasonably be expected to influence decisions that the primary users of general-purpose financial statements make on the basis of those financial statements. An entity shall apply the change for annual reporting periods beginning on or after
1st April, 2023.

Accounting policy information that relates to immaterial transactions, other events or conditions is immaterial and need not be disclosed. Accounting policy information may nevertheless be material because of the nature of the related transactions, other events or conditions, even if the amounts are immaterial. However, not all accounting policy information relating to material transactions, other events or conditions is itself material.

Accounting policy information is expected to be material if users of an entity’s financial statements need it to understand other material information in the financial statements. For example, an entity is likely to consider accounting policy information material to its financial statements if that information relates to material transactions, other events or conditions and:

(a) the entity changed its accounting policy during the reporting period and this change resulted in a material change to the information in the financial statements;

(b) the entity chose the accounting policy from one or more options permitted by Ind ASs;

(c) the accounting policy was developed in accordance with Ind AS 8 Accounting Policies, Changes in Accounting Estimates and Errors in the absence of an Ind AS that specifically applies;

(d) the accounting policy relates to an area for which an entity is required to make significant judgements or assumptions in applying an accounting policy, and the entity discloses those judgements or assumptions in accordance with paragraphs 122 and 125 of Ind AS 1; or

(e) the accounting required for them is complex and users of the entity’s financial statements would otherwise not understand those material transactions, other events or conditions — such a situation could arise if an entity applies more than one Ind AS to a class of material transactions.

Since the above list is not exhaustive, entities also need to consider if there are any other qualitative factors that would make accounting policy information material to the financial statements. For example, an entity could act as a principal in some classes of transactions and as an agent in other similar transactions depending on whether it controls the goods or services before transferring them to the customer or not. In such instances, in addition to the disclosures about significant judgements, a primary user could require accounting policy information explaining the two situations and the accounting policy differences to understand the related information in the financial statements.

Accounting policy information that focuses on how an entity has applied the requirements of the Ind ASs to its own circumstances provides entity-specific information that is more useful to users of financial statements than standardised information, or information that only duplicates or summarises the requirements of the Ind ASs.If an entity discloses immaterial accounting policy information, such information shall not obscure material accounting policy information. An entity’s conclusion that accounting policy information is immaterial does not affect the related disclosure requirements set out in other Ind ASs. For example, if an entity applying the amendments decides that accounting policy information about intangible assets is immaterial to its financial statements, the entity would still need to disclose the information required by Ind AS 38 Intangible Assets that the entity had determined to be material.

An entity shall disclose, along with material accounting policy information or other notes, the judgements, apart from those involving estimations, that management has made in the process of applying the entity’s accounting policies and that have the most significant effect on the amounts recognised in the financial statements.

In many cases, information about the measurement basis (or bases) used in preparing the financial statements is material. However, in some cases, the measurement basis (or bases) used for a particular asset or liability would not be material and, therefore, would not need to be disclosed. For example, information about a measurement basis might be immaterial if:

(a) an Ind AS Standard required an entity to use a measurement basis—in which case an entity would not apply choice or judgement in complying with the Standard; and

(b) information about the measurement basis would not be needed for users to understand the related material transactions, other events or conditions.

In assessing whether accounting policy information is material to its financial statements, an entity considers whether users of the entity’s financial statements would need that information to understand other material information in the financial statements. An entity makes this assessment in the same way it assesses other information: by considering qualitative and quantitative factors. The diagram below illustrates how an entity assesses whether accounting policy information is material and, therefore, shall be disclosed.

Entity-specific qualitative factors include the involvement of related parties, uncommon or non-standard features in transactions, other events or conditions and unexpected variations or changes in trends. The context in which the entity operates could also impact the relevance of information to the primary users; this is referred to as external qualitative factors. Examples include geographical locations, industry sector, and the state of the economy in which the entity operates. Sometimes the absence of an external qualitative factor is relevant, for example, if the entity is not exposed to a certain risk to which many other entities in its industry are exposed, information about that lack of exposure could be material information

Determining whether accounting policy information is material

Paragraph 117B of Ind AS1 includes examples of circumstances in which an entity is likely to consider accounting policy information to be material to its financial statements. The list is not exhaustive but provides guidance on when an entity would normally consider accounting policy information to be material.

Paragraph 117C of Ind AS 1 describes the type of material accounting policy information that users of financial statements find most useful. Users generally find information about the characteristics of an entity’s transactions, other events or conditions—entity-specific information—more useful than disclosures that only include standardised information or information that duplicates or summarises the requirements of the Ind AS Standards. Entity-specific accounting policy information is particularly useful when that information relates to an area for which an entity has exercised judgment—for example, when an entity applies an Ind AS Standard differently from similar entities in the same industry.

Although entity-specific accounting policy information is generally more useful, material accounting policy information could sometimes include information that is standardised, or that duplicates or summarises the requirements of the Ind AS Standards. Such information may be material if, for example:

a. users of the entity’s financial statements need that information to understand other material information provided in the financial statements. Such a scenario might arise when an entity applying Ind AS 109 Financial Instruments has no choice regarding the classification of its financial instruments. In such scenarios, users of that entity’s financial statements may only be able to understand how the entity has accounted for its material financial instruments if users also understand how the entity has applied the requirements of Ind AS 109 to its financial instruments.

b. an entity reports in a jurisdiction in which entities also report applying local accounting standards.

c. the accounting required by the Ind AS Standards is complex, and users of financial statements need to understand the required accounting. Such a scenario might arise when an entity accounts for a material class of transactions, other events or conditions by applying more than one Ind AS Standard.

Paragraph 117D of Ind AS1 states that if an entity discloses immaterial accounting policy information, such information shall not obscure material information.

Example A—making materiality judgements and focusing on entity-specific information while avoiding standardised (boilerplate) accounting policy information

Background

An entity operates within the telecommunications industry. It has entered into contracts with retail customers to deliver mobile phone handsets and data services. In a typical contract, the entity provides a customer with a handset and data services over three years. The entity applies Ind AS 115 Revenue from Contracts with Customers and recognises revenue when, or as, the entity satisfies its performance obligations in line with the terms of the contract.

The entity has identified two performance obligations and related considerations:

(a) the handset—the customer makes monthly payments for the handset over three years; and

(b) data—the customer pays a fixed monthly charge to use a specified monthly amount of data over three years.

For the handset, the entity concludes that it should recognise revenue when it satisfies the performance obligation (when it provides the handset to the customer). For the provision of data, the entity concludes that it should recognise revenue as it satisfies the performance obligation (as the entity provides data services to the customer over the three-year life of the contract).

The entity notes that, in accounting for revenue it has made judgements about:

a. the allocation of the transaction price to the performance obligations; and

b. the timing of satisfaction of the performance obligations.

The entity has concluded that revenue generated from these contracts is material to the reporting period.

Application

The entity notes that for contracts of this type it applies separate accounting policies for two sources of revenue, namely revenue from:

(a) the sale of handsets; and

(b) the provision of data services.

Having identified revenue from contracts of this type as material to the financial statements, the entity assesses whether accounting policy information for revenue from these contracts is, in fact, material.

The entity evaluates the effect of disclosing the accounting policy information by considering the presence of qualitative factors. The entity noted that its revenue recognition accounting policies:

(a) were unchanged during the reporting period;

(b) were not chosen from accounting policy options available in the Ind AS Standards;

(c) were not developed in accordance with Ind AS8 Accounting Policies, Changes in Accounting Estimates and Errors in the absence of an Ind AS Standard that specifically applies; and

(d) are not so complex that primary users will be unable to understand the related revenue transactions without standardised descriptions of the requirements of Ind AS 115.

However, some of the entity’s revenue recognition accounting policies relate to an area for which the entity has made significant judgements in applying its accounting policies—for example, in deciding how to allocate the transaction price to the performance obligations, and the timing of revenue recognition.

The entity considers that in addition to disclosing the information required by paragraphs 123–126 of Ind AS 115 about the significant judgements made in applying Ind AS 115, primary users of its financial statements are likely to need to understand related accounting policy information. Consequently, the entity concludes that such accounting policy information could reasonably be expected to influence the decisions of the primary users of its financial statements. For example, understanding:

(a) how the entity allocates the transaction price to its performance obligations is likely to help users understand how each component of the transaction contributes to the entity’s revenue and cash flows; and

(b) that some revenue is recognised at a point in time, and some is recognised over time is likely to help users understand how reported cash flows relate to revenue.

The entity also notes that the judgements it made are specific to the entity. Consequently, material accounting policy information would include information about how the entity has applied the requirements of Ind AS 115 to its specific circumstances.

The entity, therefore, assesses that accounting policy information about revenue recognition is material and should be disclosed. Such disclosure would include information about how the entity allocates the transaction price to its performance obligations and when the entity recognises revenue.

Example B—making materiality judgements on accounting policy information that only duplicates requirements in the IFRS Standards

Background

Property, plant and equipment are material to an entity’s financial statements.

The entity has no intangible assets or goodwill and has not recognised an impairment loss on its property, plant or equipment in either the current or comparative reporting periods.

In previous reporting periods, the entity disclosed accounting policy information relating to the impairment of non-current assets which duplicates the requirements of Ind AS 36 Impairment of Assets and provides no entity-specific information. The entity disclosed that:

“The carrying amounts of the group’s intangible assets and its property, plant and equipment are reviewed at each reporting date to determine whether there is any indication of impairment. If any such indication exists, the asset’s recoverable amount is estimated. For goodwill and intangibles with an indefinite useful life, the recoverable amount is estimated at least annually.

An impairment loss is recognised in the statement of profit or loss whenever the carrying amount of an asset or its cash-generating unit exceeds its recoverable amount.

The recoverable amount of assets is the greater of their fair value less costs to sell and their value in use. In measuring value in use, estimated future cash flows are discounted to present value using a pre-tax discount rate that reflects current market assessments of the time value of money and the risks specific to the asset. For an asset that does not generate largely independent cash inflows, the recoverable amount is determined for the cash-generating unit to which the asset belongs.

Impairment losses recognised in respect of cash-generating units are allocated first to reduce the carrying amount of any goodwill allocated to that cash-generating unit and then to reduce the carrying amount of the other assets in the unit on a pro-rata basis.

An impairment loss in respect of goodwill is not subsequently reversed. For other assets, an impairment loss is reversed if there has been a change in the estimates used to determine the recoverable amount, but only to the extent that the new carrying amount does not exceed the carrying amount that would have been determined, net of depreciation and amortisation, if no impairment loss had been recognised.”

Application

Having identified assets subject to impairment testing as being material to the financial statements, the entity assesses whether the accounting policy information for impairment is, in fact, material.

As part of its assessment, the entity considers that an impairment or a reversal of an impairment had not occurred in the current or comparative reporting periods. Consequently, accounting policy information about how the entity recognises and allocates impairment losses is unlikely to be material to its primary users. Similarly, because the entity has no intangible assets or goodwill, information about its accounting policy for impairments of intangible assets and goodwill is unlikely to provide its primary users with material information.

However, the entity’s impairment accounting policy relates to an area for which the entity is required to make significant judgements or assumptions, as described in paragraphs 122 and 125 of Ind AS1. Given the entity’s specific circumstances, it concludes that information about its significant judgements and assumptions related to its impairment assessments could reasonably be expected to influence the decisions of the primary users of the entity’s financial statements. The entity notes that its disclosures about significant judgements and assumptions already include information about the significant judgements and assumptions used in its impairment assessments.

The entity decides that the primary users of its financial statements would be unlikely to need to understand the recognition and measurement requirements of Ind AS36 to understand related information in the financial statements.

Consequently, the entity concludes that disclosing a summary of the requirements in Ind AS36 in a separate accounting policy for impairment would not provide information that could reasonably be expected to influence decisions made by the primary users of its financial statements. Instead, the entity discloses material accounting policy information related to the significant judgements and assumptions the entity has applied in its impairment assessments elsewhere in the financial statements.

Although the entity assesses some accounting policy information for impairments of assets as immaterial, the entity still assesses whether other disclosure requirements of Ind AS 36 provide material information that should be disclosed.

Example C — Disclosures of the accounting policies on revenue recognition

Background information

V-Trade is an AC retailer. As per local law, V-Trade is required to repair any damages to the AC up until 12 months after delivery, to the extent that the damage relates to defects existing at the delivery date (“assurance warranty”). Each AC sold also includes an obligation for V-Trade to perform specific services beyond the mandatory warranty requirements for a period of three years (extended warranty).

V-Trade does not sell extended warranties separately, but the sales contracts for the ACs explicitly identify which services are included. V-Trade’s competitors do not bundle such service plans into their sale of cars by default but offer similar extended warranty as an option for an extra price. V-Trade concludes that the extended warranty meets the Ind AS 115 definition of a service-type warranty.

Customers are charged the total contract price upon delivery of the AC, which includes the extended warranty. V-Trade recognises revenue when, or as, it satisfies its performance obligations. It has identified two performance obligations in the contracts: (1) the AC and (2) the extended warranty. Consequently, V-Trade allocates the transaction price to each performance obligation and recognises revenue, separately, as it satisfies each performance obligation.

V-Trade determines that its performance obligation for an AC is satisfied at the point in time when the AC is delivered to the customer (and at the same time recognises an obligation for the mandatory warranty). The performance obligation for the extended warranty is satisfied over the three-year service period. At year-end 31 March 20×1, V-Trade concluded that revenues from both AC sales and extended warranty are material in its financial statements.

Question

V-Trade is preparing its financial statements for the year ending 31 March 20X1. Should accounting policy information on revenue recognition be disclosed?

Answer

V-Trade observes that:

  • the accounting policies were unchanged during the year;
  • the accounting policies applied are not chosen from an available set of alternatives;
  • accounting policies for revenue recognition are described in Ind AS, and not derived by V-Trade from paragraphs 10–12 of Ind AS 8; and
  • the accounting policies are not very complex.

However, V-Trade observes that the revenue amounts are material to the financial statements and that judgment has been used in applying the accounting policies, for example in:

  • identification of performance obligations, in particular concluding that its extended warranty service is distinct from the sale of the AC even though they are not sold separately;
  • determining if any significant financing component exists in the prepaid warranty plan;
  • allocating the contract price to the performance obligations; and
  • determination of when the performance obligation for the extended warranty (service-type warranty) is satisfied.

Consequently, to sufficiently understand the amounts presented, primary users of V-Trade’s financial statements might need information about how the accounting policies for revenue recognition have been applied by V-Trade.

Hence, entity-specific information about accounting policies for revenue recognition would likely be disclosed, in addition to the disclosures of significant judgements made in the application of paragraphs 123–125 of Ind AS 115
and other relevant disclosure requirements in Ind AS 115.

Measurement of operating segment profit or loss, assets and liabilities

The accounting policy information about policies of the operating segments is the same as those described as part of the significant accounting policy information, except that pension expense for each operating segment is recognised and measured on the basis of cash payments to the pension plan. Diversified Company evaluates performance on the basis of profit or loss from operations before tax expense not including non-recurring gains and losses and foreign exchange gains and losses.

Transition and comparative information

The amendments affect the disclosure of narrative and descriptive information. Comparative information is only required for narrative and descriptive information if it is ‘relevant to understanding the current period’s financial statements’ (paragraph 38 of Ind AS 1). Providing comparative accounting policy information would be unnecessary in most circumstances because
if the accounting policy:

(a) is unchanged from the comparative periods, the disclosure of the current period’s accounting policy is likely to provide users with all the accounting policy information that is relevant to an understanding of the current period’s financial statements; or

(b) has changed from the comparative periods, the disclosures required by paragraphs 28–29 of Ind AS 8 are likely to provide any information about the comparative period’s accounting policies that relevant to an understanding of the current period’s financial statements.

Amendment to Ind AS 12 – Deferred Tax Related to Assets and Liabilities Arising from a Single Transaction

WHAT IS THE ISSUE?

MCA issued amendments to Ind AS 12 Income Taxes in order to address potential issues of inconsistency and interpretation by users in respect of the initial recognition exemption (“IRE”) detailed in paragraphs 15 and 24 of Ind AS 12 (for deferred tax liabilities and assets respectively).

Ind AS 12 contains exceptions from recognising the deferred tax effects of certain temporary differences arising on the initial recognition of some assets and liabilities, generally referred to as the ‘initial recognition exception’ or ‘IRE’. Prior to amendment views differed on whether (and to what extent) the IRE applied to transactions and events, such as leases, that lead to the recognition of an asset and a liability.

The amendments introduce an exception to the initial recognition exemption in Ind AS 12. Additional exclusions have been added to the IRE, detailed in paragraphs 15(b)(iii) and 24(c) for deferred tax liabilities and assets respectively. Applying this exception, an entity does not apply the initial recognition exemption for transactions that give rise to equal taxable and deductible temporary differences – such that deferred taxes are calculated and booked for both temporary differences, both at initial recognition and subsequently. Only if the recognition of a lease asset and lease liability (or decommissioning liability and decommissioning asset component) give rise to taxable and deductible temporary differences that are not equal, would the IRE be applied.

Example

  • An entity (Lessee) enters into a five-year lease of a building.
  • The annual lease payments are ₹100 payable at the end of each year.
  • Advance lease payments and initial direct costs are assumed to be nil.
  • The interest rate implicit in the lease cannot be readily determined. Lessee’s incremental borrowing rate is 5 per cent per year.
  • At the commencement date:
  • Lessee recognises a lease liability of ₹435 (measured at the present value of the five lease payments of ₹100, discounted at the interest rate of 5 per cent per year) ,
  • Lessee measures the right-of-use asset (lease asset) at ₹435, comprising the initial measurement of the lease liability (₹435).

 

  • Tax law:
  • The tax law allows tax deductions for lease payments when an entity makes those payments.
  • Economic benefits that will flow to Lessee when it recovers the carrying amount of the lease asset will be taxable.
  • A tax rate of 20 per cent is expected to apply to the period(s) when Lessee will recover the carrying amount of the lease asset and will settle the lease liability.
  • After considering the applicable tax law, Lessee concludes that the tax deductions it will receive for lease payments relate to the repayment of the lease liability.

Deferred tax on the lease liability and related component of the lease asset’s cost:

  • At the inception:
  • The tax base of the lease liability is NIL because Lessee will receive tax deductions equal to the carrying amount of the lease liability (₹435).
  • The tax base of the related component of the lease asset’s cost is also NIL because Lessee will receive no tax deductions from recovering the carrying amount of that component of the lease asset’s cost (₹435).
  • The differences between the carrying amounts of the lease liability and the related component of the lease asset’s cost (₹435) and their tax bases of nil result in the following temporary differences at the inception:
  • a taxable temporary difference of ₹435 associated with the lease asset; and
  • a deductible temporary difference of ₹435 associated with the lease liability.
  • IRE does not apply because the transaction gives rise to equal taxable and deductible temporary differences.
  • Lessee concludes that it is probable that taxable profit will be available against which the deductible temporary difference can be utilised.
  • Lessee recognises a deferred tax asset and a deferred tax liability at inception, each of ₹87 (₹435 × 20 per cent), for the deductible and taxable temporary differences.

TRANSITIONAL PROVISIONS

98J Deferred Tax related to Assets and Liabilities arising from a Single Transaction, amended paragraphs 15, 22 and 24 and added paragraph 22A. An entity shall apply these amendments in accordance with paragraphs 98K–98L for annual reporting periods beginning on or after 1st April, 2023.

98K An entity shall apply Deferred Tax related to Assets and Liabilities arising from a Single Transaction to transactions that occur on or after the beginning of the earliest comparative period presented.

98L An entity applying Deferred Tax related to Assets and Liabilities arising from a Single Transaction shall also, at the beginning of the earliest comparative period presented:

(a) recognise a deferred tax asset — to the extent that it is probable that taxable profit will be available against which the deductible temporary difference can be utilised — and a deferred tax liability for all deductible and taxable temporary differences associated with:

(i) right-of-use assets and lease liabilities; and

(ii) decommissioning, restoration and similar liabilities and the corresponding amounts recognised as part of the cost of the related asset; and

(b) recognise the cumulative effect of initially applying the amendments as an adjustment to the opening balance of retained earnings (or other component of equity, as appropriate) at that date.

EXAMPLE

Entity X recognised a provision for the decommissioning of a nuclear plant in 2011 for ₹9,00,00,000; it capitalised the associated expenses as an asset and depreciated this over the 60-year expected period of use until decommissioning is required. The tax rules allow for deduction of these expenses on a cash basis. At the time of the transaction, Entity X applied the IRE to both the asset and liability separately, therefore, no deferred tax has ever been accounted for in relation to this transaction. The decommissioning provision has been discounted in accordance with Ind AS 37 Provisions, Contingent Liabilities and Contingent Assets. The table below shows the associated carrying values of the provision and asset at relevant dates:

Date Carrying value of provision (₹) in million Deferred tax asset at 20 per cent (₹) in million Carrying value of asset (₹) in million Deferred tax liability at 20 per cent (₹) in million
1st April, 2011 90.0 18.0 90.0 18.0
1st April, 2022 170.8 34.2 73.6 14.7

Entity X adopts the Ind AS 12 amendments in its financial statements for the year ended 31st March, 2024, with the
beginning of the earliest period presented being 1st April, 2022. The required accounting entry on the date of transition (1st April, 2022) is:

Dr deferred tax asset ₹34.2m

Cr deferred tax liability ₹14.7m

Cr retained earnings ₹19.5m

If Entity X had, instead, previously recognised deferred tax on a net basis (i.e., assessed the temporary differences net), then, brought forward, as at 1st April, 2022 it would already be carrying a deferred tax asset of ₹19.5m. In which case, the required accounting entry on transition (1st April, 2022) is:

Dr deferred tax asset ₹14.7m

Cr deferred tax liability ₹14.7m

That is, there would be nil impact on opening retained earnings.

Ind AS 2023 Amendments

Ind AS 8 — ACCOUNTING POLICIES, CHANGES TO ACCOUNTING ESTIMATES AND ERRORS

The amendments to Ind AS 8 Accounting Policies, Changes to Accounting Estimates and Errors, introduce a new definition of accounting estimates. The amendments are designed to clarify the distinction between changes in accounting estimates changes in accounting policies and the correction of errors.

DEFINITION OF AN ACCOUNTING ESTIMATE

The current version of Ind AS 8 does not provide a definition of accounting estimates. Accounting policies, however, are defined. Furthermore, the standard defines the concept of a “change in accounting estimates”. A mixture of a definition of one item with a definition of changes in another has resulted in difficulty in drawing the distinction between accounting policies and accounting estimates in many instances. In the amended standard, accounting estimates are now defined as, “monetary amounts in financial statements that are subject to measurement uncertainty”.

To clarify the interaction between an accounting policy and an accounting estimate, paragraph 32 of Ind AS 8 has been amended to state that: “An accounting policy may require items in financial statements to be measured in a way that involves measurement uncertainty – that is, the accounting policy may require such items to be measured at monetary amounts that cannot be observed directly and must instead be estimated. In such cases, an entity develops an accounting estimate to achieve the objective set out by the accounting policy”. Accounting estimates typically involve the use of judgements or assumptions based on the latest available reliable information.

The amended standard explains how entities use measurement techniques and inputs to develop accounting estimates and states that these can include estimation and valuation techniques. The term “estimate” is widely used in accounting and may sometimes refer to estimates other than accounting estimates. Therefore, the amended standard clarifies that not all estimates will meet the definition of an accounting estimate, but rather may refer to inputs used in developing accounting estimates.

CHANGES IN ACCOUNTING ESTIMATES

Distinguishing between a change in accounting policy and a change in accounting estimate is, in some cases, quite challenging. To provide additional guidance, the amended standard clarifies that the effects on an accounting estimate of a change in input or a change in a measurement technique are changes in accounting estimates if they do not result from the correction of prior period errors.

The previous definition of a change in accounting estimate specified that changes in accounting estimates may result from new information or new developments. Therefore, such changes are not corrections of errors. The standard-setters felt that this aspect of the definition is helpful and should be retained. For example, if the applicable standard permits a change between two equally acceptable measurement techniques, that change may result from new information or new developments and is not necessarily the correction of an error.

ILLUSTRATIVE EXAMPLE

Applying the definition of accounting estimates—Fair value of a cash-settled share-based payment liability

FACT PATTERN

On 1st April, 20X0, Entity A grants 100 share appreciation rights (SARs) to each of its employees, provided the employee remains in the entity’s employment for the next three years. The SARs entitle the employees to a future cash payment based on the increase in the entity’s share price over the three-year vesting period starting on 1st April, 20X0.

Applying Ind AS 102 Share-based Payment, Entity A accounts for the grant of the SARs as cash-settled share-based payment transactions—in doing so it recognises a liability for the SARs and measures that liability at its fair value (as defined by Ind AS 102). Entity A applies the Black–Scholes–Merton formula (an option pricing model) to measure the fair value of the liability for the SARson 1st April, 20X0 and at the end of the reporting period.

At 31st March, 20X2, because of changes in market conditions since the end of the previous reporting period, Entity A changes its estimate of the expected volatility of the share price—an input to the option pricing model—in estimating the fair value of the liability for the SARs at that date. Entity A has concluded that the change in that input is not a correction of a prior period error.

APPLYING THE DEFINITION OF ACCOUNTING ESTIMATES

The fair value of the liability is an accounting estimate because:

a. the fair value of the liability is a monetary amount in the financial statements that is subject to measurement uncertainty. That fair value is the amount for which the liability could be settled in a hypothetical transaction—accordingly, it cannot be observed directly and must instead be estimated.

b. the fair value of the liability is an output of a measurement technique (option pricing model) used in applying the accounting policy (measuring a liability for a cash-settled share-based payment at fair value).

c. to estimate the fair value of the liability, Entity A uses judgements and assumptions, for example, in:

i. selecting the measurement technique—selecting the option pricing model; and

ii. applying the measurement technique—developing the inputs that market participants would use in applying that option pricing model, such as the expected volatility of the share price and dividends expected on the shares.

In this fact pattern, the change in the expected volatility of the share price is a change in an input used to measure the fair value of the liability for the SARson 31st March, 20X2. The effect of this change is a change in accounting estimates because the accounting policy—to measure the liability at fair value —has not changed.

Feedback on the draft amendments expressed a concern that measurement techniques might meet the definition of accounting policies—for example, a valuation technique is a measurement technique but could also be seen as a practice and, therefore, meet the definition of an accounting policy. Accordingly, there is a risk that the effects of a change in a measurement technique could be seen as both a change in accounting estimate and a change in accounting policy. To avoid this risk, the standard-setter specified in paragraph 34A that the effects of a change in measurement technique are changes in accounting estimates unless they result from the correction of prior period errors.

The amendments also specified that measurement techniques an entity uses to develop accounting estimates include estimation techniques and valuation techniques. Specifying this avoids ambiguity about whether the effect of a change in an estimation technique or a valuation technique is a change in accounting estimate. The terms ‘estimation techniques’ and ‘valuation techniques’ appear in Ind AS Standards—for example, Ind AS107 Financial Instruments: Disclosures uses the term ‘estimation techniques’ and Ind AS 113 Fair Value Measurement uses the term ‘valuation techniques’.

The amendments state that the term ‘estimate’ in the Standards sometimes refers not only to accounting estimates but also to other estimates. For example, it sometimes refers to inputs used in developing accounting estimates. The amendments specified that the effects on an accounting estimate of a change in input are changes in accounting estimates.

SELECTING INVENTORY COST FORMULAS

The standard-setter proposed clarifying that, for ordinarily interchangeable inventories, selecting a cost formula (that is, first-in, first-out (FIFO) or weighted average cost) in applying Ind AS 2 Inventories constitutes selecting an accounting policy. However, some felt that selecting a cost formula could also be viewed as making an accounting estimate. Since paragraph 36(a) of Ind AS 2 already states that selecting a cost formula constitutes selecting an accounting policy, this issue was not revisited. It was observed that entities rarely change the cost formula used to measure inventories and, accordingly, there would be little benefit in the standard-setter doing so.

EFFECTIVE DATE AND TRANSITION

The amendments become effective for annual reporting periods beginning on or after 1st April, 2023 and apply to changes in accounting policies and changes in accounting estimates that occur on or after the start of that period.

Adjustment of Knock-On Errors

Fact Pattern

Entity A granted a fixed Ind AS 19 Employee Benefits cash-bonus to its executive officers on 1st April 20X1. Payment of the bonus is conditional upon reaching a determined level of Ind AS 115 (Revenue from Contracts with Customers) – revenues in the 20X1-X2 Ind AS financial statements. Based on the revenues determined for the financial statements of 20X1-20X2, the revenue target was met and Entity A records the following entry:

31st March, 20X2

Dr. Compensation expense

Cr. Bonus payable

Entity A is legally entitled, and has an obligation, to clawback the bonus paid in the event the revenue target is no longer met as a result of a restatement made in accordance with Ind AS 8 Accounting Policies, Changes in Accounting Estimates and Errors. During 20X2-X3, a material error was detected in the prior-year financial statements and consequently the 20X1-X2 revenues were restated in the 20X2-X3 financial statements. Based on the restated revenues, the revenue target was not met. The error was identified before the bonus was paid out in cash. Entity A will not pay the bonus.

QUERY

Do you agree that the compensation expense (knock-on error) and provision for the bonus as of 31st March 20X2 (and the corresponding income taxes) should be adjusted retrospectively as part of the revenue error correction?

RESPONSE

Accounting Standard References

Ind AS 8 Accounting Policies, Changes in Accounting Estimates and Errors

Paragraph 5

Retrospective restatement is correcting the recognition, measurement and disclosure of amounts of elements of financial statements as if a prior period error had never occurred.

Paragraph 10

In the absence of an Ind AS that specifically applies to a transaction, other event or condition, management shall use its judgement in developing and applying an accounting policy that results in information that is: relevant to the economic decision-making needs of users; and reliable, in that the financial statements: (i) represent faithfully the financial position, financial performance and cash flows of the entity; (ii) reflect the economic substance of transactions, other events and conditions, and not merely the legal form; (iii) are neutral, ie free from bias; (iv) are prudent; and (v) are complete in all material respects.

Paragraph 11

In making the judgement described in paragraph 10, management shall refer to, and consider the applicability of, the following sources in descending order: (a) the requirements in Ind ASs dealing with similar and related issues; and (b) the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the Framework.

Paragraph 12

In making the judgement described in paragraph 10, management may also first consider the most recent pronouncements of International Accounting Standards Board and in absence thereof those of the other standard-setting bodies that use a similar conceptual framework to develop accounting standards, other accounting literature and accepted industry practices, to the extent that these do not conflict with the sources in paragraph 11.

Paragraph 42

Subject to paragraph 43, an entity shall correct material prior period errors retrospectively in the first set of financial statements approved for issue after their discovery by: (a) restating the comparative amounts for the prior period(s) presented in which the error occurred; or (b) if the error occurred before the earliest prior period presented, restating the opening balances of assets, liabilities and equity for the earliest prior period presented

Paragraph 43

A prior period error shall be corrected by retrospective restatement except to the extent that it is impracticable to determine either the period-specific effects or the cumulative effect of the error.

US GAAP ASC 250-10-45-8

Retrospective application shall include only the direct effects of a change in accounting principle, including any related income tax effects. Indirect effects that would have been recognised if the newly adopted accounting principle had been followed in prior periods shall not be included in the retrospective application. If indirect effects are actually incurred and recognised, they shall be reported in the period in which the accounting change is made.

View A — Yes, the adjustments should be made retrospectively

According to Ind AS 8 paragraph 5, a retrospective restatement is correcting the recognition, measurement and disclosure of amounts of elements of financial statements as if a prior period error had never occurred.”

If the 20X1-X2 revenues had not been overstated, it would have been evident that the revenue target was not met and that the bonus would not have been awarded. As a result, the entity would not have recognised the bonus provision and corresponding personnel expense in the 20X1-X2 financial statements.

Moreover, the guidance on implementing Ind AS 8 (Example 1) includes an example where the costs of goods sold that were originally recognised were too low. As part of the costs of goods sold restatement, the income taxes are also retrospectively adjusted. This might be understood to demonstrate that the restatement should also extend to correcting related impacts of the underlying consequential errors (i.e. indirect errors).

It is not impracticable (see paragraph 43 above) to determine the effects of the revenue error on the accounting for the cash bonus in 20X1-X2. Therefore, the financial statements of the period in which the revenue error was identified 20X2-X3 should include a restatement to the comparative period / opening balance sheet for the Ind AS 19 accounting (and the resulting effect on the income taxes).

View B — No, the adjustments should only be made in the period in which the revenue error is identified

The requirement in IAS 8.42 relates to the correction of the error itself (i.e. the incorrect revenue recognised) but there is nothing in Ind AS 8 that specifically requires the retrospective correction for the knock-on implications of that error (i.e. the fact that an employee is no longer entitled to a bonus). In the absence of specific guidance, IAS 8.12 requires entities to consider other similar standards. The US GAAP equivalent of Ind AS 8 includes more specific guidance (ASC 250-10-45-8) on this point and does not adjust for indirect impacts retrospectively.

In this view, the compensation award is an indirect effect of the revenue error. The Ind AS 19 accounting itself was not erroneous in 20X1-X2 and is therefore not adjusted retrospectively. It is only when the entity has a right to cancel the award, as a result of the separate employee agreement / clawback policy, that it no longer has an employee related expense. If the entity does not have a right to cancel / clawback the promise, the expense continues to be a valid expense for the entity. Therefore, the ability to reverse the expense is not as a result of the revenue error but rather the right established through the clawback mechanism. That right, established by the clawback agreement, only kicks-in when the error in the financial statements is discovered.

The trigger for recognition of the reversal of the employee expense should be the discovery of the revenue error. Because the employee expense is an indirect impact of the revenue error, the reversal is recognised as a separate transaction in the period in which the revenue error is identified. In other words, in 20X2-X3 financial statements, a reversal will be made, but will not be carried out as a retrospective restatement.

View C — Accounting policy choice.

As there is no clear guidance in Ind AS 8 regarding the scope of an error correction, the Ind AS 19 accounting can be adjusted retrospectively as part of the revenue error correction (View A) or the impact of the revenue error correction on the rights and obligations associated with the compensation agreement can be regarded as separate transaction (View B).

CONCLUSION

The author believes that View A is the most appropriate response, since Example 1 in Ind AS 8 contains a clear guidance where knock-on effects are also adjusted when correcting past errors.

Ind AS/IGAAP — Interpretation and Practical Application

Activities that represent efforts by a service provider in fulfilling the performance obligations, and which trigger revenue recognition, sometimes can be lumpy and unpredictable; whereas the cash received from the customer can be time-based, smooth and predictable. Therefore, the question is whether revenue recognition can follow a smooth pattern, rather than get recognized in a lumpy manner. Very often, stock markets reward more stable and predictable earnings per share (EPS), rather than a highly volatile EPS each quarter. Most entities, therefore, prefer to have a smooth revenue recognition pattern. The big question is whether such smoothing is possible under Ind AS 115 Revenue from Contracts with Customers. This question is addressed through a simple fact pattern.

QUERY

Repair Company Ltd (RepCo) provides repair and maintenance (R&M) services as well as overhaul and relining of crusher machines that are used in mining operations. The contract is for a period of six years. At the end of the second, fourth and sixth year, RepCo does a complete relining and overhaul of the crusher. Additionally, RepCo also provides R&M services for the crusher on a continuous basis, and for this purpose, it will have two of its mechanics located at the customer’s site on a full-time basis for a period of 6 years, along with certain stores and spares that would be required for relining, overhaul and regular R&M.

For the next six years, the customer will pay RepCo a consideration at the end of each month. The consideration is variable and is dependent upon the usage of the crusher determined at the end of each month; however, the customer will pay a basic minimum amount, even if the crusher was idle through the period. The customer does not pay separately for the relining and overhaul, and that consideration is embedded in the monthly payments.

For the sake of simplicity, consider that typically the R&M involves 40% effort and the relining and overhaul involves 60% effort.

RepCo, wants to recognize revenue, in line with the payment by the customer, i.e., recognize as revenue, the consideration paid by the customer at the end of each month. Is that permissible under Ind AS?

RESPONSE

Ind AS 115 Revenue from Contracts with Customers

22 At contract inception, an entity shall assess the goods or services promised in a contract with a customer and shall identify as a performance obligation each promise to transfer to the customer either: (a) a good or service (or a bundle of goods or services) that is distinct; or (b) a series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer (see paragraph 23).

23 A series of distinct goods or services have the same pattern of transfer to the customer if both of the following criteria are met: (a) each distinct good or service in the series that the entity promises to transfer to the customer would meet the criteria in paragraph 35 to be a performance obligation satisfied over time; and (b) in accordance with paragraphs 39–40, the same method would be used to measure the entity’s progress towards complete satisfaction of the performance obligation to transfer each distinct good or service in the series to the customer.

29 In assessing whether an entity’s promises to transfer goods or services to the customer are separately identifiable in accordance with paragraph 27(b), the objective is to determine whether the nature of the promise, within the context of the contract, is to transfer each of those goods or services individually or, instead, to transfer a combined item or items to which the promised goods or services are inputs. Factors that indicate that two or more promises to transfer goods or services to a customer are not separately identifiable include, but are not limited to, the following: (a) the entity provides a significant service of integrating the goods or services with other goods or services promised in the contract into a bundle of goods or services that represent the combined output or outputs for which the customer has contracted. In other words, the entity is using the goods or services as inputs to produce or deliver the combined output or outputs specified by the customer. A combined output or outputs might include more than one phase, element or unit. (b) one or more of the goods or services significantly modifies or customises, or are significantly modified or customised by, one or more of the other goods or services promised in the contract. (c) the goods or services are highly interdependent or highly interrelated. In other words, each of the goods or services is significantly affected by one or more of the other goods or services in the contract. For example, in some cases, two or more goods or services are significantly affected by each other because the entity would not be able to fulfil its promise by transferring each of the goods or services independently.

46 When (or as) a performance obligation is satisfied, an entity shall recognise as revenue the amount of the transaction price (which excludes estimates of variable consideration that are constrained in accordance with paragraphs 56–58) that is allocated to that performance obligation.

56 An entity shall include in the transaction price some or all of an amount of variable consideration estimated in accordance with paragraph 53 only to the extent that it is highly probable that a significant reversal in the amount of cumulative revenue recognised will not occur when the uncertainty associated with the variable consideration is subsequently resolved.

84 Variable consideration that is promised in a contract may be attributable to the entire contract or to a specific part of the contract, such as either of the following: (a) one or more, but not all, performance obligations in the contract (for example, a bonus may be contingent on an entity transferring a promised good or service within a specified period of time); or (b) one or more, but not all, distinct goods or services promised in a series of distinct goods or services that forms part of a single performance obligation in accordance with paragraph 22(b) (for example, the consideration promised for the second year of a two-year cleaning service contract will increase on the basis of movements in a specified inflation index).

85 An entity shall allocate a variable amount (and subsequent changes to that amount) entirely to a performance obligation or to a distinct good or service that forms part of a single performance obligation in accordance with paragraph 22(b) if both of the following criteria are met: (a) the terms of a variable payment relate specifically to the entity’s efforts to satisfy the performance obligation or transfer the distinct good or service (or to a specific outcome from satisfying the performance obligation or transferring the distinct good or service), and (b) allocating the variable amount of consideration entirely to the performance obligation or the distinct good or service is consistent with the allocation objective in paragraph 73 when considering all of the performance obligations and payment terms in the contract.

86 The allocation requirements in paragraphs 73–83 shall be applied to allocate the remaining amount of the transaction price that does not meet the criteria in paragraph 85.

Ind AS 108 Operating Segments

27 An entity shall 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: (a) ………. (b) the nature of any differences between the measurements of the reportable segments’ profits or losses and the entity’s profit or loss before income tax expense or income and discontinued operations (if not apparent from the reconciliations described in paragraph 28). Those differences could include accounting policies and policies for the allocation of centrally incurred costs that are necessary for an understanding of the reported segment information.

28 An entity shall provide reconciliations of all of the following: (a) ………. (b) the total of the reportable segments’ measures of profit or loss to the entity’s profit or loss before tax expense (tax income) 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.

ANALYSIS

RepCo will apply paragraph 29, to identify the different performance obligations in the six-year contract. There are three promises, namely, (a) performing thrice the relining and overhaul services during the contract period (b) supplying spares as and when required (c) stand-ready obligations towards R&M.

The relining and overhaul service is distinct from the daily R&M service, as (a) the two services are not integrated with each other (b) the two promises do not modify each other (c) the two services are not highly interdependent or highly interrelated.

On the other hand, the stand-ready obligation to R&M, and to provide the necessary spares to deliver such a service is to be treated as one performance obligation. The customer has contracted with RepCo to provide daily R&M service, and in doing so, RepCo would need to use the services of mechanics or spares. In other words, the use of spares is an input to providing the service of daily R&M services.

Therefore, in accordance with the requirements of paragraph 29, the contract comprises two performance obligations, namely, the (a) three relining and overhaul services and (b) daily R&M service.

Paragraphs 22 and 23 contain requirements with respect to a series of distinct goods and services. An entity may provide a series of distinct goods or services that are substantially the same and have the same pattern of transfer to the customer. Examples could include services provided on an hourly or daily basis, such as cleaning services or security services. This requirement was incorporated in the standard to simplify the model and promote consistent identification of performance obligations in cases when an entity provides the same good or service over a period of time. Without the series requirement, applying the revenue model would have presented operational challenges because an entity would have to identify multiple distinct goods or services, allocate the transaction price to each distinct good or service on a stand-alone selling price basis and then recognise revenue when those performance obligations are satisfied.

A series of distinct goods or services has the same pattern of transfer to the customer if both of the following criteria are met:

(i) each distinct good or service in the series that the entity promises to transfer to the customer would meet the criteria to be a performance obligation satisfied over time; and

(ii) the same method would be used to measure the entity’s progress towards complete satisfaction of the performance obligation to transfer each distinct good or service in the series to the customer.

The series guidance requires each distinct good or service to be “substantially the same”. The promise to provide daily R&M services and stand ready for the same fulfils the series requirement. This is because the entity is providing the same service of “standing ready to provide R&M” each moment, even though some of the underlying activities may vary each day (for e.g., some days may involve more work and other days may not involve any R&M). The distinct service within the series is each time increment of performing the service (for example, each day or month of service).

The consideration in the contract is variable to the usage of the crusher, for e.g., the number of hours the crusher was in operation or volume crushed. At the inception of the contract, RepCo will have to estimate the variable consideration. In accordance with paragraphs 46 and 56, variable consideration is allocated to a performance obligation, only to the extent that it is highly probable that a significant reversal in the amount of cumulative revenue recognised will not occur when the uncertainty associated with the variable consideration is subsequently resolved.

In accordance with paragraphs 84–86, RepCo considers the underlying distinct goods or services in the contract, rather than the single performance obligation identified under the series requirement, when applying the requirement with respect to allocation of variable consideration. Consider a 5-year service contract that includes fixed annual fees plus a bonus (variable consideration) upon completion of a milestone at the end of year two. If the entire service period is determined to be a single performance obligation, comprising a series of distinct services, the entity may be able to conclude that the bonus should be allocated directly to its efforts to perform the distinct services up to the date the milestone is achieved (e.g., the underlying distinct services in years one and two). This would result in the entity recognizing the entire bonus amount, if earned, at the end of year two. In contrast, if the entity determines that the entire service period is a single performance obligation that is composed of non-distinct services, the bonus (after applying constraint) would be included in the transaction price and recognized based on the measure of progress determined for the entire service period. For example, assume the bonus becomes part of the transaction price at the end of year two (when it is probable to be earned and not subject to a revenue reversal). In that case, a portion of the bonus would be recognized at the end of year two based on performance completed to date and a portion would be recognized as the remainder of the performance obligation is satisfied. As a result, the bonus amount would be recognized as revenue through to the end of the five-year service period. The series requirement does not apply to the allocation of variable consideration; therefore, in this example, the bonus will be recognized at the end of year two.

The above analysis can be summarised as follows:

1. RepCo will determine the total consideration including the variable consideration to be allocated to the two performance obligations, namely (a) fulfilment of the promise to provide three overhaul and relining services and (b) the provision of daily R&M services.

2. The transaction price will include the basic minimum amount and the variable consideration to the extent that it is highly probable that a significant reversal in cumulative revenue recognized will not occur. Variable consideration is included in the transaction price when the uncertainty associated with the variable consideration is subsequently resolved.

3. The series requirement will apply separately to both, the relining/overhaul services and the daily R&M services. However, as discussed above the series requirement is not applied for the allocation of variable consideration. In other words, with respect to the daily R&M, if the usage of the crusher in the first month is greater than the usage in the following month, the variable consideration to the extent it is crystallized at the end of the first month, is recognized in that month.

4. Overhaul and relining service revenue will be recognized thrice when those services are performed. The overhaul and relining service revenue recognized at the end of the 2nd, 4th and 6th year, will be determined by the consideration received in years 1 & 2, years 3 & 4 and years 5 & 6, respectively.

5. Therefore, in accordance with the above analysis applied to the fact pattern, each month, when consideration is crystallized, 40% of revenue is recognized as relating to R&M, and 60% is carried forward to be recognized once the overhaul and relining services are provided.

CONCLUSION

RepCo will be unable to smoothen revenue as it desires because the relining and overhaul revenue gets recognised at the end of years 2, 4 and 6, and therefore it would result in lumpy revenue in those quarters. However, RepCo can soften the impact of such lumpy revenue, by doing the following:

1. Educate the investors and analysts on why there is lumpy revenue in certain quarters, and low revenue in other quarters.

2. Ensure that contracts are entered into and executed in a manner, that the lumpy revenue arises in each quarter, and the impact of lumpy revenue is therefore minimized. We see that typically happening in real estate contracts and other entities whose revenue is impacted by seasons, e.g., air conditioners. To achieve this objective, RepCo will have to carry out appropriate planning, scheduling and forecasting, such that each quarter will have an equal amount of relining and overhaul work, from different contracts.

3. RepCo can follow a different policy for the purposes of segment results, and to that extent the investors and analysts can be provided with a revenue pattern based on the cash flows received each month. Appropriate reconciliation between RepCo’s profit or loss and the segment profit or loss shall be disclosed in the financial statements (see paragraphs 27 & 28 of Ind AS 108)

4. Additional analysis can be provided over investor calls post the quarter results to mitigate the impact of lumpy revenue. This will ensure that RepCo’s earnings multiply and consequently the valuation of the share price is not adversely affected.

Accounting Of Losses in an Associate

BACKGROUND

Hold Co has a 25 per cent investment in Low Co. Hold Co accounts for investment in Low Co as an associate in its consolidated financial statements (CFS) because it has representation on the board of Low Co and exercises significant influence.

Low Co has incurred significant losses, far exceeding the equity of the owners. In the CFS, Hold Co has absorbed its proportion of the losses to the extent of the cost of investment, making it zero, and the remaining unabsorbed losses are not accounted for, as equity-accounted investments cannot be negative. This is in compliance with the requirements of paragraph 38 of Ind AS 28 Investments in Associates and Joint Ventures.

Low Co has prepared its business plan and it requires further capitalisation by all the equity owners in proportion to their shareholding. Hold Co would also like to further invest in Low Co, considering the strategic benefits arising out of investments in Low Co.

Consider the following simple example:

1. Hold Co has 25 per cent equity share in Low Co. Other investors own the remaining 75 per cent equity.

2. Hold Co had invested ₹100 million for the 25 per cent equity shares.

3. At the end of the financial year, Low Co had incurred a cumulative loss of ₹500 million.

4. Hold Co’s share of losses is ₹125 million. In the CFS, Hold Co has absorbed losses to the tune of ₹100 million, and ₹25 million loss remains unabsorbed.

5. Accordingly, the value of the equity-accounted investment in the CFS is zero.

6. Hold Co makes an additional equity investment of R60 million, just a little before the end of the financial year. Other investors contribute their share proportionately.

7. The prospects for Low Co are extremely bright, and there is no objective evidence of any impairment.

ISSUE

What should be the accounting of investment of further equity by Hold Co in Low Co? Should the unabsorbed losses be allocated to the new investment, i.e.

Option 1

Should the unabsorbed losses of ₹25 million be immediately allocated to the new equity investment of ₹60 million, and consequently, the equity accounted investment is determined to be ₹35 million?

or

Option 2

The unabsorbed losses should not be allocated to the new investment, and accordingly, the new investment should be reflected as ₹60 million, and the earlier investment at zero value?

RESPONSE

Accounting Standard References

Ind AS 28 – Investments in Associates and Joint Ventures

Paragraph 3 – Definitions

The equity method is a method of accounting whereby the investment is initially recognised at cost and adjusted thereafter for the post-acquisition change in the investor’s share of the investee’s net assets. The investor’s profit or loss includes its share of the investee’s profit or loss and the investor’s other comprehensive income includes its share of the investee’s other comprehensive income.

10. Under the equity method, on initial recognitionthe investment in an associate or a joint venture is recognised at cost, and the carrying amount is increased or decreased to recognise the investor’s share of the profit or loss of the investee after the date of acquisition. The investor’s share of the investee’s profit or loss is recognised in the investor’s profit or loss. Distributions received from an investee reduce the carrying amount of the investment.

19. When an entity has an investment in an associate, a portion of which is held indirectly through a venture capital organisation, or a mutual fund, unit trust and similar entities including investment-linked insurance funds, the entity may elect to measure that portion of the investment in the associate at fair value through profit or loss in accordance with Ind AS 109 regardless of whether the venture capital organisation has significant influence over that portion of the investment. If the entity makes that election, the entity shall apply the equity method to any remaining portion of its investment in an associate that is not held through a venture capital organisation.

24. If an investment in an associate becomes an investment in a joint venture or an investment in a joint venture becomes an investment in an associate, the entity continues to apply the equity method and does not remeasure the retained interest.

25. If an entity’s ownership interest in an associate or a joint venture is reduced, but the entity continues to apply the equity method, the entity shall reclassify to profit or loss the proportion of the gain or loss that had previously been recognised in other comprehensive income relating to that reduction in ownership interest if that gain or loss would be required to be reclassified to profit or loss on the disposal of the related assets or liabilities.

26. Many of the procedures that are appropriate for the application of the equity method are similar to the consolidation procedures described in Ind AS 110. Furthermore, the concepts underlying the procedures used in accounting for the acquisition of a subsidiary are also adopted in accounting for the acquisition of an investment in an associate or a joint venture.

38. If an entity’s share of losses of an associate or a joint venture equals or exceeds its interest in the associate or joint venture, the entity discontinues recognising its share of further losses.

39. After the entity’s interest is reduced to zero, additional losses are provided for, and a liability is recognised, only to the extent that the entity has incurred legal or constructive obligations or made payments on behalf of the associate or joint venture. If the associate or joint venture subsequently reports profits, the entity resumes recognising its share of those profits only after its
share of the profits equals the share of losses not recognised.

40. After application of the equity method, including recognising the associate’s or joint venture’s losses in accordance with paragraph 38, the entity applies paragraphs 41A-41C to determine whether there is any objective evidence that its net investment in the associate or joint venture is impaired.

AUTHOR’S VIEWS

As per paragraph 38, if an entity’s share of losses of an associate or a joint venture equals or exceeds its interest in the associate or joint venture, the entity discontinues recognising its share of further losses.

As per paragraph 39, after the entity’s interest is reduced to zero, additional losses are provided for, and a liability is recognised, only to the extent that the entity has incurred legal or constructive obligations or made payments on behalf of the associate or joint venture. If the associate or joint venture subsequently reports profits, the entity resumes recognising its share of those profits only after its share of the profits equals the share of losses not recognised.

Since the associate is likely to do very well in future, paragraph 40 is not of any concern.

Unfortunately, the standard does not provide a straightforward solution to the questions raised in the query. There are two possible views, both of which are supported by using analogies from the accounting standard references in Ind AS 28.

Option 1

Under option 1, the entity records the unabsorbed losses of ₹25 million, which is immediately allocated to the new equity investment of ₹60 million, and consequently, the equity-accounted investment at the end of the financial year is determined to be ₹35 million.

In this view, the entire investment in the associate is treated as one equity investment. In other words, a distinction is not made between the initial investment and the subsequent investment.

Option 1 can be supported by the following arguments:

• The definition in paragraph 3, “The equity method is a method of accounting whereby the investment is initially recognised at cost and adjusted thereafter for the post-acquisition change in the investor’s share of the investee’s net assets.” The definition along with paragraph 10 may be interpreted to support Option 1 or 2. One interpretation is that the losses post the acquisition of the associate are to be considered, including any additions made to the investment post the initial acquisition of the associate. In other words, the entire investment in the associate is treated as one, rather than two separate units, one the initial investment and two the subsequent addition.

• Paragraph 25 seems to support a retrospective approach; therefore, on this basis, the past losses would have to be absorbed by the fresh additional investment.

• When fresh investment is made in a subsidiary that has losses beyond the equity value, the losses continue to remain absorbed. If this analogy was used, then Paragraph 26 would require absorption of past losses for the additional investment made in the associate.

Option 2

Under option 2, the unabsorbed losses are not allocated to the new investment, and accordingly, the new investment is reflected as ₹60 million, and the earlier investment of ₹100 million is recorded at zero value.

• The definitions in paragraph 3 and paragraph 10 may be interpreted to mean that each investment in the associate is tracked separately. Therefore, on the second tranche past losses are not absorbed, but only future losses incurred after the acquisition of the second tranche are to be considered.

• Paragraph 19 allows an investment in an associate to be split into two, one for equity accounting and the other for fair value accounting by the venture capitalist and similar entities. Taking support from this, in the given situation, the investment can be split into two for the purpose of absorbing the losses.

• Paragraph 24 supports the continuation of equity accounting, rather than fair valuation of retained interest. Likewise, the additional investment in the associate could be accounted as a separate unit, and past losses shall in no way impact the additional investment made in the associate.

CONCLUSION

The author believes that both views are tenable in the absence of any clarity in the standards. It may also be noted that similar issues arise when an associate is acquired in stages. In such situations, multiple approaches have emerged in practice, such as the cost accumulation approach and the fair value approach. Within the cost accumulation approach, different variations can be applied.

Whichever approach is followed by the entity, appropriate disclosure of the accounting policy applied should be made and the accounting policy chosen should be consistently followed.

Can Negative Revenue Be Reclassified to Expense?

In recent months, global regulators have become active on the topic of reclassification of negative revenue to expenses under IFRS 15 Revenue from Contracts with Customers (Ind AS 115 Revenue from Contracts with Customers). The purpose of this article is to help address this question and to clarify the authors’ view under Ind AS. This issue will require significant judgement and therefore formal consultation is desirable.

Payments to customers can take many different forms, including payments made by an entity to current customers (such as compensation for delays paid by an airline to its passengers), and payments or discounts provided by an entity to its customers’ customers. This issue is, therefore, closely linked to:

  • Principal versus agent considerations;
  • Determining who is(are) the current customer(s) (and the customer’s customer); and
  • Whether payments or discounts granted to a customer’s customer are the result of contractual or implied promises to one’s direct customer (and, therefore, in the scope of Ind AS 115).

All of these have the potential to be judgemental assessments and will depend on the facts. Therefore, the application of the same requirements might look different between entities.

AUTHOR’S VIEW

Ind AS 115.70 requires payments to customers that are not in exchange for a distinct good or service to be treated as a reduction of the transaction price. Therefore, in light of the words in the standard, we believe it is acceptable for an entity to present payments to a customer in excess of the transaction price that are not in exchange for a distinct good or service within revenue (i.e., not reclassify to expense). This would be the most preferred treatment.

However, the author believes it might also be acceptable, in certain circumstances, to reclassify negative revenue to expense in an entity’s income statement. For example, if an entity demonstrates that characterisation of consideration payable to a customer as a reduction of revenue results in negative revenue for a specific customer on a cumulative basis (i.e., since the inception of the financial year between the entity and the customer or inception of the relationship with the customer and considering anticipated future contracts), then the amount of the cumulative negative revenue for a financial year could be reclassified to expense.

Ideally, whether cumulative negative revenue exists for a specific customer, revenues from all contracts with that customer recognised by all entities within the consolidated group that includes the entity paying the consideration to the customer needs to be considered (i.e., revenues recognised from sales to the customer from all of the consolidated entities needs to be considered). However, that could be very restrictive and not practical, and therefore a more practical approach in this regard may be acceptable. There could be situations, where some contracts with a customer result in positive revenue whereas other contracts with that customer result in negative revenue. Even in such circumstances, the author believes that the positive revenue and negative revenue need not be set off against each other for presentation purposes, and the negative revenue could be presented as an expense and the positive revenue presented as revenue. To justify this position, the entity shall have to demonstrate that each of these contracts with the customer were negotiated based on independently fair terms, and the contracts that resulted in negative revenue were entered into due to the exigencies involved and keeping in mind the market situation and nature of the product sold or service delivered at that time.

HOW DOES AN ENTITY MAKE THE ASSESSMENT?

An entity needs to use its judgement to make the assessment relating to the presentation of negative revenue. The answers to the questions below may provide an insight into the analysis for negative revenue and the degree of complexity involved.

  • Is the entity the principal or the agent in relation to specified goods or services in the contract and, therefore, who are its current customers? Note: the focus of this discussion is current customers (not former or potential customers)
  • Does the entity make payments to its identified customer(s) and / or other entities in the distribution chain for that contract (i.e., a customer’s customer)? Such payments are in the scope of the requirements for consideration payable to a customer in Ind AS 115.
  • Are any payments or discounts made to end-consumers (i.e., a customer’s customer) outside the distribution chain that are a contractual or implied promise to the entity’s direct customer? Such payments are also in the scope of the requirements for consideration payable to a customer in Ind AS 115.
  • If there is more than one customer (e.g., the merchants and end-consumers are both customers), to which customers do the payment or discount relate? i.e., understand to which customer relationship the consideration payable to a customer relates. This is important because, as noted above, it might not automatically relate to the party to whom it is paid (e.g., if it is paid by the entity on behalf of a customer to another party, who also happens to be a customer of the entity).

ILLUSTRATIVE EXAMPLE

This illustrative example is provided to assist in understanding this guidance. However, it is not intended to limit the types of fact patterns to which this guidance relates (e.g., the above guidance equally applies to direct payments to customers, arrangements involving more than one customer (e.g., where an end-consumer is also a customer), entities arranging other goods or services through websites, apps etc. (e.g., food delivery, taxi rides) for only a single merchant or several merchants).

Entity A operates a platform that facilitates the booking of air travel from various airlines through its website. Entity A has determined that it is the agent and that its performance obligation is to facilitate the sale of air travel on behalf of the airlines. For the sake of simplicity, assume that the airlines are Entity A’s only customers.

Even though the airlines set the prices for the tickets, Entity A has discretion in determining what price it charges the end-consumers. Therefore, Entity A is able to discount the amounts end-consumers pay, while still having to pay the full price to the airlines. It offers discounts to end-consumers to increase their use of the platform. However, it has determined that these payments are an implied promise to its customers (the airlines). That is, its customers have a valid expectation that the payment will be made to the end-consumer based on reasonably available information about the entity’s incentive program, including written or oral communications and any customary business practices of the entity.

As Entity A is an agent and its customers are the airlines, the assessment of cumulative negative revenue on a customer relationship basis would be with the individual airlines (and its group companies), not with each individual end-consumer.

Assume Entity A has two Airlines as customers (B and C). In each case, Entity A determines that these discounts:

  • Are not outside the scope of Ind AS 115 – while they might be paid to anyone, they are an implied promise to their customer (each Airline) and, therefore, the consideration payable to a customer,
  • Are not within the scope of other requirements in Ind AS 115 – e.g., they are not in settlement of a refund (or other) liability,
  • Are not in exchange for a distinct good or service – while they are intended to drive traffic to the website, that is not sufficient to conclude they are providing a distinct marketing service (or similar) to the entity.

Therefore, Entity A calculates total cumulative revenue (including consideration paid or payable to the customer) from all transactions with each Airline (and their group companies) across past, current, and anticipated future customer contracts or for a particular financial year.

Scenario 1: Net amount is not negative on a cumulative basis [Customer Airline B]

Entity A has earned, and expects to earn from current and anticipated contracts, revenue from Airline B that is sufficient to exceed any current discounts provided to Airline B’s customers (the end-consumers). Therefore, it treats the current discounts as a reduction of revenue and does not reclassify any amounts in the current period (even if it causes revenue in the current period to be negative for this customer).

However, as discussed above the entity may have good reasons to classify with regards to Airline B, all the negative revenue as the expense and all positive revenue as revenue, depending upon facts and circumstances, which are discussed earlier.

Scenario 2: Net amount is negative on a cumulative basis [Customer Airline C]

Entity A has earned, and expects to earn from current and anticipated contracts, revenue from Airline C that is not sufficient to exceed any current discounts provided to Airline C’s customers (the end-consumers). That is, the entity performed a thorough review of all past, current and anticipated contracts with Airline C, and all revenues from and payments to that customer recognised by all entities within the consolidated group that includes the entity paying the consideration to the customer and determining that there is a cumulative negative revenue for Airline C.

Therefore, the entity can reclassify the cumulative negative revenue (not the current period shortfall) to expense. However, the entity is not mandatorily required to do so; i.e., negative amounts could remain in revenue in accordance with Ind AS 115.70.

CONCLUSION

There are multiple ways of addressing the presentation of negative revenue, in the absence of specific guidance under Ind AS 115 on this topic. The presentation of negative revenue can be extremely complex under Ind AS and formal consultation on the matter is always desirable.

Streaming Arrangements

Mining companies (also referred to as producers) use metal streaming arrangements to raise funds. The Producer enters into a metal streaming arrangement with a streaming company (the “Investor) where the Producer may receive an upfront cash payment plus ongoing predetermined per unit payments for part or all of the metal production and sometimes by-product metals (e.g., silver extracting from zinc ores). This enables the Producer to access funding by monetizing the product or by-product metal. The Investor too is assured of a supply of metals without having to develop or operate the mine. The accounting of such arrangements can be extremely complex and is dealt with below.

QUERY

Hindustan Metal (HM), owns iron ore mines. HM enters into a streaming arrangement with the Investor. HM commits to deliver 60 per cent of the iron ore production of the mine over the life of the mine in exchange for an upfront advance of $100 million and the lesser of, $120 and the market price per tonne of iron ore, for each future tonne or iron ore delivered. The upfront advance funds generally will be used to finance capital expenditures in the development of the mine project for which HM holds the mineral rights. When the market price exceeds $120 / tonne, the notional drawdown of the upfront advance funds is based on the difference between the market price of iron ore at the time of delivery and the actual amount received (i.e., the $120 / tonne.). Even if the advance is reduced to zero, HM is still contractually obligated to deliver iron ore over the remaining term of the arrangement and will receive the lesser of $120 / tonne and the market price. The balance of the upfront advance may be reimbursable (in cash, usually without interest) to the Investor at a specified date or the end of the life of the mine if the amount has not previously been reduced to zero. How is the arrangement recorded in the books of HM?

RESPONSE

Streaming arrangements may be accounted for by the Producer in a number of ways based on an analysis of all of the relevant facts and circumstances. Potential methods of accounting for these streaming arrangements by the Producer include, but are not necessarily limited to be discussed after the accounting standard references below:

ACCOUNTING STANDARD REFERENCES

Ind AS 109 Financial Instruments

Paragraph 2.4

This Standard shall be applied to those contracts to buy or sell a non-financial item that can be settled net in cash or another financial instrument, or by exchanging financial instruments, as if the contracts were financial instruments, with the exception of contracts that were entered into and continue to be held for the purpose of the receipt or delivery of a non-financial item in accordance with the entity’s expected purchase, sale or usage requirements. However, this Standard shall be applied to those contracts that an entity designates as measured at fair value through profit or loss in accordance with paragraph 2.5.

Paragraph 2.6

There are various ways in which a contract to buy or sell a non-financial item can be settled net in cash or another financial instrument or by exchanging financial instruments. These include: 

(a) when the terms of the contract permit either party to settle it net in cash or another financial instrument or by exchanging financial instruments; 

(b) when the ability to settle net in cash or another financial instrument, or by exchanging financial instruments, is not explicit in the terms of the contract, but the entity has a practice of settling similar contracts net in cash or another financial instrument or by exchanging financial instruments (whether with the counterparty, by entering into offsetting contracts or by selling the contract before its exercise or lapse); 

(c) when, for similar contracts, the entity has a practice of taking delivery of the underlying and selling it within a short period after delivery for the purpose of generating a profit from short term fluctuations in price or dealer’s margin; and 

(d) when the non-financial item that is the subject of the contract is readily convertible to cash. 

A contract to which (b) or (c) applies is not entered into for the purpose of the receipt or delivery of the non-financial item in accordance with the entity’s expected purchase, sale or usage requirements and, accordingly, is within the scope of this Standard. Other contracts to which paragraph 2.4 applies are evaluated to determine whether they were entered into and continue to be held for the purpose of the receipt or delivery of the non-financial item in accordance with the entity’s expected purchase, sale or usage requirements and, accordingly, whether they are within the scope of this Standard.

RESPONSE
Following are some of the factors (not an exhaustive list) to be considered when making an assessment of the appropriate accounting for streaming arrangements:

  • The settlement mechanism of the upfront advance (e.g., through delivery of the commodity, cash or other financial assets)? Settlement through the delivery of commodity may suggest that own-use exemption may apply.
  • When settlement happens fully or partly using cash or another financial asset, the following aspects may need to be considered:
  • Contingent settlement provisions, whereby the Producer is required to pay cash only under certain conditions and the genuineness of those conditions;
  • Provisions which allow the Investor the right or option to receive cash instead of commodity;
  • The right of the Investor to cancel the arrangement and require the Producer to make a lump sum cash payment or transfer other financial assets;
  • Reimbursement of the upfront advance at a specified date or the end of the life of the mine if the upfront advance has not been reduced to zero and whether such an amount could be significant.
  • When settled through delivery of the commodity, will it always be obtained from the Producer’s operations or expected to be purchased from the open market or a third party? Own-use exemption may not apply when settlement is the basis of the purchase from an open market or third party, which may be suggestive of a derivative contract. Other related factors to consider may be:
  • The amount of the commodity required to settle the arrangement compared to expected future production from the Producer’s operation and estimated mineral quantity;
  • The timing of expected future production from the operation compared to any specific delivery dates per the arrangement;
  • The past business practice of the producer for similar arrangements;
  • The term of the arrangement in relation to the expected life of the mine;
  • Understanding how the risks are shared between the Producer and the Investor if the output of the mine is not as expected or changes in government policy regulating mines?
  • Which party bears the price risk of the underlying commodity?
  • Which party bears the risk that the cost of developing the mine is higher than anticipated?
  • Whether the Producer or the Investor controls the mines and who has the right to take significant decisions relating to the operation of the mine, such as a go or no-go area?
  • Can the commodity be readily converted to cash? Is the commodity indexed to a quoted price?
  • Provisions relating to defaults, e.g., the right of the Investor to levy a penalty on the Producer for not delivering the commodity as per the agreed schedule. Such a right may be suggestive that the risks relating to the mine are not shared by the Investor, and therefore, the arrangement may not qualify as a part sale of assets. It would mean that such arrangements are commodity arrangements and assessment would be required to determine if an own-use exemption applies.
  • Is there an explicit or implicit and significant financing component (e.g., rate of interest) in the arrangement?

COMMODITY ARRANGEMENT

This arrangement may qualify as a commodity arrangement that is outside of the scope of Ind AS 109 provided the streaming arrangement is determined to be an executory arrangement to deliver an expected amount of the commodity to the Investor from the Producer’s own operation (i.e., it meets the “own-use” exemption as set out in paragraph 2.4 of Ind AS 109). For the “own-use exemption” to apply, the arrangement must always be settled through the delivery of the commodity which has been obtained by the Producer as part of its own operations.

If the own-use exemption applies, then the arrangement is treated as an executory arrangement to be fulfilled on an ongoing basis, and the upfront advance received by the Producer is accounted as an advance payment (unearned revenue) related to the future sale of commodities. Care is needed when analysing all the terms of the arrangement to determine whether they give rise to separable embedded derivatives (such as caps, floors and collars) that need to be separated and accounted for as derivatives.

DERIVATIVE CONTRACT

If the “own-use exemption” does not apply, the streaming arrangement may qualify as a derivative under Ind AS 109. When the commodity is readily convertible to cash, or either party can settle net in cash or has a past practice of doing so, and delivery will not be made with the Producer’s own production, the arrangement would qualify as a derivative. If the streaming arrangement is considered a derivative, it would be measured at fair value through profit and loss (“FVTPL”). In such an assessment, the upfront advance made under the streaming arrangement would make the derivative partially pre-paid.

FINANCIAL LIABILITY

The arrangement may qualify as a financial liability (i.e., debt) in accordance with Ind AS 109 when the streaming arrangement establishes a contractual obligation for the Producer to deliver cash or another financial asset. An example of net settlement in cash is where a commodity producer enters into a contract to supply a specified amount of a commodity and, in addition, pays or receives an amount in cash based on the difference between the market price of the commodity on the date of its supply and the price stated in the contract. Settlement may be part or the entire contract can be paid in cash, instead of through the physical delivery of the commodity.

When the streaming arrangement is classified as a financial liability, the commodity-linked principal (and interest) may be separated from the host debt instrument and accounted for at FVTPL because it is exposed to dissimilar risks and would not be closely related. Alternatively, a company could elect for the entire instrument to be measured at FVTPL. A call, put, or prepayment option embedded in a host debt instrument should be reviewed to determine if separation is required. Caution needs to be exercised when analysing all the terms of the arrangement to determine whether they give rise to other embedded derivatives and/or if they are important in the assessment of the classification of the streaming arrangement.

SALE OF A MINERAL INTEREST AND A CONTRACT TO PROVIDE SERVICES

Such an arrangement may qualify as a sale of a mineral interest and a contract to provide services — such as extraction, refining, etc., in accordance with Ind AS 16 Property, Plant and Equipment and Ind AS 115 Revenue from Contracts with Customers when the streaming arrangement meets the criteria under Ind AS 115 for a sale.

Under the sale of the mineral interest classification, an argument might be made that the upfront advance relates to the sale of a portion of the mineral interest, and the price per unit payments made by the Investor as the commodity is delivered in the future relates to the cost of the services (e.g., extraction, refining, etc.) provided by the Producer to the Investor.

The service portion of the arrangement may include a “cap” or “out-of-the-money floor” on the selling price of a commodity that may need to be accounted for separately as an embedded derivative. Caution needs to be exercised to determine whether such features give rise to embedded derivatives or if they are determinative in the assessment of the classification of the streaming arrangement.

CONCLUSION

Determining the appropriate accounting approach is not an accounting policy choice but rather an assessment of the specific facts and circumstances. Examples of additional terms that can be found in these arrangements include a cap on the price per tonne, interest-bearing upfront advance, a commitment to deliver a minimum quantity within a specified limit, time-bound arrangements, buy-back rights of the producer, etc. Some arrangements may include by-products only, e.g., fines (pieces of iron ore) rather than the iron ore.

The determination of how to account for a streaming arrangement requires significant judgment and careful consideration of the facts and circumstances, as discussed above. Globally, it appears that there is a mixed practice for the accounting of streaming arrangements.

Purchase-As-Produced Contracts – Whether Derivative or Not?

ISSUE

Kleen Co. enters into a power purchase agreement (PPA) with a windmill operator to purchase electricity. Both Kleen and the operator are connected through a common national grid. The PPA obliges Kleen to acquire a 45 per cent fixed share of the wind energy produced by the operator. The price per unit for the energy is fixed in advance and remains stable throughout the contract duration of 25 years. The operator does not guarantee a specific amount of output (energy) but estimates with 80 per cent probability an expected amount. The energy produced is transferred to Kleen through the national grid.

The total energy demand of Kleen by far exceeds both the contracted share of the estimated output and the contracted share of the peak output of the wind park. However, Kleen does not operate its production facilities 24/7 but pauses production during the night times, on weekends and holiday season. There is thus a mismatch between the demand profile of Kleen and the supply profile of the wind park.

Kleen is obliged to acquire the energy of the wind park in the amount (45 per cent of the current production volume) and at the time it is produced. Since Kleen has no feasible option to store the energy, it sells energy that cannot be consumed immediately (e.g., on weekends or overnight) to the spot market and repurchases (at least) the same amount from that market at times when the production facilities are operated. The windmill operator continues to transfer the amounts of energy fed into the grid to the account of Kleen and Kleen has to sell unused amounts from its account to third parties. The process of selling and repurchasing is designed to be an autopilot that acts without the intention of trading to realize profits and has the sole intention to enable Kleen’s operations. The process of selling and repurchasing is delegated to a service provider.
For the purpose of this discussion, it is assumed that the conditions do not change throughout subsequent periods and that some market transactions become necessary for unused amounts of energy.

Will own-use exemption apply in this case, and consequently, whether the above PPA is to be treated as a derivative or not?

Kleen has considered aspects relating to whether the PPA is accounted for applying another Ind AS Accounting Standard, for example, Ind AS 110 Consolidated Financial Statements, Ind AS 111 Joint Arrangements, and/or Ind AS 116 Leases, and believes that those do not apply in the extant fact pattern.

RELEVANT REQUIREMENTS OF IND AS 109 FINANCIAL INSTRUMENTS

Paragraph 2.4 of Ind AS 109 states:

This Standard shall be applied to those contracts to buy or sell a non financial item that can be settled net in cash or another financial instrument, or by exchanging financial instruments, as if the contracts were financial instruments, with the exception of contracts that were entered into and continue to be held for the purpose of the receiptor delivery of a non financial item in accordance withthe entity’s expected purchase, sale or usage requirements. However, this Standard shall be applied to those contracts that an entity designates as measured at fair value through profit or loss in accordance with paragraph 2.5.

Paragraph 2.6 of Ind AS 109 states:

There are various ways in which a contract to buy or sell a non-financial item can be settled net in cash or another financial instrument or by exchanging financial instruments. These include:

(a)    when the terms of the contract permit either party to settle it net in cash or another financial instrument or by exchanging financial instruments;

(b)    when the ability to settle net in cash or another financial instrument, or by exchanging financial instruments, is not explicit in the terms of the contract, but the entity has a practice of settling similar contracts net in cash or another financial instrument or by exchanging financial instruments (whether with the counterparty, by entering into offsetting contracts or by selling the contract before its exercise or lapse);

(c)    when, for similar contracts, the entity has a practice of taking delivery of the underlying and selling it within a short period after delivery for the purpose of generating a profit from short-term fluctuations in price or dealer’s margin; and

(d)    when the non-financial item that is the subject of the contract is readily convertible to cash.

A contract to which (b) or (c) applies is not entered into for the purpose of the receipt or delivery of the non financial item in accordance with the entity’s expected purchase, sale or usage requirements and, accordingly, is within the scope of this Standard. Other contracts to which paragraph 2.4 applies are evaluated to determine whether they were entered into and continue to be held for the purpose of the receipt or delivery of the non financial item in accordance with the entity’s expected purchase, sale or usage requirements and, accordingly, whether they are within the scope of this Standard.

ACCOUNTING FOR THE PPA

On the date of inception of the contract, Kleen regards the sole purpose of the PPA as a contract to buy a non-financial item as it is entered for the purpose of the receipt of energy in accordance with its expected usage requirements, as laid out in Ind AS 109.2.4. Kleen does not designate the contract as measured at fair value through profit or loss in accordance with Ind AS 109.2.5. Kleen views the difference in prices (lower prices during night times, on weekends and during the holiday season when production is paused vs. higher prices when repurchased on spot markets during peak times) as costs of storage, i.e., it uses the energy spot market as a storage facility. Kleen does not operate as a trading party in the market, the production schedule and the consumption profile dictate spot price transactions.Kleen further analyses whether the contract can be settled net in cash in accordance with Ind AS 109.2.6.

Kleen is always in a net purchaser position, i.e., it buys more energy from the spot market than it has sold to it based on a monthly view (meaning that for every calendar month, the Kleen has purchased more energy on spot markets than it has sold). The average purchase price exceeds the average sale price, so that Kleen incurs expenses for “storing” the energy on spot markets which is part of the fee paid to a service provider involved to sell unused amounts of energy to and repurchase additional demands from the grid/spot markets.

The various views are presented below:

View A

Kleen assesses at the inception of the contract that

(a)    the terms of the contract do not provide for an option to settle net in cash or by exchanging financial instruments.

(b)    Kleen has no practice of settling similar contracts net in cash or another financial instrument or by exchanging financial instruments.

(c)    Kleen intends to sell unwanted energy out of the contract to the spot market and also intends to purchase at least the same amount of energy at times when it is needed. Kleen uses the spot market as a storage mechanism and does not intend to generate profits from those transactions although it cannot rule out that some transactions will lead to profits or losses. Transactions on the spot market are solely used to store the energy.

(d)    Kleen assesses the non-financial item to be readily convertible to cash as there is an active market where unused energy can be sold and purchased at any time.

Kleen concludes that the own-use-exemption applies to its contract because it is entered into and continues to be held for the purpose of taking delivery of the non-financial asset (energy), in accordance with the entity’s expected (energy) consumption.

View B

Kleen expects transactions on the spot market already at the inception of the contract for the amount of energy it cannot use when it is produced. Under View B this would disqualify the contract from the application of the own-use-exemption because the contract was not – in its entirety – being held to the purpose of the receipt of the energy at the specific time of production (Ind AS 109.2.4) but with some anticipated sales transactions.View C

As Kleen intends to sell unused energy to the spot market, it creates a practice of settling similar contracts on the spot market and therefore the contract is not entered into for the purpose of the receipt of the energy (Ind AS 109.2.6(b)).View D

Under this View D, the transactions on the spot market may lead to a breach of the requirement set out in Ind AS 109.2.6(c) (generating profit from short-term fluctuations in price or dealer’s margin) because Kleen cannot rule out that profit arises from some sales transactions, even though this is not intended.CONCLUSION

Under View A, the PPA would be treated as a normal purchase of an electricity contract. However, Views B-D would all result in recognising the contract as a derivative financial instrument.

As laid out above, there are several ways to interpret the requirements of Ind AS 109.2.4 and .2.6 which give rise to diversity in practice. Failure to meet the requirements of the own-use-exemption results in a mandatory recognition as a financial derivative at fair value. Given PPA durations of 25 years and above, the fair value of such PPA is both difficult to measure and subject to enormous volatility and likely leads to massive effects on the financial statements and financial performance when changes in the fair value are recognized in profit or loss. It would also decouple the effects of Kleen’s efforts to secure its supply of energy from the operating results as the fair value changes will occur and be presented before the consumption of the energy, the production phase and the sale of the output manufactured using this energy.

There is a need for clarification on how Ind AS 109 isto be applied in the circumstances described above. The author believes that the economic purpose and the intention of Kleen when entering the contract are not adequately reflected by the treatment of such contracts as derivative financial instruments, solely because there is no feasible way to store the quantities of energy involved and Kleen has to use the spot market as a storage mechanism.

The author also questions whether accounting for such contracts as derivative financial instruments would adequately depict the operating performance of Kleen, since energy costs would affect the operating profit at their spot prices, and the effect of the PPA containing fixed prices would occur as a measurement adjustment in periods different from the period of consumption.

When the standards are not absolutely clear, it is essential to understand the intention of the standard-setters, and what the standard is trying to achieve. In the present case, Kleen’s objective is not to trade in electricity or profit from short-term fluctuations in the prices. On the contrary, the unwanted electricity is sold at a price lower than the fixed price per unit under the PPA. The average purchase price exceeds the average sale price, so that Kleen incurs expenses for “storing” the energy on spot markets which is part of the fee paid to a service provider involved to sell unused amounts of energy to and repurchase additional demands from the grid/spot markets.

Furthermore, in totality, Kleen is always a net purchaser rather than a net seller, i.e., it buys more energy from the spot market than it has sold to it based on a monthly view (meaning that for every calendar month, Kleen has purchased more energy on spot markets than it has sold).

Based on the above discussion, the author believes that View A is the most appropriate view, and reflects the intention of Kleen as well as the standard-setter and the overall economics of the PPA.

Borrowing Costs

As per Ind AS 23 BorrowingCosts, an entity shall capitalise borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset, as part of the cost of that asset. An entity shall recognise other borrowing costs as an expense in the period in which it incurs them. Though this appears simple, in practice, numerous complicated situations arise, particularly, with respect to allocation of interest on general borrowings, treatment of interest income, foreign exchange gains and losses, etc. Here, we take a look at the treatment of interest income earned on the mobilisation advances made to vendors involved in the construction of a project.

QUERY

1. Dixon is a debt-free company. For the purposes of constructing a new manufacturing plant, it has used internally generated funds that are currently deposited in fixed deposits with banks. The funds will be used to provide advances to vendors involved in the construction of the plant. These advances carry interest at applicable market rates. Since the fixed deposits are withdrawn, Dixon will no longer earn the interest income on fixed deposits. However, Dixon will earn interest income on the mobilisation advance. How is the interest income on mobilisation advance accounted for? Can Dixon capitalise as project cost the notional interest income lost on the fixed deposits, which going forward it will no longer earn?

2. Amber was hitherto a debt-free company. For the purposes of constructing a new manufacturing plant, it has borrowed money from a financial institution. The amount borrowed will be used to provide advances to vendors involved in the construction of the plant. These advances carry interest at applicable market rates. Since advances are extended over time, the surplus funds are temporarily invested in a bank and interest income is earned on the same. How are the interest expense and interest income accounted for?

RESPONSE

References

Indian Accounting Standard (Ind AS) 16 Property, Plant and Equipment

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

Indian Accounting Standard (Ind AS) 23 Borrowing Costs

5 Borrowing costs are interest and other costs that an entity incurs in connection with the borrowing of funds.

12 To the extent that an entity borrows funds specifically for the purpose of obtaining a qualifying asset, the entity shall determine the amount of borrowing costs eligible for capitalisation as the actual borrowing costs incurred on that borrowing during the period less any investment income on the temporary investment of those borrowings.

14 … The amount of borrowing costs that an entity capitalises during a period shall not exceed the amount of borrowing costs it incurred during that period.

26 An entity shall disclose: (a) the amount of borrowing costs capitalised during the period; and (b) the capitalisation rate used to determine the amount of borrowing costs eligible for capitalisation.

ANALYSIS

1. As per Ind AS 23, in accordance with the definition of borrowing costs in paragraph 5, borrowing costs are to be incurred. Also, paragraph 12 requires the borrowing costs to be the actual borrowing costs incurred. Additionally, paragraph 14 makes it clear that borrowing costs capitalised during a period shall not exceed the amount of borrowing costs incurred during the period. In other words, borrowing costs cannot be imputed costs or notional costs; they have to be actually incurred.

2. As per paragraph 12 of Ind AS 23, to the extent that an entity borrows funds specifically for the purpose of obtaining a qualifying asset, the entity shall determine the amount of borrowing costs eligible for capitalisation as the actual borrowing costs incurred on that borrowing during the period, less any investment income on the temporary investment of those borrowings.

3. As per paragraph 21 of Ind AS 16, because incidental operations are not necessary to bring an item to the location and condition necessary for it to be capable of operating in the manner intended by management, the income and related expenses of incidental operations are recognised in profit or loss and included in their respective classifications of income and expense.

CONCLUSION

Accounting by Dixon

1. As discussed above, borrowing costs cannot be negative, notional or imputed. Consequently, in accordance with paragraphs 5, 12 and 14 of Ind AS 23, the interest income earned by Amber on the mobilisation advance, as well as the imputed interest income on fixed deposits, which will no longer be earned by Amber going forward, cannot be reduced from the amount to be capitalised as project cost. The interest income earned from vendors on mobilisation advance should be accounted for as interest income under other income or other operating revenue as appropriate.

The above position can also be corroborated with paragraph 21 of Ind AS 16, which requires the income and related expenses of incidental operations to be recognised in profit or loss and included in their respective classifications of income and expense.

Accounting by Amber

2. In the case of Amber, there seems to be a direct correlation between the amount borrowed and used for the purposes of constructing the plant. Also, there is a direct correlation between the borrowing costs and the funds invested temporarily on which interest income is earned.

Consequently, Amber will reduce the said interest income from the interest expense, and capitalise only the net amount as part of the project cost, in accordance with the requirement of paragraph 12 of Ind AS 23.

DISCLOSURES

Both Dixon and Amber will make the requisite disclosures required under paragraph 26 of Ind AS 23. Additionally, the accounting policy applied will also be disclosed.

COMMON CONTROL TRANSACTIONS

When a subsidiary merges
with its parent company, the profit element in the inter-company transactions
and the consequential tax effects need to be eliminated from the earliest
comparative period. This article explains why and how this is done.

 

FACTS

A parent has several
subsidiaries and is listed on Indian exchanges. One of the subsidiaries merges
with the parent. The merger order is passed by the NCLT on 30th
November, 2020 with the appointed date of 1st April, 2019. The
appointed date is relevant for tax and regulatory purposes.

 

Prior to 1st
April, 2019 the subsidiary had sold inventory to the parent for onward sale by
the parent. The cost of inventory was INR 80 and the subsidiary had sold it to
the parent at INR 100. At 1st April, 2019 the inventory was lying
with the parent company. The tax rate applicable for the parent and the
subsidiary is 20%.

 

The parent sells the
inventory to third parties at a profit in May, 2019. In June, 2019, the
subsidiary sells inventory to the parent. The cost of inventory was INR 160 and
the subsidiary had sold it to the parent at INR 200. At 30th June,
2019 the inventory remains unsold in the books of the parent company.

 

After the merger, the
subsidiary becomes a division of the parent company and the inventory transfer
between the division and the parent is made at cost.

 

In preparing the merged
financial statements, whether adjustments are made for the unrealised profits
and the consequential tax effects? If yes, how are these adjustments carried
out?

 

RESPONSE

Paragraph 2 of Appendix C
of Ind AS 103 Business Combinations of Entities Under Common Control
defines a common control transaction as

‘Common
control business combination means a business combination involving entities or
businesses in which all the combining entities or businesses are ultimately
controlled by the same party or parties both before and after the business
combination, and that control is not transitory.’

 

Paragraph 8 states as
follows

‘Business
combinations involving entities or businesses under common control shall be
accounted for using the pooling of interests method.’

 

Paragraph 9 states as
under:

‘The pooling of interest
method is considered to involve the following:

(i)  The assets and liabilities of the combining
entities are reflected at their carrying amounts.

(ii)  No adjustments are made to reflect fair values
or recognise any new assets or liabilities. The only adjustments that are made
are to harmonise accounting policies.

(iii) The financial information in the financial
statements in respect of prior periods should be restated as if the business
combination had occurred from the beginning of the preceding period in the
financial statements, irrespective of the actual date of the combination.
However, if business combination had occurred after that date, the prior period
information shall be restated only from that date.’

 

The following conclusions
can be drawn:

1. The transaction is a common control transaction
and is accounted for using the pooling of interests method.

2. The financial statements for prior periods are
restated from the earliest comparative period, i.e., from 1st April,
2019.

3. Adjustments are made to the financial
statements to harmonise accounting policies. Therefore, in the merged accounts
unrealised profits arising from the transaction between the parent and the
merged subsidiary should be eliminated.

4. As this is a listed entity and information
relating to comparative quarters is provided in the financial results, the
adjustments for unrealised profits are made for all comparative and current
year quarters, up to the date the merger takes place.

 

In the merged accounts, the
following adjustments are made with respect to the unrealised profits:

 

At 1st April,
2019, the following adjustment will be required to the merged numbers:

Inventory
credit                                                 20

Deferred
tax asset debit (20% on 20)                  4

Retained
earnings debit                                     16

 

The adjustment is made to
reflect the fact that when the inventory is sold to external parties, the
merged entity will not be subject to tax again on INR 20.

 

As the inventory is sold in
the first quarter, the following entry will be passed with respect to tax:

P&L (deferred tax line)
debit                  4

Deferred tax asset credit                       4

 

At 30th June,
2019 the following adjustment will be required:

Inventory
credit                                    40

Current
tax asset debit (20% on 40)       8

P&L
debit                                            32

 

Since the parent will file
a revised return for the previous financial year, the tax paid on INR 40 will
be shown as recoverable from the tax authorities, rather than as a deferred tax
asset.

 

The above adjustments are carried out
for all the quarterly results from 1st April 2019 up to the date of
the NCLT order, i.e. 30th November, 2020.

 

 

COMMON CONTROL TRANSACTIONS

This article deals with the
appropriate accounting in an interesting situation where a parent merges with
its own subsidiary. At present there is no direct guidance on this subject.

 

FACTS
OF THE CASE

*    Entity X is a listed entity and has only two
subsidiaries; 35% in X is held by the Promoter Group and the remaining 65% is
widely dispersed. All entities have businesses.

*    During the year, the Board of Directors of X
has decided to carry out a two-step restructuring plan.

*    As part of the restructuring plan, first Y
will get merged into X and then X will be merged into Z (the surviving entity).

*    Both Y and Z were acquired by X five years
ago and goodwill relating to the acquisition is appearing in the consolidated
financial statement (CFS) of X.

*    The rationale for this plan is to utilise the
incentives / deduction under the Income Tax Act that Entity Z has and to create
greater operational synergies.

*    After the merger, Z is the only surviving
entity and there will be no CFS to be prepared.

 

 

What is the accounting in
the books of Z, which is the surviving entity?

 

RESPONSE

Reference
to standards and other pronouncements

The relevant portion of
Appendix C, Business Combinations of Entities under Common Control of Ind AS
103 – Business Combinations, is reproduced below.

 

Paragraph 2 defines common
control business combination as – ‘Common control
business combination means a business combination involving entities or
businesses in which all the combining entities or businesses are ultimately
controlled by the same party or parties both before and after the business
combination, and that control is not transitory.’

 

‘8
Business combinations involving entities or businesses under common control
shall be accounted for using the pooling of interests method.

 

9 The
pooling of interest method is considered to involve the following:

 

i.   The assets and liabilities of the combining
entities are reflected at their carrying amounts………’

 

ICAI’s Ind AS Transition Facilitation Group Bulletin 9 (ITFG 9),
Issue No 2, provides the following clarifications:

 

When two subsidiaries
merge, it requires the merger to be reflected at the carrying values of assets
and liabilities as appearing in the standalone financial statements of the
subsidiaries as follows:

 

In
accordance with the above, it may be noted that the assets and liabilities of
the combining entities are reflected at their carrying amounts. Accordingly, in
accordance with paragraph 9(a)(i) of Appendix C of Ind AS 103, in the separate
financial statements of C Ltd., the carrying values of the assets and
liabilities as appearing in the standalone financial statements of the entities
being combined, i.e., B Ltd. & C Ltd. in this case shall be recognised.

 

When a subsidiary merges
with the parent entity, it requires the merger to be reflected at the carrying
values of assets and liabilities as appearing in the consolidated financial
statements of the parent entity as follows:

 

In
this case, since B Ltd. is merging with A Ltd. (i.e., parent) nothing has
changed and the transaction only means that the assets, liabilities and
reserves of B Ltd. which were appearing in the consolidated financial
statements of Group A immediately before the merger would now be a part of the
separate financial statements of A Ltd. Accordingly, it would be appropriate to
recognise the carrying value of the assets, liabilities and reserves pertaining
to B Ltd. as appearing in the consolidated financial statements of A Ltd.
Separate financial statements to the extent of this common control transaction
shall be considered as a continuation of the consolidated group.

 

ANALYSIS

In our fact pattern,
because there is no change in the shareholders or their ownership, post
ultimate restructuring, this is a common control transaction. The accounting
will be done step-wise in the following manner:

 

Step
I: Merger of Y (Subsidiary) with X (Parent)

This transaction has been
dealt with in ITFG 9 Issue 2,
wherein it is concluded that it would be appropriate to recognise in separate
financial statements (SFS) of X the carrying value of the assets, liabilities
and reserves pertaining to Y as appearing in the consolidated financial statements
of X, as this merger transaction has changed nothing and the transaction only
means that the assets, liabilities, reserves, including goodwill and intangible
assets recognised upon acquisition of Y which were appearing in the
consolidated financial statements of Group X immediately before the merger,
would now be a part of the separate financial statements of X Ltd.

 

Step
II: Post Step I, merger of X (Parent) with Z (Subsidiary)

Drawing an analogy from the
ITFG 9 Issue 2, wherein it is concluded that
when subsidiary merges with parent, it is appropriate to use CFS numbers for merger accounting, a similar
conclusion can be drawn, where parent merges with subsidiary as direction of
merger (i.e., whether parent merges with subsidiary or vice versa), should not change the
conclusion. Besides, if X’s SFS is used in accounting for the merger, the
goodwill recognised for acquisition of Z would disappear, which will not be
appropriate.

 

In a nutshell, Z will account for this transaction by recording
assets, liabilities, reserves, including goodwill and intangible assets
recognised upon acquisition of Y and Z, by using the numbers appearing in the
CFS of X. This is the most appropriate thing to do because otherwise the
acquisition accounting reflected in the CFS for acquisition of Y and Z will
simply disappear, which will not be appropriate.

 

 

 

Today we live in a society in
which spurious realities are manufactured by the media, by governments, by big
corporations, by religious groups, political groups… So I ask, in my writing,
What is real? Because unceasingly we are bombarded with pseudo-realities
manufactured by very sophisticated people using very sophisticated electronic
mechanisms. I do not distrust their motives; I distrust their power. They have
a lot of it. And it is an astonishing power: that of creating whole universes,
universes of the mind. I ought to know.
I do the same thing

 —  Philip K. Dick

 

Accounting of Export Incentives

Accounting for Government Grants can be complex because grants may be subjected to numerous conditions, some of which could provide conflicting signals as to what the grant is trying to compensate or incentivise. Additionally, Ind AS 20 is based on the legacy IAS 20, which has not been revised for many years and may have outlived its utility. The accounting of the grant should reflect what the grant is meant to do, on a broad level. Here, we look at an export incentive scheme and discuss the various accounting issues and the appropriate Ind AS accounting and presentation.

QUERY

Gopaldas Exports Ltd (GEL), the exporter, is eligible to receive export incentives for merchandise exports under the RoDTEP (Remission of Duties and Taxes on Exported Products) Scheme under the Foreign Trade Policy of the Government of India. Under the scheme:

1. GEL is entitled to receive Duty Credit Scrips (DCS) ranging from 1.5 per cent to 2 per cent of the exported goods, depending on the type of product exported.

2. DCS can be used by the GEL for payment of import duty or it may sell it in the market. Typically, the DCS scrips would fetch 80 per cent to 95 per cent of the value in the market, depending upon the demand and supply for DCS at the time of sale.

3. DCS is allowed at the time of presentation of the shipping bill, but it is subject to receipt of foreign exchange. If foreign exchange is not ultimately collected, DCS will be deemed to be ineligible.

GEL has raised the following queries:

1. Is the DCS incentive a government grant or government assistance?

2. At what point in time should DCS be recorded as income?

3. At what amount should DCS be recorded as income?
4. Whether the incentive income is presented as revenue from operations, other income or other operating revenue?

RESPONSE

First, let us take a look at the various relevant references.

Ind AS 20 Accounting for Government Grants and Disclosure of Government Assistance

Definition

Government grants are assistance by the government in the form of transfer of resources to an entity in return for past or future compliance with certain conditions relating to the operating activities of the entity. They exclude those forms of government assistance which cannot reasonably have a value placed upon them, and transactions with the government which cannot be distinguished from the normal trading transactions of the entity.

7 Government grants, including non-monetary grants at fair value, shall not be recognised until there is reasonable assurance that: (a) the entity will comply with the conditions attached to them; and (b) the grants will be received.

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

29 Grants related to income are presented as part of profit or loss, either separately or under a general heading such as ‘Other income’; alternatively, they are deducted in reporting the related expense.

GN on Division II – Ind AS Schedule III to the Companies Act 2013

9.1.7. Revenue from operations needs to be disclosed separately as revenue from (a) the sale of products, (b) the sale of services and (c) other operating revenues. It is important to understand what is meant by the term “other operating revenues” and which items should be classified under this head vis-à-vis under the head “Other Income”.

9.1.8. The term “other operating revenue” is not defined. This would include Revenue arising from a company’s operating activities, i.e., either its principal or ancillary revenue-generating activities, but which is not revenue arising from the sale of products or rendering of services. Whether a particular income constitutes “other operating revenue” or “other income” is to be decided based on the facts of each case and a detailed understanding of the company’s activities.

9.1.9. The classification of income would also depend on the purpose for which the particular asset is acquired or held. For instance, a group engaged in the manufacture and sale of industrial and consumer products also has one real estate arm. If the real estate arm is continuously engaged in leasing of real estate properties, the rent arising from leasing of real estate is likely to be “other operating revenue”. On the other hand, consider a consumer products company which owns a 10 storied building. The company currently does not need one floor for its own use and has given the same temporarily on rent. In that case, lease rent is not an “other operating revenue”; rather, it should be treated as “other income”.

9.1.10. To take other examples, the sale of Property, Plant and Equipment is not an operating activity of a company, and hence, profit on the sale of Property, Plant and Equipment should be classified as other income and not other operating revenue. On the other hand, the sale of manufacturing scrap arising from operations for a manufacturing company should be treated as other operating revenue since the same arises on account of the company’s main operating activity.

RESPONSE TO QUERY 1

Government grants are assistance by the government in the form of transfer of resources to an entity in return for past or future compliance with certain conditions relating to the operating activities of the entity. They exclude those forms of government assistance which cannot reasonably have a value placed upon them and transactions with the government which cannot be distinguished from the normal trading transactions of the entity. For e.g., free access to water supply by the government, which is not subjected to any normal trading transaction or future condition, would qualify as government assistance.

A reasonable value can be placed on the DCS scrips and are earned basis conditions to be fulfilled and arise from normal trading transactions. Consequently, basis the Ind AS definition, the DCS scrips qualify as government grants. Additionally, as per paragraph 9, it does not matter if the incentive is received in cash or by way of scrips; that does not change the view that the incentive is a grant.

RESPONSE TO QUERY 2

As per paragraph 7, government grants, including non-monetary grants at fair value, shall not be recognised until there is reasonable assurance that: (a) the entity will comply with the conditions attached to them; and (b) the grants will be received.

The most important condition for earning the DCS incentive is the export of the merchandise. However, if the foreign exchange remittance is not received, GEL will be ineligible for the DCS incentive. It may be fair to assume that the export proceeds will be collected in due time since most of the exports are based on letters of credits or another form of guarantees. Therefore, the DCS incentive shall be recognised once the export is made and revenue is recognised in accordance with Ind AS 115 Revenue from Contracts with Customers.

RESPONSE TO QUERY 3

As per paragraph 7, government grants, including non-monetary grants at fair value, shall not be recognised until there is reasonable assurance that: (a) the entity will comply with the conditions attached to them; and (b) the grants will be received. Therefore, the DCS incentive should be recognised at the full amount, subject to the following adjustments:

  • If DCS is intended to be sold rather than used for importing goods, appropriate adjustments should be made for the decline in the market value. For e.g., the value of DCS is Rs. 100, but it can be sold in the market only at R80, DCS should be recognised at Rs. 80, rather than Rs. 100.
  •  To the extent it is estimated that foreign exchange would not be received, the DCS incentive amount to be recognised should be reduced.

RESPONSE TO QUERY 4

In the extant case, the government is providing an incentive to export rather than paying any revenue amount on behalf of the importer. Therefore, treating this as revenue from operations is clearly incorrect. However, with respect to classification as other income or other operating revenue, there seems to be a debate.

Paragraph 29 of Ind AS 20 requires the presentation of the incentive as ‘other income’. On the other hand, as per the guidance (paragraphs 9.1.7 to 9.1.10 above) under the ICAI GN on Division II – Ind AS Schedule III to the Companies Act 2013, the incentive may be presented as ‘other operating revenue’ if those arise from the normal trading activities of the entity. Since DCS arises from GEL’s trading activities, the same is operating in nature, and hence may be presented as ‘other operating revenue’. Basis paragraph 29 of Ind AS 20, the incentive may even be presented as ‘other income’.

Split Accounting – How Is A Convertible Instrument Accounted For?

This article deals with split accounting of a convertible bond into equity and financial liability. The CFO of the entity wants to do the split accounting basis the fair value of the liability and fair value of equity which according to him shall include the probability whether the liability would be settled or not and accordingly derive the value of the financial liability and equity. Would that be acceptable?

QUESTION

An entity issues 300,000 convertible bonds at the start of year 1 having three-year tenure, issued at par with a face value of Rs. 100 per bond, resulting in total proceeds of Rs. 30 million. Interest is payable annually in arrears at a nominal annual interest rate of 6 per cent. Each bond is convertible, at any time up to maturity, into 20 ordinary shares (meets the fixed for fixed test). When the bonds are issued, the prevailing market interest rate for similar debt without conversion option is 9 per cent. Since the issue costs are negligible, the same may be ignored. The CFO believes that the chances of the bond being converted to equity are almost 99 per cent. Therefore, keeping in mind the high probability of conversion to equity and extremely low probability that the liability would be settled by cash, the amount attributed to liability should be negligible. Do you agree? How does the entity account for the bond?

RESPONSE

Extracts from Ind AS 32, Financial Instruments: Presentation

“29 An entity recognises separately the components of a financial instrument that (a) creates a financial liability of the entity and (b) grants an option to the holder of the instrument to convert it into an equity instrument of the entity. For example, a bond or similar instrument convertible by the holder into a fixed number of ordinary shares of the entity is a compound financial instrument. From the perspective of the entity, such an instrument comprises two components: a financial liability (a contractual arrangement to deliver cash or another financial asset) and an equity instrument (a call option granting the holder the right, for a specified period of time, to convert it into a fixed number of ordinary shares of the entity). The economic effect of issuing such an instrument is substantially the same as issuing simultaneously a debt instrument with an early settlement provision and warrants to purchase ordinary shares, or issuing a debt instrument with detachable share purchase warrants. Accordingly, in all cases, the entity presents the liability and equity components separately in its balance sheet.

30 Classification of the liability and equity components of a convertible instrument is not revised as a result of a change in the likelihood that a conversion option will be exercised, even when exercise of the option may appear to have become economically advantageous to some holders. Holders may not always act in the way that might be expected because, for example, the tax consequences resulting from conversion may differ among holders. Furthermore, the likelihood of conversion will change from time to time. The entity’s contractual obligation to make future payments remains outstanding until it is extinguished through conversion, maturity of the instrument or some other transaction.

31 Ind AS 109 deals with the measurement of financial assets and financial liabilities. Equity instruments are instruments that evidence a residual interest in the assets of an entity after deducting all of its liabilities. Therefore, when the initial carrying amount of a compound financial instrument is allocated to its equity and liability components, the equity component is assigned the residual amount after deducting from the fair value of the instrument as a whole the amount separately determined for the liability component. The value of any derivative features (such as a call option) embedded in the compound financial instrument other than the equity component (such as an equity conversion option) is included in the liability component. The sum of the carrying amounts assigned to the liability and equity components on initial recognition is always equal to the fair value that would be ascribed to the instrument as a whole. No gain or loss arises from initially recognising the components of the instrument separately.

32 Under the approach described in paragraph 31, the issuer of a bond convertible into ordinary shares first determines the carrying amount of the liability component by measuring the fair value of a similar liability (including any embedded non-equity derivative features) that does not have an associated equity component. The carrying amount of the equity instrument represented by the option to convert the instrument into ordinary shares is then determined by deducting the fair value of the financial liability from the fair value of the compound financial instrument as a whole.

AG31 A common form of compound financial instrument is a debt instrument with an embedded conversion option, such as a bond convertible into ordinary shares of the issuer, and without any other embedded derivative features. Paragraph 28 requires the issuer of such a financial instrument to present the liability component and the equity component separately in the balance sheet, as follows: (a) The issuer’s obligation to make scheduled payments of interest and principal is a financial liability that exists as long as the instrument is not converted. On initial recognition, the fair value of the liability component is the present value of the contractually determined stream of future cash flows discounted at the rate of interest applied at that time by the market to instruments of comparable credit status and providing substantially the same cash flows, on the same terms, but without the conversion option. ………………

Ind AS 32 states that the economic effect of issuing convertible instrument is substantially the same as simultaneously issuing a debt instrument with an early settlement provision and warrants to purchase ordinary shares or issuing a debt instrument with detachable share purchase warrants. [Ind AS 32.29].

The liability component of a convertible bond should be measured first, at the fair value of a similar liability that does not have an associated equity conversion feature, but including any embedded non–equity derivative features, such as an issuers or holder’s right to require early redemption of the bond, if any such terms are included. In practical terms, this will be done by determining the net present value of all potential contractually determined future cash flows under the instrument, discounted at the rate of interest applied by the market at the time of issue to instruments of comparable credit status and providing substantially the same cash flows, on the same terms, but without the conversion option. [Ind AS 32.31].

The equity component is not (other than by coincidence) recorded at its fair value. Instead, in accordance with the general definition of equity as a residual, the equity component of the bond is simply the difference between the fair value of the compound instrument (total issue proceeds of the bond) and the liability component as determined in the illustration below.

The liability component is measured first by discounting the contractually determined stream of future cash flows (interest and principal) to present value using a discount rate of 9 per cent (that is, the market interest rate for similar bonds having no conversion rights), as shown below.

 

Rs.

PV of interest payable at the end of year 1- 1,800,000/1.09

1,651,376

PV of interest payable at the end of year 2- 1,800,000/(1.09)2

1,515,024

PV of interest payable at the end of year 3- 1,800,000/(1.09)3

1,389,830

PV of principal of INR 30,000,000 payable at the end of three years- 30,000,000/(1.09)3

23,165,505

Total liability component

27,721,735

Total equity component (residual)*

2,278,165

Fair value of bonds

30,000,000

* The equity component is a written call option that allows the holder to call for the shares on exercise of the conversion option at any time before maturity (American option). The difference between the proceeds of the bonds and the liability component’s fair value of the liability component (as computed above) ­— the residual — is assigned to the equity component.

The methodology of ‘split–accounting’ in IAS 32 has the effect that the sum of the carrying amounts assigned to the liability and equity components on initial recognition is always equal to the fair value that would be ascribed to the instrument as a whole. No gain or loss arises from the initial recognition of the separate components of the instrument.

The amount credited to equity of Rs. 2,278,165 is not subsequently remeasured. The liability component will be classified, under Ind AS 109, either as a financial liability at fair value through profit or loss if that is appropriate or as another liability measured at amortised cost using the effective interest rate method.

The likelihood of conversion may change from time to time. The entity’s contractual obligation to make future payments remains outstanding until it is extinguished through conversion, maturity of the instrument or some other transaction. [Ind AS 32.30]. After initial recognition, the classification of the liability and equity components of a convertible instrument is not revised, for example, as a result of a change in the likelihood that a conversion option will be exercised, even when exercise of the option may appear to have become economically advantageous to some holders.

Ind AS does not deal with how the equity is presented within the various components of equity, rather the same is determined by local legislation. In India, typically, if ultimately the bonds are converted to equity, the same may be attributed to shareholders equity. If on the other hand, there is no conversion and the liability is eventually paid off in cash, the equity component may be classified as reserves, thereby allowing the entity to treat it as a distributable reserve. However, legal opinion is advised, since this is a matter of legal interpretation.

‘Split accounting’ is to be applied only by the issuer of a compound financial instrument. The accounting treatment by the holder is dealt with in Ind AS 109 Financial Instruments and is significantly different. In the holder’s financial statements, under Ind AS 109, the instrument fails the criteria for measurement at amortised cost (in particular the ‘contractual cash flow characteristics test’) and is therefore almost always carried at fair value through profit or loss.

As per AG 31, the issuer’s obligation to make scheduled payments of interest and principal is a financial liability that exists as long as the instrument is not converted. On initial recognition, the fair value of the liability component is the present value of the contractually determined stream of future cash flows discounted at the rate of interest applied at that time by the market to instruments of comparable credit status and providing substantially the same cash flows, on the same terms, but without the conversion option. This makes it abundantly clear that in the split accounting the fair value of the financial  liability is determined on the basis of the present value of the contractually determined cash flows. The probability of these cash flows is not relevant. Once the fair value of the financial liability is determined as demonstrated in the illustration, the residual amount is  determined as equity. As already discussed above, the residual amount of equity is not the same as fair value of equity (though it may occur by coincidence). In conclusion, the view of the CFO is not tenable, as probability is not a basis under Ind AS 32 for split accounting under Ind AS 32.”

Audit Trail – Key Considerations for Auditors and Companies

INTRODUCTION

 

Section 143(3) of the Companies Act, 2013 provides various matters on which auditors are required to report in their auditor’s report. Clause (j) of Section 143(3) states that auditor’s report shall also state such other matters as may be prescribed. Rule 11 of the Companies (Audit and Auditors) Rules, 2014 specifies such other matters that are to be reported by the auditor.The requirement with respect to audit trail was contained in Rule 11(g) with regard to auditor’s reporting requirements. The requirement was initially made applicable for the financial year commencing on or after the 1st April, 2021 vide notification G.S.R. 206(E) dated 24th March, 2021. However, the applicability was deferred to financial year commencing on or after 1st April, 2022, vide MCA notification G.S.R. 248(E) dated 1st April, 2021.

The corresponding requirement for companies has been prescribed under the proviso to Rule 3(1) of the Companies (Accounts) Rules, 2014 requiring companies, which use accounting software for maintaining their books of account, to use only such accounting software which has audit trail feature. This requirement for companies was initially made applicable for financial year commencing on or after 1st April, 2021. However, its applicability has been deferred two times and this requirement is finally applicable from financial year commencing on or after 1st April, 2023.

The respective requirement for companies under Rule 3(1) of Companies (Accounts) Rules, 2014 and for auditors under Rule 11(g) of Companies (Audit and Auditors) Rules, 2014 are given below.

Text of Proviso to Rule 3(1) of Companies (Accounts)
Rules, 2014

Text of Rule 11(g) of Companies (Audit and Auditors)
Rules, 2014

Provided that for the
financial year commencing on or after the 1st April, 2023, every
Company which uses accounting software
for maintaining its books of account, shall use only such accounting

Whether the company,
in respect
of financial years commencing on or after the 1st April, 2022, has
used such accounting software
for maintaining its books of
account which has a feature of recording

software which has a
feature of recording audit trail of each and every transaction, creating an
edit log of each change made in the books of account along with the date when
such changes were made and ensuring that the audit trail cannot be disabled.

audit trail (edit
log) facility and the same has been operated throughout the year for all
transactions recorded in the software and the audit trail feature has not
been tampered with and it has been preserved by the company as per the
statutory requirements for record retention.

The ICAI has issued an Implementation Guide on Reporting under Rule 11(g) of Companies (Audit and Auditors) Rules, 2014 (IG) to enable the auditors to comply with the reporting requirements of Rule 11(g). The author provides additional insights through Q&As on the subject.

WHAT IS MEANT BY BOOKS OF ACCOUNTS FOR THE PURPOSES OF RULE 3(1) AND RULE 11(G) PRESENTED ABOVE?

The definitions are included in Section 2 of the Companies Act, 2013. These are given below.

(12) “book and paper” and “book or paper” include books of account, deeds, vouchers, writings, documents, minutes and registers maintained on paper or in electronic form;

(13) “books of account” includes records maintained in respect of—

i.    all sums of money received and expended by a company and matters in relation to which the receipts and expenditure take place;

ii.    all sales and purchases of goods and services by the company;

iii.    the assets and liabilities of the company; and

iv.    the items of cost as may be prescribed under section 148 in the case of a company which belongs to any class of companies specified under that section;

WHAT IS MEANT BY AUDIT TRAIL?

This is defined in the IG as follow: Audit Trail (or Edit Log) is a visible trail of evidence enabling one to trace information contained in statements or reports back to the original input source. Audit trails are a chronological record of the changes that have been made to the data. Any change to data including creating new data, updating or deleting data that must be recorded. Records maintained as audit trail may include the following information:

  •  when changes were made i.e., date and time (time stamp)

 

  • who made the change i.e., User Id/Internet protocol (IP)

 

  • what data was changed i.e., data/transaction reference; success/failure

Audit trails may be enabled at the accounting software level depending on the features available in such software or the same may be captured directly in the database underlying such accounting software.

The requirement for companies applies for financial year commencing on or after 1st April, 2023. On the other hand, the requirement to report on audit trail applies to auditors only w.e.f. financial years commencing on or after 1st April, 2022. For the financial year ended 31st March, 2023, should the auditor report on the audit trail?

For the year ended 31st March, 2023, it may not be appropriate for the auditor to comment on whether audit trail is maintained or not by the company, since the requirement for companies applies only in the following year. The auditor shall state in his report this fact and not make any other observations on whether the company has complied with the requirement of audit trail or not.

WHETHER THE AUDIT TRAIL REQUIREMENT APPLIES TO BOOKS OF ACCOUNT PREPARED MANUALLY?

The requirement applies only to books of account prepared electronically using an accounting software. It does not apply where the books of account are entirely maintained manually. In such a case, as the assessment and reporting responsibility under Rule 11(g) will not be applicable, the same would need to be reported as a statement of fact by the auditor against this clause. Wherever, some books of account are maintained manually, whereas other are maintained electronically, the requirement would apply to books of accounts maintained electronically.

WHETHER AUDIT TRAIL REQUIREMENT FOR BOOKS OF ACCOUNTS INCLUDE COST RECORDS?

Yes, it will include cost records because as per Section 2(13)(iv) of the Companies Act, 2013, books of accounts include cost records if it belongs to any class of companies specified under section 148 of the Companies Act, 2013. It may also apply to cost records of other companies, if the information generated by those cost records is used in some manner for the purposes of preparing the company’s trial balance or financial statements or is otherwise integrated with the financial records used for preparing financial statements.

WHETHER AUDIT TRAIL REQUIREMENT WOULD APPLY TO THINGS SUCH AS RENTAL AGREEMENTS OR CASH VOUCHERS, ETC?

The audit trail requirement applies to books of accounts and not books and papers. Therefore, the audit trail requirement would not apply to papers such as rental agreements or cash vouchers. In other words, if changes are made to the underlying cash voucher that was prepared digitally, there is no need to maintain an edit log for the same. However, from an internal control point of view, it is important that the authentication of the persons preparing and approving the voucher is appropriately documented on the cash voucher.

FOR AUDITOR REPORTING UNDER RULE 11(G), DOES THE REQUIREMENT APPLY TO STANDALONE FINANCIAL STATEMENTS (SFS) ONLY OR SHALL APPLY TO CONSOLIDATED FINANCIAL STATEMENTS (CFS)?

Section 129(4) of the Act specifically states that the provisions of the Act that apply to SFS with respect to financial statements, shall, mutatis mutandis, apply to the CFS. Therefore, the requirements apply both to SFS and CFS. However, while reporting on CFS, the auditor shall exclude certain components included in the CFS which are (a) either not companies under the Act, or (b) are incorporated outside India. The auditors of such components are not required to report on these matters since the provisions of the Act do not apply to them.The reporting on compliance with Rule 11(g) would be on the basis of the reports of the statutory auditors of subsidiaries, associates and joint ventures that are companies defined under the Companies Act, 2013. The auditors of the parent company should apply professional judgment and comply with applicable Standards on Auditing, in particular, SA 600, “Using the Work of Another Auditor” while assessing the matters reported by the auditors of subsidiaries, associates and joint ventures that are Indian companies.

WHICH ACCOUNTING SOFTWARE IS COVERED UNDER RULE 3(1)?

Any software that maintains records or transactions that fall under the definition of books of account as per section 2(13) of the Companies Act will be considered as accounting software for this purpose. For e.g., if sales are recorded in a standalone software and only consolidated entries are recorded monthly into the software used to maintain the general ledger, the sales software should also have the audit trail feature because it is part of the financial records.

WHETHER ENVIRONMENTAL, SOCIAL, GOVERNANCE (ESG) SOFTWARE AND ESG RECORDS ARE COVERED UNDER RULE 3(1)?

No, since ESG records do not constitute books of accounts as defined under Section 2(13) of the Companies Act, 2013.

WHETHER EDIT LOG NEEDS TO BE MAINTAINED FOR CREATION OF A USER IN THE ACCOUNTING SOFTWARE?

No, because creating a user account in the accounting software does not change the books of accounts. Nonetheless, from the perspective of internal controls, it would be necessary to have edit logs for creation of a user in the accounting software.

 

DOES TALLY PRIME LATEST VERSION HAVE EDIT LOG FEATURES?

Tally has made two different product releases, ‘TallyPrime Edit Log Release 2.1’ and the regular ‘TallyPrime release 2.1’. As per Tally, TallyPrime Edit Log Release 2.1 comes with an edit log feature enabled all the time, without an option to disable it. While TallyPrime Release 2.1 gives an option to enable/disable the edit log when required.It will be inappropriate to compare Tally to a sophisticated ERP such as SAP. Can the auditor rely on Tally as a tool on which reliance could be placed to review the inbuilt or digital controls relating to audit trail or should it be looked at as a black box? Tally’s representation that the edit log cannot be disabled or tampered with and that the inbuilt digital controls can be relied upon needs to be tested and validated by the auditor before drawing that conclusion.

Is the accounting software required to be hosted on a physical server located in India?

It should be noted that the accounting software may be hosted and maintained in or outside India or may be on-premises or on cloud or subscribed to as Software as a Service (SaaS) software. Further, a company may be using a software maintained at a service organisation. For example, the company may have outsourced its payroll processing with a shared service centre that may use its own software to process payroll for the company. On the other hand, back-up of books and papers are required to be maintained on a physical server located in India only.

IF COMPANIES (ACCOUNTS) RULES ARE NOT FOLLOWED, WILL IT TANTAMOUNT TO NON-COMPLIANCE WITH REGULATIONS AS PER SA 250 CONSIDERATION OF LAWS AND REGULATIONS IN AN AUDIT OF FINANCIAL STATEMENTS?

Yes, it will be a non-compliance with laws and regulations, but no additional qualification is required on this account alone if the penalty amount is likely to be insignificant. However, auditors need to consider the likelihood of frauds and conduct appropriate procedures. Also, the Audit Committee needs to be properly briefed.

DOES NON AVAILABILITY OF EDIT-LOGS IMPLY FAILURE OF INTERNAL CONTROL SYSTEM, AND WOULD AUDITOR NEED TO QUALIFY THE INTERNAL CONTROL REPORT?

The answer to this question would depend upon detailed facts and circumstances of the case. Sometimes mere non-availability of audit trail does not necessarily imply failure or material weakness in the operating effectiveness of internal financial controls over financial reporting. For e.g., due to some temporary glitch the audit trail may have not worked, that does not mean that the internal financial control system would deserve a negative reporting from the auditor. An important point to note is that the requirement of the audit trail applies throughout the financial year; however, as regards the internal financial control, any weaknesses if resolved prior to the end of the financial year would not attract any qualification or reservation from the auditor.

Food Co runs several restaurants, and the revenue includes a sizable portion collected in cash from the customers. The company does not have any system of edit logs associated with the cash collection process or with respect to the accounting in the sales ledger and general ledger. How should the auditor approach this situation?

This is a serious issue, and the auditor needs to consider several aspects, a few of which are listed below:1.    Should the auditor accept such a client and when already accepted, should the auditor continue doing an audit of such a client? This assessment needs to be carried out by the auditor.

2.    The auditor shall perform an assessment of risk of material misstatements due to fraud and would consider both qualitative and quantitative factors in assessing a deficiency or combination of deficiencies as a significant deficiency or material weakness. This audit procedure would accordingly require application of professional judgement while linking the reporting against Rule 11(g) and the internal control reporting requirements.

3.    The auditor may need to disclaim several clauses of CARO, such as with respect to reporting on the clause relating to fraud. The auditor would have to state that the occurrence of an error or fraud could not be established due to lack of maintenance, availability or retrievability of audit trails.

Ze Co maintains edit logs for each and every transaction; however, for a particular day during the financial year Ze could not produce any edit logs, as that system was down. What would be the auditor’s responsibility in such cases?

Audit report under Rule 11(g) is a factual reporting. The auditor will have to report the non-availability of edit logs for the particular day for reporting under Rule 11(g). The auditor will have to state in the report that edit logs were available throughout the financial year except for a particular day and provide the reason why the edits logs were not available for that day. Additionally, the auditor will also have to carry out detail procedures to validate if the absence of edit logs was or was not related to any fraud as well as evaluate the implications on the reporting on internal financial controls.

A company has outsourced its payroll processing to an external party. In such a case, whether the requirements of audit trail are applicable, and how does the auditor verify the same?

As per the requirements, the accounting software should be capable of creating an edit log of “each change made in books of account” and the audit trail feature has not been tampered with. In case of accounting software supported by service providers, the company’s management and the auditor may consider using independent auditor’s report of service organisation (e.g., Service Organisation Control Type 2 (SOC 2)/SAE 3402, “Assurance Reports on Controls at a Service Organisation”) for compliance with audit trail requirements. The independent auditor’s report should specifically cover the maintenance of audit trail in line with the requirements of the Act.

A company did not preserve audit trail for a few of its in-house application such as the payroll processing system for earlier years, though edit logs are fully preserved for the financial year commencing on and after 1st April, 2023. Whether any reporting is required by the auditor under Rule 11(g)?

The auditor is required to comment whether ‘the audit trail has been preserved by the company as per the statutory requirements for record retention’. Considering the requirement of Section 128(5) of the Act, which requires books of account to be preserved by companies for a minimum period of eight years, the company would need to retain audit trail for a minimum period of eight years, i.e., effective from the date of applicability of the Account Rules (i.e., currently 1st April, 2023, onwards). Therefore, if audit trail has not been preserved for earlier years, no reporting is required by the auditor under Rule 11(g).

As per Rule 3(1), the accounting software shall have a feature of recording audit trail of each and every transaction, creating an edit log of each change made in the books of account along with the date when such changes were made and ensuring that the audit trail cannot be disabled. Would the software ensure that the audit trail feature cannot be disabled or management has to ensure that the audit trail feature is not disabled?

Most of the commonly used accounting software, including Enterprise Resource Planning (ERP) software, has an audit trail feature that can be enabled or disabled at the discretion of the company. The management of the company may have put in place certain controls such as restricting access to the administrators and monitoring changes to configurations that may impact the audit trail. Auditors are accordingly expected to evaluate management’s policies in this regard and test such controls to determine whether the feature of audit trails has been implemented and operating effectively throughout the reporting period.

The requirement should not be interpreted to conclude that if the software has the feature to disable audit trail, it should be automatically treated as non-compliant with Rule 3(1). Most advanced business applications have many features that can be enabled and disabled as per client’s business requirements. This by itself, does not create a compliance issue.

In order to demonstrate that the audit trail feature was functional, operated and was not disabled, a company would have to design and implement specific internal controls (predominantly IT controls) which in turn, would be evaluated by the auditors, as appropriate. For e.g., these could relate to

  •     Controls to ensure that the audit trail feature has not been disabled or deactivated.

 

  •     Controls to ensure that User IDs are assigned to each individual and that User IDs are not shared.

 

  •     Controls to ensure that changes to the configurations of the audit trail are authorised and logs of such changes are maintained.

 

  •     Controls to ensure that access to the audit trail (and backups) is disabled or restricted and access logs, whenever the audit trails have been accessed are maintained.

 

  •     Controls to ensure that administrative access to the audit trail is restricted to authorised representatives.

 

  •     Periodic testing of controls relating to audit trail configuration by management or internal auditors.

HOW DOES AN AUDITOR, AUDIT THE AUDIT TRAIL?

There are many direct and indirect evidences that an auditor needs to collect / review to ascertain compliance with the requirements. This includes but not limited to management representation, review, on a sample basis, the audit trail records maintained by management for each applicable year and evaluate management controls for maintenance of such records without any alteration and retrievability of logs maintained for the required period of retention.The management should ensure that an internal control system is implemented and operates effectively throughout the year. A combination of prevent and detect controls, ITGC’s, ITAC’s, should be used, supported also by Entity Level Controls (ELC’s). The management should conduct proper tests to ensure that controls are operating effectively throughout the year and take quick remedial actions in case of defects and auditors should test those controls.

Some examples of how the auditor can verify controls relating to audit trail are given below:

Controls over changes in configuration of audit trails whether those are authorised and whether logs of such changes are maintained can be verified by applying the following steps

Obtain a log of changes made to audit trail configuration made during the year.

Select sample changes made.

Ask for approvals or authorizations for such changes made.

Controls to ensure that the audit trail feature has not been disabled or deactivated; the auditor can check this from change management log in SAP.

The management should ensure that every user is assigned a User ID; auditor can take a sample of new joiners and verify if they are allotted an ID; the auditor can also verify for every User ID if there is an employee identified and that there are no dummy IDs.

Controls to ensure that User ID’s and Passwords are not shared; e.g., auditor can check for instances where multiple users log-in from the same machine (IP).

CONCLUSION

The intent of the audit trail seems to be to prevent fabrication of books through overwriting the books of accounts. The trail is expected to easily track the changes made to the books of accounts,and would require the company to explain the reasons thereof. Globally, no similar reporting obligation exists for the auditors.In the past, several instances have come to notice, where senior executives of companies have tampered with the books of accounts, without leaving any footsteps on the changes made, and who made those and at what time. Hopefully, with these changes, such instances would be significantly curtailed or exposed.

Ind AS/IGAAP – Interpretation and Practical Application

COMPANIES (ACCOUNTS) RULES ON BACK-UPS
The Ministry of Corporate Affairs (MCA) vide its notification dated 5th August, 2022 has amended the Companies (Accounts) Rules, 2014 regarding books of accounts. Here, we discuss only the matters relating to back-ups, the change in back-up rules, management and auditor’s responsibility with respect to the same.

Rule 3(5) of the Companies (Accounts) Rules pre-amendment and post-amendment are set out below.

RULE 3(5) PRE-AMENDMENT

There shall be a proper system for storage, retrieval, display or printout of the electronic records as the Audit Committee, if any, or the Board may deem appropriate and such records shall not be disposed of or rendered unusable, unless permitted by law:

Provided that the back-up of the books of account and other books and papers of the company maintained in electronic mode, including at a place outside India, if any, shall be kept in servers physically located in India on a periodic basis.


RULE 3(5) POST-AMENDMENT

There shall be a proper system for storage, retrieval, display or printout of the electronic records as the Audit Committee, if any, or the Board may deem appropriate and such records shall not be disposed of or rendered unusable, unless permitted by law:Provided that the back-up of the books of account and other books and papers of the company maintained in electronic mode, including at a place outside India, if any, shall be kept in servers physically located in India on a daily basis.

As a result of the amendment, the back-up is now required to be maintained on a daily basis instead of a periodic basis. Given below are a few Q&A’s relating to the rules and the amendment.

QUERY

What is the purpose of the rules and the amendment?

RESPONSE

Back-ups are an important feature of any disaster recovery plan. Pre-amendment, the requirement to take periodic back-up could have been complied with by the entities by taking a back-up once in a financial year, say, at the end of the financial year. By changing the back-up rules to requiring it on a daily basis, the objective of a disaster recovery plan is better met. Besides, regulators have ensured that up- to-date information is available from a company in an investigation.

QUERY

Is back-up required for books and papers which are maintained manually?

RESPONSE

Back-up is not required for books and papers which are maintained manually. Back-up is only required for books and papers maintained electronically.

QUERY

Back-up is required of books and papers. What does that include?

RESPONSE

As per Section 2(12) of Companies Act, 2013 – “book and paper” include books of account, deeds, vouchers, writings, documents, minutes and registers maintained on paper or in electronic form.

As per Section 2(13) of the Companies Act, 2013 “Books of Account” includes records maintained in respect of—

(i) all sums of money received and expended by a company and matters in relation to which the receipts and expenditure take place;

(ii) all sales and purchases of goods and services by the company;

(iii) the assets and liabilities of the company; and

(iv) the items of cost as may be prescribed under section 148 in the case of a company which belongs to any class of companies specified under that section;

As per the above definition, back-up is required for the following:

1. All books of accounts that result in the trial balance and financial statements for an entity need to be backed-up on a daily basis. They not only include the primary ledger but also subsidiary ledgers. Therefore, general ledger, sales ledger, purchase ledger, payroll ledger, etc will all be included. Let’s consider a simple example. An entity maintains employee master ledger that contains the salary break-up and leave details for each employee. The payroll computation is performed using such details from the master ledger. In such a situation, the master ledger would constitute books of accounts. If, however, the facts were such, that the master ledger only comprised appraisals and other personal details, but not any financial information such as the salary break-up or details relating to leave taken, etc., the master ledger would not constitute “books of accounts.”

2. Cost records prescribed under section 148 are also required to be backed-up on a daily basis.

3. Back-up requirements apply to papers as well, which are maintained in an electronic form, which may include, vouchers or invoices that support an entry in the books of accounts.

QUERY

Why is the requirement for daily back-up considered to be highly onerous?

ANSWER

Very often, a daily back-up may fail due to numerous reasons, such as the network may be down on certain days, or the volume of transactions on certain days may be too high which may create an impediment for a back-up or the system may have got corrupted or crashed, etc. This may result in non-compliance with the rules and a potential penalty.

QUERY

Can the back-up be maintained on cloud?

Response

Yes, the back-up can be maintained on cloud provided it is on an identified physical server that is located in India. If an entity uses a cloud service provider to do a back-up, the entity should have an arrangement with the cloud service provider requiring the back-up to be maintained on an identified server physically located in India.

If an entity uses the mirroring technique to maintain immediate back-ups, the mirroring should happen on a physical server located in India.

QUERY

As per Section 143(3) of the Companies Act

The auditor’s report shall also state—

(b) Whether, in his opinion, proper books of account as required by law have been kept by the company;

(h) Any qualification, reservation or adverse remark relating to the maintenance of accounts and other matters connected therewith;

(i) Whether the company has adequate internal financial controls system in place and the operating effectiveness of such controls;

Is there a responsibility for the auditor to report any non-compliance with respect to the back-up rules? In what situations auditor needs to qualify?

RESPONSE

Yes, the auditor is required to report any non-compliance with respect to the back-up rules. As per Section 143(3), the auditor has to opine on whether proper books of accounts as required by law have been kept by the company. In the author’s view, proper books of accounts should be interpreted to include not only situations where the books of accounts do not present a true and fair view but also situations where other requirements of the law relating to books of accounts are not complied with, such as daily back-ups or maintenance of an audit trail.

Audit qualification may be warranted in the following situations:

  • Books of accounts are not accessible in India or not always accessible in India
  • Back-up of books available, but no back-ups of underlying invoices, vouchers
  • Back-ups maintained physically but not on a server
  • Back-ups maintained electronically (e.g., a CD) but not on a server
  • Back-up server is not physically located in India
  • Back-ups done weekly, but not daily
  • Back-up done daily, except a few days when server was down
  • Back-up is being done daily, but that process was started only in March 2023 (instead of August 2022 and onwards), prior to that back-up were done monthly
  • Back-up on cloud and servers located outside of India

The obligation of a daily back-up is highly onerous and there are many situations which could lead to an audit qualification.

QUERY

An entity’s software configuration requires daily back-up however, the entity does not have an audit log to demonstrate to the auditor that the daily back-ups were indeed being taken. What is the auditor’s responsibility in such a situation?

RESPONSE

The auditor will have to state in his audit report that it was not possible to verify if daily back-ups were being taken in the absence of any evidence to that effect.

QUERY

Does taking a daily back-up mean that the entity will have 365 or 366 days of separate back-up information?

RESPONSE

The entity has to take daily back-up. However, the back-ups taken on each day will update the previous back-ups. In other words, on any given day, the entity will have one cumulative back-up of the books of accounts and papers. Consequently, at the end of the financial year, the entity will have one set of original books of account, and another set of back-up of those books of accounts.

QUERY

A company has a Document Management System (DMS), where for certain underlying documents the paper trail is not maintained, will back-up be required of the DMS?

RESPONSE

Many companies maintain “papers” in the DMS application – which is primarily a computer system/ software to store, manage and track electronic documents and electronic images of paper-based information. Requirements of this law will extend to such applications as well. Therefore, back-up would be required of the DMS.

QUERY

A company has a physical server in India, where the original set of books of accounts are maintained. In such a situation, can back-up be located in a physical server outside India?

RESPONSE

No. The requirements prescribed under Rule 3 of the Accounts Rules (including taking daily backups) are applicable to all companies having their servers in or outside India. Particularly, it may be noted that even companies having their main server in India are also required to maintain back-up server in India.

QUERY

Since back-ups are taken on a daily basis, would it by analogy mean that the books of accounts have to be closed on a daily basis?

RESPONSE

The amended Rule envisages that backups of books of account and other books and paper should be taken on a daily basis. The Rule does not require the management to carry out books closing process on a daily basis.

QUERY

If the server is down at times, back-ups may not happen, would that tantamount to a non-compliance with the Rules?

RESPONSE

Yes, that is a non-compliance with the Rules and will require an audit qualification.

Accounting of a Demerger Scheme that is Not a Common Control Transaction

In this article, we deal with the date and other aspects of accounting for a demerger scheme that is not a common control transaction in the books of the transferor and the transferee, and its interaction with the MCA General Circular 9/2019 dated 21st August, 2019 on clarification on “appointed date” referred to in section 232(6) of the Companies Act, 2013.

FACT PATTERN

a)    Oz Co (“transferor”) transfers one of the business divisions to a shell company, New Co (“transferee”).

b)    Oz Co is a widely held company and there are no controlling shareholders.

c)    New Co issues shares to the shareholders of Oz Co on a proportionate basis as a consideration for the demerger.

d)    The demerger is undertaken through a court scheme that will need to be approved by the NCLT.

e)    The appointed date in the scheme is dated 1st April, 20X2, though the scheme is filed later.

f)    Oz Co and New Co follow the financial year.

g)    NCLT approves the scheme on 1st May, 20X3, i.e., F.Y. 20X3-X4. The financial statements for year ended 31st March, 20X3, were approved and circulated to shareholders prior to 1st May, 20X3.

How will the scheme be accounted for in the books of the transferor and transferee companies? At what date the transferor will account for the profit or loss from the transfer?

RESPONSE

Technical Literature

MCA General Circular 9/2019 dated 21st August, 2019: Paragraph 6

a)    The provision of section 232(6) of the Act enables the companies in question to choose and state in the scheme an ‘appointed date’. This date may be a specific calendar date or may be tied to the occurrence of an event such as grant of license by a competent authority or fulfilment of any preconditions agreed upon by the parties, or meeting any other requirement as agreed upon between the parties, etc., which are relevant to the scheme.

b)    The ‘appointed date’ identified under the scheme shall also be deemed to be the ‘acquisition date’ and date of transfer of control for the purpose of conforming to accounting standards (including Ind-AS 103 Business Combinations).

c)    Where the ‘appointed date’ is chosen as a specific calendar date, it may precede the date of filing of the application for scheme of merger/amalgamation in NCLT. However, if the ‘appointed date’ is significantly ante-dated beyond a year from the date of filing, the justification for the same would have to be specifically brought out in the scheme and it should not be against public interest.

d)    The scheme may identify the ‘appointed date’ based on the occurrence of a trigger event which is key to the proposed scheme and agreed upon by the parties to the scheme. This event would have to be indicated in the scheme itself upon occurrence of which the scheme would become effective. However, in case of such event being based on a date subsequent to the date of filing the order with the Registrar under section 232(5), the company shall file an intimation of the same with the Registrar within 30 days of such scheme coming into force.

Ind AS 10 Events after the Reporting Period – Appendix A Distribution of Non-cash Assets to Owners

5. This Appendix does not apply to a distribution of a non-cash asset that is ultimately controlled by the same party or parties before and after the distribution. This exclusion applies to the separate, individual and consolidated financial statements of an entity that makes the distribution.

10. The liability to pay a dividend shall be recognised when the dividend is appropriately authorised and is no longer at the discretion of the entity, which is the date:

(a) when declaration of the dividend, e.g., by management or the board of directors, is approved by the relevant authority, e.g., the shareholders, if the jurisdiction requires such approval, or

(b) when the dividend is declared, e.g., by management or the board of directors, if the jurisdiction does not require further approval.

11. An entity shall measure a liability to distribute non-cash assets as a dividend to its owners at the fair value of the assets to be distributed.

13. At the end of each reporting period and at the date of settlement, the entity shall review and adjust the carrying amount of the dividend payable, with any changes in the carrying amount of the dividend payable recognised in equity as adjustments to the amount of the distribution.

14. When an entity settles the dividend payable, it shall recognise the difference, if any, between the carrying amount of the assets distributed and the carrying amount of the dividend payable in profit or loss.

ANALYSIS AND CONCLUSION

Accounting in the books of the Transferor, Oz

  • The transaction is not a common control transaction because it is not controlled by the same party before and after the transaction. Therefore, in accordance with paragraph 5 of Appendix A to Ind AS 10, Oz is scoped into the said Appendix and need to comply with its requirements.
  • As per paragraph 11, the liability for dividend payable is recognised at fair value, which in this case, is the fair value of the business division that is demerged.
  • As per paragraph 10, the liability to pay a dividend shall be recognised when the dividend is appropriately authorised and is no longer at the discretion of the entity. The question is whether such a liability is recognised at the appointed date; i.e., 1st April, 20X2 or when the NCLT approves the scheme, i.e. 1st May, 20X3
  • As per paragraph 14, when an entity settles the dividend payable, it shall recognise the difference, if any, between the carrying amount of the assets distributed and the carrying amount of the dividend payable in profit or loss. The question is should this date be the appointed date or date when NCLT approves the scheme; i.e., 1st May, 20X3?
  • As per paragraph 13, at the end of each reporting period and at the date of settlement, the entity shall review and adjust the carrying amount of the dividend payable, with any changes in the carrying amount of the dividend payable recognised in equity as adjustments to the amount of the distribution. For this purpose, should the settlement of dividend be considered to have occurred at 1st April, 20X2 or 1st May, 20X3. If the settlement date is considered as 1st May, 20X3, then is any adjustment required in accordance with paragraph 13, at 31st March, 20X3?

Paragraph 6(b) of the MCA circular makes it clear that the schemes for which circular is issued are not only for business combination schemes under Ind AS 103. The MCA circular applies to other schemes as well such as a demerger scheme undertaken in accordance with the Company Law. The author believes that the MCA circular clearly lays down the path, for the recording of such transactions at the appointed date. Consequently, the dividend payable should be recorded at the appointed date; i.e., 1 April, 20X2.

The other related question is when should  the dividend settlement be recorded along with the corresponding adjustment to the statement of profit and loss. Again, the author believes that it is the appointed date from which the settlement takes place, and therefore the dividend settlement too should be recorded at the appointed date, though the NCLT approval is received on 1st May, 20X3.

The recognition of profit (assuming fair value of business division is greater than book value) on the dividend distribution is a tricky issue. Should it be recognised on the appointed date, and therefore recorded in retained earnings at 1 April, 20X2 or F.Y. 20X2-X3, i.e., the year in which the appointed date falls or financial year in which the NCLT approval is received, i.e., 20X3-X4.

The author believes that the profit should not be recognised at the appointed date in retained earnings, because that would be a clear violation of Appendix A of Ind AS 10, paragraph 14. Rather the profit shall be recognised in F. Y. 20X2-X3, which is the financial year in which the appointed date falls. Since the settlement of the dividend is recognised in the F. Y. 20X2-X3, the requirement of paragraph 13 to adjust the dividend payable amount at 31st March, 20X3 does not arise.

ACCOUNTING IN THE BOOKS OF THE TRANSFEREE, NEW CO

Though this is not a common control business combination, which requires pooling of interest method to be applied, the transferee may record the business transferred using the pooling of interest method. Essentially, the transfer of the division entails division of the company, but with the same set of shareholders. From the transferee’s perspective, the transfer of the business division is merely a change in geography of the assets, lacking meaningful substance, and therefore should be accounted for using the pooling of interest method.

However, some may argue, that the accounting in the books of the transferor and the transferee should be reciprocal. Therefore, since the transferor records the dividend payable at fair value, there is no reason why the transferee should not record the transaction at fair value. The other argument that supports accounting at fair value is that the demerger transaction should not be seen as a division simpliciter, but a transaction that unlocks value, such that the results achieved are greater than sum of the parts.

The author believes that the book value method (may also be referred to as pooling of interest or continuation method) is the most appropriate representation in the books of the transferee. An analogy can be drawn from the book value accounting applicable to common control business combination.

Accounting of Pre-IPO Instruments

Pre-IPO investors are issued equity instruments at a lower valuation compared to retail investors. However, these equity instruments come with certain restrictions such as lock-in restrictions, and the accounting can be complex. This article deals with the accounting of convertible instruments issued to financial institutions as a part of pre-IPO funding.

FACT PATTERN

The new company will be soon launching its IPO. As a part of its pre-IPO funding, it has issued CCPS (Compulsorily Convertible Preference Shares) to SBI. These instruments are convertible into equity shares on the IPO taking place. The conversion ratio is variable depending upon the timing of the IPO and the valuation of the company at IPO, after deducting from the valuation a discount is typically available to pre-IPO investors. All pre-IPO investors that are issued these instruments are treated equally. The pre-IPO investors are provided a discount over the valuation of the company to compensate for the lock-in restrictions applicable to pre-IPO investors and for the uncertainty on the occurrence of the IPO and the timing of the IPO. If the IPO does not happen by a certain date, then the conversion will occur by a formula predetermined on the date of issue of the CCPS, that will provide as many shares, as are required to settle the liability, for e.g., if the CCPS amount is R100, and the share price is Rs. 1 the liability will be settled by providing 100 shares to the holder of the CCPS.

QUERY

How does the new company, the issuer, account for this instrument? Is the discount on the valuation a one-day loss that needs to be amortised over the period of the instrument?

RESPONSE

Technical Literature

Ind AS 32 Financial Instruments: Presentation

11. A financial liability is any liability that is: (a) a contractual obligation : (i) to deliver cash ………(b) a contract that will or may be settled in the entity’s own equity instruments and is: (i) a non-derivative for which the entity is or may be obliged to deliver a variable number of the entity’s own equity instruments; or (ii) a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments. ………..

Ind AS 109 Financial Instruments

4.2.1 An entity shall classify all financial liabilities as subsequently measured at amortised cost, except for:  (a) financial liabilities at fair value through profit or loss. Such liabilities, including derivatives that are liabilities, shall be subsequently measured at fair value………

4.3.3 If a hybrid contract contains a host that is not an asset within the scope of this Standard, an embedded derivative shall be separated from the host and accounted for as a derivative under this Standard if, and only if: (a) the economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host (see paragraphs B4.3.5 and B4.3.8);  (b) a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative; and  (c) the hybrid contract is not measured at fair value with changes in fair value recognised in profit or loss (i.e. a derivative that is embedded in a financial liability at fair value through profit or loss is not separated).  

4.3.4 If an embedded derivative is separated, the host contract shall be accounted for in accordance with the appropriate Standards. This Standard does not address whether an embedded derivative shall be presented separately in the balance sheet.  

4.3.5 Despite paragraphs 4.3.3 and 4.3.4, if a contract contains one or more embedded derivatives and the host is not an asset within the scope of this Standard, an entity may designate the entire hybrid contract as at fair value through profit or loss unless:  (a) the embedded derivative(s) do(es) not significantly modify the cash flows that otherwise would be required by the contract; or  (b) it is clear with little or no analysis when a similar hybrid instrument is first considered that separation of the embedded derivative(s) is prohibited, such as a prepayment option embedded in a loan that permits the holder to prepay the loan for approximately its amortised cost.  

5.1.1A However, if the fair value of the financial asset or financial liability at initial recognition differs from the transaction price, an entity shall apply paragraph B5.1.2A.

B5.1.2A The best evidence of the fair value of a financial instrument at initial recognition is normally the transaction price (i.e., the fair value of the consideration given or received, see also Ind AS 113). If an entity determines that the fair value at initial recognition differs from the transaction price as mentioned in paragraph 5.1.1A, the entity shall account for that instrument at that date as follows: (a) at the measurement required by paragraph 5.1.1 if that fair value is evidenced by a quoted price in an active market for an identical asset or liability (i.e., a Level 1 input) or based on a valuation technique that uses only data from observable markets. An entity shall recognise the difference between the fair value at initial recognition and the transaction price as a gain or loss.  (b) in all other cases, at the measurement required by paragraph 5.1.1, adjusted to defer the difference between the fair value at initial recognition and the transaction price. After initial recognition, the entity shall recognise that deferred difference as a gain or loss only to the extent that it arises from a change in a factor (including time) that market participants would take into account when pricing the asset or liability.

ANALYSIS AND CONCLUSION

1. The hybrid instrument comprises two elements, namely, (a) financial liability representing, conversion terms that allow the holder to convert the financial liability into the number of shares equal to the carrying amount of the financial liability at maturity that results in a contractual obligation to deliver a variable number of its own equity instruments and therefore it is a financial liability. [Ind AS 32.11 (b)(i)], and (b) the instrument contains an embedded derivative that provides an upside if an IPO were to happen; this embedded derivative should be viewed as a purchased call option, that is net share settled.

2. As per paragraph 4.2.1 of Ind AS 109, an entity shall classify all financial liabilities as subsequently measured at amortised cost, except for financial liabilities at fair value through profit or loss.

3. In accordance with paragraph 4.3.3 of Ind AS 109, an embedded derivative shall be separated from the host and accounted for as a derivative if, and only if: (a) the economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host;  (b) a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative; and  (c) the hybrid contract is not measured at fair value with changes in fair value recognised in profit or loss (i.e. a derivative that is embedded in a financial liability at fair value through profit or loss is not separated).

4. As per paragraph 4.3.4 of Ind AS 109, the embedded derivative will be separated and accounted for separately from the host financial liability contract. However, as per paragraph 4.3.5, if the embedded derivative has a significant impact on the combined instrument, it need not be separated.  In such a case, under paragraph 4.3.5, the entity may designate the entire hybrid contract at fair value through profit or loss (FVTPL).

5. Therefore, the entire CCPS financial liability may be fair valued to profit or loss or the CCPS may be broken up into two, namely, the host contract and the embedded derivative, and each of them accounted for separately. Whichever approach is taken, the overall impact on financial statements will not be materially different.

6. The other question that needs to be addressed is that the new company has issued the instrument at a discount to SBI. Therefore, should it attribute a one-day loss when accounting for the instrument at inception as per paragraph 5.1.1A, followed by amortising such a loss over the contract period in accordance with paragraph B5.1.2A.

7. Typically, the pre-IPO investors are provided a discount over the valuation of the company to compensate for the lock-in restrictions applicable to pre-IPO investors and for the uncertainty on the occurrence of the IPO and the timings of the IPO. Therefore, the discount provided to the pre-IPO investor is not out of any benevolent act. Rather the transaction price is reflective of the fair value of such instruments, keeping in mind the restrictions on such instruments and the uncertainty of the IPO.  Consequently, the author believes there is no one-day loss in the instant case, and the instrument is accounted for at the transaction price, which is the fair value of the instrument.

CONCLUSION

At inception, the instrument is accounted for at the transaction price which in the instant case is the fair value of the instrument. The instrument may be accounted for in its entirety at FVTPL, which is the more straightforward approach compared to splitting the instrument into a host component and an embedded derivative component.

As the entity approaches the IPO and uncertainty diminishes, the fair value of the financial liability will keep increasing, if the valuation of the company keeps increasing, resulting in a corresponding charge to P&L, in the books of the new company.  Assuming the shares are priced at Rs. 200 based on valuation of the company, on IPO date the fair value of the financial liability just before the conversion, will be Rs. 200 less discount.  Once the IPO concludes, the CCPS (financial liability) will get converted into equity shares (equity), therefore, the fair value of the financial liability as determined on the date of conversion is derecognised with corresponding credit being recognised in the equity in the books of the new company. There is no gain or loss on conversion. The fair value gain /loss on CCPS at each reporting period till the conversion date is recognised in the Statement of Profit or Loss.

Equity Vs. Financial Liability

Classification, measurement and presentation of financial instruments as financial liabilities or equity will give information to users of financial statements about the nature, timing and amount of future cash flows of the entity. Reclassification of a financial instrument from equity to financial liability or vice-versa would not only affect its presentation in the balance sheet but also its measurement (equity is not remeasured whereas financial liabilities are) and, may result in a remeasurement gain or loss.

This article deals with the issue of whether reclassification between financial liabilities and equity instruments should be required or prohibited for changes in the substance of contractual terms without a modification to the contract.

FACT PATTERN

An entity issues a four-year convertible bond, where the holder has the option to convert it into the issuer’s equity shares after the first year, but where the conversion ratio is only fixed at the end of the first year at the lower of R6 and 120 per cent of the equity share price. Should an instrument be reclassified when the original classification might have changed but the contractual terms have not?

RESPONSE

Technical literature

Ind AS 32, Financial Instruments, Presentation

Paragraph 17 “……. a critical feature in differentiating a financial liability from an equity instrument is the existence of a contractual obligation of one party to the financial instrument (the issuer) either to deliver cash or another financial asset to the other party (the holder) ………”

Paragraph 15 “The issuer of a financial instrument shall classify the instrument, or its component parts, 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 definitions of a financial liability, a financial asset and an equity instrument.”

Ind AS 109, Financial Instruments

Paragraph 3.3.1 “An entity shall remove a financial liability (or a part of a financial liability) from its balance sheet when, and only when, it is extinguished – i.e., when the obligation specified in the contract is discharged or cancelled or expires.”

RESPONSE

In the described fact pattern, the instrument is a financial liability since there is a contractual obligation to pay cash, should the holder decide not to exercise his option to convert the instrument into equity. Additionally, the holder has a right to convert the instrument into equity which is an embedded derivative. Because the number of shares into which the bond could be converted is variable at inception, the conversion option is recognised on initial recognition, as a separate embedded derivative (financial liability). At the end of the first year, under the contract’s original terms, the conversion ratio is fixed, and so the embedded derivative no longer meets the definition of a financial liability. The question is, should the embedded derivative (financial liability) be reclassified from financial liability to equity, when the original classification as financial liability might have changed without the contractual terms having undergone any change?

Ind AS is not clear on whether an entity should reclassify an instrument if the contractual terms have not changed. Ind AS 32 and Ind AS 109 appears to have contradictory requirements. Ind AS 32 only prescribes that an entity should classify the instrument, or its component parts, on initial recognition. For example, paragraphs 15 and 17 are applied at inception. On the other hand, paragraph 3.3.1 of Ind AS 109 states that an entity should remove a financial liability from its balance sheet when it is extinguished; that is, the obligation specified in the contract is discharged or is cancelled or expires.

Consequently, there are two views that can be considered.

VIEW A

In considering the guidance in Ind AS 32, the change in the conversion ratio, from variable to fixed at the end of year 1, would not result in reclassification, because the assessment of whether the embedded derivative feature is a financial liability or equity would be based only on the terms at inception of the contract.

View B

In considering the guidance in Ind AS 109 (paragraph 3.3.1), the conversion option would be reclassified from a derivative liability to equity, because the obligation to deliver a variable number of shares on conversion expires, and the obligation to then deliver a fixed number of shares meets the definition of equity.

Both treatments can be supported; an entity should determine an appropriate accounting policy and apply it consistently.  If an entity does elect to reclassify an instrument from financial liability to equity, the below accounting policy choice exists in how to account for the change (which should be consistently applied and disclosed properly):

  • An entity can apply the same accounting treatment as when the convertible debt is converted into shares, where the existing debt’s carrying value is transferred to equity, and no gain or loss is recorded on conversion.
  • The exchange of an existing debt instrument of the issuer with new equity instruments could be viewed as an extinguishment of the existing financial liability. The original debt instrument is de-recognised, and the new equity instruments that are issued are recognised at fair value. The difference is recognised as a gain or loss in the profit or loss, in accordance with Appendix D of Ind AS 109 Extinguishing Financial Liabilities with Equity Instruments.

CONCLUSION

The International Finanical Reporting Intepretation Committee (IFRSIC) in earlier discussions has not provided any conclusive point of view on this matter. The International Accounting Standards Boards (IASB) will be resolving this issue in its current project Financial Instruments with Characteristics of Equity. The author believes that View B is more appropriate since it reflects the substance of the change and is in consonance with the broad principles of Ind AS 32 and Ind AS 109.

Identification of Related Party Relationships

This article evaluates whether (a) subsidiary of an associate is related to the investor and (b) associate of an associate is related to the investor under Ind AS 24 Related Party Disclosures.

QUERY

Following are the definitions of terms such as associate, significant influence, control and subsidiary under the respective standards.

 

Ind AS 28 Investments in Associates and Joint Ventures

Paragraph 3An associate is an entity over which the investor has a significant influence.Significant influence is the power to participate in the financial and operating policy decisions of the investee but is not control or joint control of those policies.
Ind AS 110 Consolidated Financial Statements

Appendix A – Defined termsControl of an investee – An investor controls an investee when the investor 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.Subsidiary – An entity that is controlled by another entity.In the table below, there are two examples:1. Investor X has an Associate Y, which has a Subsidiary Z2. Investor P has an Associate Q, which has an Associate R

In the above example is (a) X related to Z and (b) P related to R under Ind AS 24 Related Party Disclosures?

RESPONSE

Technical references

Ind AS 24 Related Party Disclosures

Paragraph 9

The following terms are used in this Standard with the meanings specified:

A related party is a person or entity that is related to the entity preparing its financial statements (in this Standard 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 of 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 is related to a reporting entity if any of the following conditions applies:

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).

viii.  The entity, or any member of a group of which it is a part, provides key management personnel services to the reporting entity or to the parent of the reporting entity.

Paragraph 12

In the definition of a related party, an associate includes subsidiaries of the associate and a joint venture includes subsidiaries of the joint venture. Therefore, for example, an associate’s subsidiary and the investor that has significant influence over the associate are related to each other.

 

ANALYSIS AND CONCLUSION
Before we proceed to respond to the two questions, please note that definition of group under paragraph 9 (b) (i) means a parent, subsidiaries and fellow subsidiaries.

 
ANSWER TO QUESTION 1
X is related to Y, the associate in accordance with paragraph 9 (b) (ii) Y and Z belong to the same group, and X is related to this group by virtue of being an investor in the Associate Y. Consequently, X is related to Z. This is abundantly clear from Ind AS 24.12 which states that “in the definition of a related party, an associate includes subsidiaries of the associate”. Therefore, X and Z are related parties.
ANSWER TO QUESTION 2

P is related to Q, the associate in accordance with paragraph 9 (b) (ii). Q and R do not belong to the same group; therefore, P is related only to Q and not to R. Though, P and Q are related parties by virtue of being an investor and an associate respectively; P and R are not related parties, in accordance with the definition of related party in Paragraph 9 and in Paragraph 12 of Ind AS 24.

 

CONCLUSION
The broad conclusion that can be drawn from this article is that the relationships under Ind AS 24 are determined with reference to a group (parent and all its subsidiaries). If an entity is related to an entity of a group, it is related to all entities in that group. Therefore, in our example, since X is related to Y, it is related to Z since Y and Z are from the same group. On the other hand, P is related to Q but not to R since Q and R are not from the same group.

Whether Provision Is Required For Net Zero Commitment

Many Companies have publicly committed to become net zero on carbon emissions by a certain future date. They have also expressed that commitment on their web-site or regulatory filings. The question is whether a provision is required for the expected cost to be incurred to become a net zero company by a certain future date.

QUERY

Clean Company Limited (CCL) has publicly committed to become net zero on carbon emissions by 2030. CCL has expressed that commitment on their web-site as well as certain regulatory filings. CCL has outlined several initiatives, three of them are as follows:

a)    CCL operates in Odisha, where rice covers about 65 per cent of the cultivated area. CCL has committed to adopt biomass co-firing using rice husk for its Odisha power plant. The initiative would result in 20 per cent of its power requirement being produced with biomass by 2030, a sustainable alternative to coal. Additional costs would be incurred in the future for the said project.

b)    By 2030, CCL has committed that it would stop manufacturing petrol vehicles and will only manufacture electric vehicles. CCL will scrap its factory manufacturing petrol vehicles in 2030 and will also incur significant expenditure in building a new plant to manufacture electric vehicles.

c)    By 2030, CCL will enforce net zero requirements on all its sub-contractors; as a result, the prices the sub-contractor will charge CCL will go up by 25 per cent.

Whether a provision is required for the expected cost to be incurred on the above future initiatives?

Also, CCL has contaminated land by dumping hazardous material in the backyard of its factory. The management got wind of it only recently when it conducted an exhaustive environmental audit. The enterprise has not violated any existing legislation; however, it belongs to an international group which maintains high environmental standards and has a stated policy that they stand committed to cleaning up such environmental damage. Whether a provision for the environmental clean-up is required?

RESPONSE

References in Ind AS 37 Provisions, Contingent Liabilities and Contingent Assets

PARAGRAPH 10 DEFINITIONS

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.

An obligating event is an event that creates a legal or constructive obligation that results in an entity having no realistic alternative to settling that obligation.

A constructive obligation is an obligation that derives from an entity’s actions where: (a) by an established pattern of past practice, published policies or a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities; and (b) as a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities.

OTHER PARAGRAPHS

18. Financial statements deal with the financial position of an entity at the end of its reporting period and not its possible position in the future. Therefore, no provision is recognised for costs that need to be incurred to operate in the future. The only liabilities recognised in an entity’s balance sheet are those that exist at the end of the reporting period.

19. It is only those obligations arising from past events existing independently of an entity’s future actions (i.e., the future conduct of its business) that are recognised as provisions. Examples of such obligations are penalties or clean-up costs for unlawful environmental damage, both of which would lead to an outflow of resources embodying economic benefits in settlement regardless of the future actions of the entity. Similarly, an entity recognises a provision for the decommissioning costs of an oil installation or a nuclear power station to the extent that the entity is obliged to rectify damage already caused. In contrast, because of commercial pressures or legal requirements, an entity may intend or need to carry out expenditure to operate in a particular way in the future (for example, by fitting smoke filters in a certain type of factory). Because the entity can avoid the future expenditure by its future actions, for example, by changing its method of operation, it has no present obligation for that future expenditure, and no provision is recognised.

ANALYSIS & CONCLUSION

As per the definitions in Ind AS 37, 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. The present obligation could be a legal obligation or a constructive obligation. A constructive obligation is an obligation that derives from an entity’s actions where: (a) by an established pattern of past practice, published policies or a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities; and (b) as a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities.

Future expenditure to be incurred by CCL to adopt biomass renewable practices is not a present obligation that arises from any past event. In this situation, there is no past event that has occurred. Though CCL will have to incur the cost to adopt biomass, and it has committed to do so, no provision is required as there is no past event that has occurred. This is abundantly clear under Paragraphs 18 and 19 presented above. No provision is recognised for costs that need to be incurred to operate in the future, even when an entity stands committed to incur those costs.

For reasons already stated above, no provision is required for setting up a new plant to manufacture electric vehicles. With respect to the existing plant that is manufacturing petrol vehicles, the same is to be scrapped by 2030. Accordingly, CCL will have to re-estimate the useful life of this plant to end by 2030. This will impact CCL assessment of the depreciation and impairment charge for the plant, starting from the period CCL made the commitment.

Similarly, increase in sub-contracting cost for future periods is not a present obligation arising from past event. Rather, it is a cost of operating in the future and hence, no provision for the same is required to be made. In future periods, the profit and loss account will reflect the increase in sub-contracting costs on an ongoing basis.

CCL has contaminated land by dumping hazardous material in the backyard of its factory. The enterprise has not violated any existing legislation; however, it belongs to an international group which maintains high environmental standards. The past event is the contamination of land. There is no legal obligation but there is constructive obligation arising from the stated policies of the Group. In the given situation, there is a present obligation which is not a legal obligation but is a constructive obligation. The company is obligated by its Group policies and hence, provision is required for the contamination that has already occurred in the past (a past event), though the actual clean-up may take place much later.

Enabling Assets

INTRODUCTION

In many cases, companies must incur expenditures on items they will not own. A company may incur costs on electricity transmission lines, railway sidings and roads, referred to as ‘enabling assets’, to build a new factory. Though the company incurs costs on construction/development of these items, it will not have ownership rights on the same, i.e., the enabling assets will also be available for use to the general public.  However, the company will significantly benefit from the same.  Without incurring these costs, the company would not have been able to construct the new factory. The question addressed in this article is whether the company should capitalise enabling assets or charge the costs incurred as expenses in the Statement of Profit and Loss.

QUERY

Company X is constructing a new refinery outside the city limits. To facilitate the refinery’s construction and subsequent operations, it needs to incur costs on construction/development of items, such as, electricity transmission lines, railway sidings and roads.  X will not have ownership rights over the enabling assets that will also be available for use to the general public.

Whether X should capitalise such costs or charge them to the profit and loss account?  

If X determines that the cost needs to be capitalised, what would be the classification of such costs, e.g., factory building, plant and machinery, intangible assets, electrical fittings, etc.?

TECHNICAL REFERENCES

Ind AS 16 Property, Plant & Equipment

Paragraph 7

The cost of an item of property, plant and equipment shall be recognised as an asset if, and only if:  

(a) it is probable that future economic benefits associated with the item will flow to the entity; and

(b) the cost of the item can be measured reliably.

Paragraph 9

This Standard does not prescribe the unit of measure for recognition, i.e., what constitutes an item of property, plant and equipment. Thus, judgement is required in applying the recognition criteria to an entity’s specific circumstances. It may be appropriate to aggregate individually insignificant items, such as moulds, tools and dies, and to apply the criteria to the aggregate value.

Paragraph 11

Items of property, plant and equipment may be acquired for safety or environmental reasons. The acquisition of such property, plant and equipment, although not directly increasing the future economic benefits of any particular existing item of property, plant and equipment, may be necessary for an entity to obtain the future economic benefits from its other assets. Such items of property, plant and equipment qualify for recognition as assets because they enable an entity to derive future economic benefits from related assets in excess of what could be derived had those items not been acquired. For example, a chemical manufacturer may install new chemical handling processes to comply with environmental requirements for the production and storage of dangerous chemicals; related plant enhancements are recognised as an asset because without them the entity is unable to manufacture and sell chemicals. However, the resulting carrying amount of such an asset and related assets is reviewed for impairment in accordance with Ind AS 36, Impairment of Assets.

Paragraph 16

The cost of an item of property, plant and equipment comprises:

a) its purchase price, including import duties and non-refundable purchase taxes, after deducting trade discounts and rebates.

b) any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management.

c) the initial estimate of the costs of dismantling and removing the item ………….

Paragraph 44

An entity allocates the amount initially recognised in respect of an item of property, plant and equipment to its significant parts and depreciates separately each such part. For example, it may be appropriate to depreciate separately the airframe and engines of an aircraft……………..

Paragraph 45

A significant part of an item of property, plant and equipment may have a useful life and a depreciation method that are the same as the useful life and the depreciation method of another significant part of that same item. Such parts may be grouped in determining the depreciation charge.

RESPONSE

The Expert Advisory Committee (EAC) of the ICAI has dealt with similar issues under Indian GAAP in some of its opinions. One such opinion on the subject, ‘Treatment of capital expenditure on assets not owned by the company’, was published in the January 2011 edition of the ICAI Journal. The EAC opined that costs incurred by a company could be recognized as an asset only if it is a ‘resource controlled’ by the company. A company controlling an asset can generally deal with the asset as it pleases. For example, a company having control of an asset can exchange it 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. Further, an indicator of control of fixed assets is that the company can restrict the access of others to the benefits derived from that asset. In the case of enabling assets, the ownership does not vest with the company. Further, these assets are available for public use. Hence, as per the EAC, costs incurred by the company on such assets cannot be capitalised as a separate tangible asset.

The EAC also stated that costs incurred on ‘enabling assets’ cannot be considered as directly attributable costs and accordingly, the same cannot also be capitalised as a component of another fixed asset. Consequently, the EAC opined that the costs incurred on enabling assets not owned by a company should be charged to P&L in the accounting period in which such costs are incurred.

The author disagrees with the view of the EAC from the perspective of both Indian GAAP and Ind AS, and considers that the costs incurred on the enabling assets should be capitalised for the following reasons:

  • The costs are required to facilitate the construction of the refinery and its operations. Costs on these items are required to be incurred in order to get future economic benefits from the project as a whole which can be considered as the unit of measure for the purpose of capitalisation of the said costs even though the company cannot restrict the access of others for using the assets individually. It is clear that the aforesaid costs are directly attributable to bringing the refinery to the location and condition necessary for it to be capable of operating in the manner intended by management.  Even subsequent to the construction of the refinery, the entity will have significant benefits, as the roads and the railways sidings will provide the entity access to its refinery.  Therefore, the author believes that the requirements of paragraph 16(b) are met.
  • The requirements of paragraph 7 are met because future economic benefits will flow to the entity, and the costs can also be measured reliably.
  • Paragraph 11 of Ind AS 16 acknowledges that there may be costs forced upon a company by legislation that require it to buy ‘assets’. Examples are safety or environmental protection equipment. Ind AS 16 explains that these costs qualify for recognition as assets because they allow future benefits in excess of those that would flow if the costs had not been incurred; for example, a chemical plant might have to be closed down if the costs on environmental assets were not incurred. The author believes that the same guidance will apply to enabling assets as an entity needs to incur these costs for constructing the project as well as for subsequent use. Hence, under Ind AS 16, the EAC opinion may not apply and enabling assets shall be capitalised, if Ind AS 16 capitalisation criteria are otherwise met.
  • X may not be able to recognise costs incurred on these assets as an individual item of PPE in many cases (where it cannot restrict others from using the asset). Costs incurred may be capitalised as a part of the overall cost of the project. The costs incurred on these assets, i.e., railway siding, road and bridge, should be considered as the cost of constructing the refinery and accordingly, should be allocated and capitalised as part of the items of PPE of the refinery. If the useful life (of such costs) is more or less the same as the principal asset to which the cost is allocated, for e.g., factory building, plant and machinery, etc., then the same is depreciated as per the useful life of the principal asset. However, if the useful life is different, then such costs may be treated as a separate component and depreciated basis its own useful life as required by paragraphs 44 and 45.

Modification of Trade Receivables

This article deals with modification of trade receivables which involves significant sacrifice (cut in amounts to be received) by the debtor and the consequent accounting and disclosure requirements.

FACTS

The Ministry of Power, Government of India, introduced Electricity (Late Payment Surcharge and Related Matters) Rules, 2022 (“LPS Scheme”) vide notification no. G.S.R. 416 (E) dated 3rd June, 2022.

a.    The LPS Scheme provides a restructuring option to DISCOMs to liquidate their dues to Power Producers including late payment surcharge (LPS) on 3rd June, 2022 described in (b) below, through a maximum number of equated monthly instalments (EMI), ranging from 12 to 40 months determined based on outstanding dues amount. Therefore, if INR 100 were outstanding on 3rd June, 2022, INR 100 would be received by X by way of EMI’s without any loading of interest.

b.    DISCOM will have to pay Power Producer X LPS for all past periods of delay up to 3rd June, 2022, at the specified interest rate and period specified in LPS Scheme.

c.    In the past since it was not reasonably certain that the LPS would be received, X has not recorded LPS income.

d.    The sacrifice made by X is substantial and more than 25% of the amount due on 3rd June, 2022.

QUESTIONS

1.    How will X account the modification of trade receivable pursuant to the LPS Scheme? How is LPS for the past periods accounted for by X?

2.    What is the appropriate presentation for the modified receivables by X?

TECHNICAL REFERENCES

Ind AS 109 Financial Instruments

3.2.3 An entity shall derecognise a financial asset when, and only when:

a. the contractual rights to the cash flows from the financial asset expire, or

b. it transfers the financial asset as set out in paragraphs 3.2.4 and 3.2.5 and the transfer qualifies for derecognition in accordance with paragraph 3.2.6.

3.3.1 An entity shall remove a financial liability (or a part of a financial liability) from its balance sheet when, and only when, it is extinguished—i.e., when the obligation specified in the contract is discharged or cancelled or expires.

3.3.2 An exchange between an existing borrower and lender of debt instruments with substantially different terms shall be accounted for as an extinguishment of the original financial liability and the recognition of a new financial liability. Similarly, a substantial modification of the terms of an existing financial liability or a part of it (whether or not attributable to the financial difficulty of the debtor) shall be accounted for as an extinguishment of the original financial liability and the recognition of a new financial liability.

3.3.3 The difference between the carrying amount of a financial liability (or part of a financial liability) extinguished or transferred to another party and the consideration paid, including any non-cash assets transferred or liabilities assumed, shall be recognised in profit or loss.

3.2.6 When an entity transfers a financial asset (see paragraph 3.2.4), it shall evaluate the extent to which it retains the risks and rewards of ownership of the financial asset. In this case:

a.    if the entity transfers substantially all the risks and rewards of ownership of the financial asset, the entity shall derecognise the financial asset and recognise separately as assets or liabilities any rights and obligations created or retained in the transfer.

b.    if the entity retains substantially all the risks and rewards of ownership of the financial asset, the entity shall continue to recognise the financial asset.

c.    if the entity neither transfers nor retains substantially all the risks and rewards of ownership of the financial asset, the entity shall determine whether it has retained control of the financial asset. In this case:

i.    if the entity has not retained control, it shall derecognise the financial asset and recognise separately as assets or liabilities any rights and obligations created or retained in the transfer.

ii.    if the entity has retained control, it shall continue to recognise the financial asset to the extent of its continuing involvement in the financial asset (see paragraph 3.2.16).

5.4.3 When the contractual cash flows of a financial asset are renegotiated or otherwise modified and the renegotiation or modification does not result in the derecognition of that financial asset in accordance with this Standard, an entity shall recalculate the gross carrying amount of the financial asset and shall recognise a modification gain or loss in profit or loss. The gross carrying amount of the financial asset shall be recalculated as the present value of the renegotiated or modified contractual cash flows that are discounted at the financial asset’s original effective interest rate (or credit-adjusted effective interest rate for purchased or originated credit-impaired financial assets) or, when applicable, the revised effective interest rate calculated in accordance with paragraph 6.5.10. Any costs or fees incurred adjust the carrying amount of the modified financial asset and are amortised over the remaining term of the modified financial asset.

Extracts from IFRIC Committee Agenda Decision, September 2012 – IAS 39 Financial Instruments: Recognition and Measurement—Derecognition of financial instruments upon modification
The Interpretations Committee received a request for guidance on the circumstances in which the restructuring of Greek government bonds (GGB) should result in derecognition in accordance with IAS 39 of the whole asset or only part of it. In particular, the Interpretations Committee has been requested to consider whether:

  • the portion of the old GGBs that are exchanged for twenty new bonds with different maturities and interest rates should be derecognised, or conversely accounted for as a modification or transfer that would not require derecognition?


  • IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors would be applicable in analysing the submitted fact pattern?


  • either paragraphs AG8 or AG62 of IAS 39 would be applicable to the fact pattern submitted if the GGBs were not derecognised?


Exchange of financial instruments: derecognition?


The Interpretations Committee observed that the term ‘transfer’ is not defined in IAS 39. However, the potentially relevant portion of paragraph 18 of IAS 39 states that an entity transfers a financial asset if it transfers the contractual rights to receive the cash flows of the financial asset. The Interpretations Committee noted that, in the fact pattern submitted, the bonds are transferred back to the issuer rather than being transferred to a third party. Accordingly, the Interpretations Committee believed that the transaction should be assessed against paragraph 17(a) of IAS 39.

In applying paragraph 17(a), the Interpretations Committee noted that, in order to determine whether the financial asset is extinguished, it is necessary to assess the changes made as part of the bond exchange against the notion of ‘expiry’ of the rights to the cash flows. The Interpretations Committee also noted that, if an entity applies IAS 8 because of the absence in IAS 39 of an explicit discussion of when a modification of a financial asset results in derecognition, applying IAS 8 requires judgement to develop and apply an accounting policy. Paragraph 11 of IAS 8 requires that, in determining an appropriate accounting policy, consideration must first be given to the requirements in IFRSs that deal with similar and related issues. The Interpretations Committee noted that, in the fact pattern submitted, that requirement would lead to the development of an analogy to the notion of a substantial change of the terms of a financial liability in paragraph 40 of IAS 39.

Paragraph 40 sets out that such a change can be effected by the exchange of debt instruments or by modification of the terms of an existing instrument. Hence, if this analogy to financial liabilities is applied to financial assets, a substantial change of terms (whether effected by exchange or by modification) would result in derecognition of the financial asset.

The Interpretations Committee noted that, if the guidance for financial liabilities is applied by analogy to assess whether the exchange of a portion of the old GGBs for twenty new bonds is a substantial change of the terms of the financial asset, the assessment needs to be made taking into consideration all of the changes made as part of the bond exchange.

In the fact pattern submitted, the relevant facts led the Interpretations Committee to conclude that, in determining whether the transaction results in the derecognition of the financial asset, both approaches (i.e., extinguishment under paragraph 17(a) of IAS 39 or substantial change of the terms of the asset) would result in derecognition.

The Interpretations Committee considered the following aspects of the fact pattern in assessing the extent of the change that results from the transaction:

  • A holder of a single bond has received, in exchange for one portion of the old bond, twenty bonds with different maturities and cash flow profiles as well as other instruments in accordance with the terms and conditions of the exchange transaction.


  • All of the bond-holders received the same restructuring deal irrespective of the terms and conditions of their individual holdings. This indicates that the individual instruments, terms and conditions were not taken into account. The different bonds (series) were not each modified in contemplation of their respective terms and conditions but were instead replaced by a new uniform debt structure.


  • The terms and conditions of the new bonds are substantially different from those of the old bonds. The changes include many different aspects, such as the change in governing law; the introduction of contractual collective action clauses and the introduction of a co-financing agreement that affects the rights of the new bond holders; and modifications to the amount, term and coupons.


The Interpretations Committee noted that the starting point that it used for its analysis was the assumption in the submission that the part of the principal amount of the old GGBs that was exchanged for new GGBs could be separately assessed for derecognition. The Interpretations Committee emphasised that this assumption was more favourable for achieving partial derecognition than looking at the whole of the old bond. Hence, its conclusion that the old GGBs should be derecognised would apply even more so when taking into account that the exchange of the old GGBs was, as a matter of fact, the result of a single agreement that covered all aspects and types of consideration for surrendering the old GGBs. As a consequence, the Interpretations Committee noted that partial derecognition did not apply.

Consequently, the Interpretations Committee decided not to add the issue to its agenda.

Application of paragraphs AG62 or AG8 of IAS 39 to the submitted fact pattern-
The Interpretations Committee noted that the questions raised by the submitter assume that the old GGBs in the fact pattern would not be derecognised. In the submitted fact pattern, the Interpretations Committee concluded that the old GGBs are derecognised. The Interpretations Committee noted that, because of its conclusion on derecognition, these questions did not need to be answered.

Ind AS 1 Presentation of Financial Statements

Information to be presented in the profit or loss section or the statement of profit or loss

82. In addition to items required by other Ind ASs, the profit or loss section of the statement of profit and loss shall include line items that present the following amounts for the period:

a. revenue, presenting separately interest revenue calculated using the effective interest method;

(aa) gains and losses arising from the derecognition of financial assets measured at amortised cost;

b.  finance costs……

Ind AS 107 Financial Instruments: Disclosures

20A. An entity shall disclose an analysis of the gain or loss recognised in the statement of profit and loss arising from the derecognition of financial assets measured at amortised cost, showing separately gains and losses arising from derecognition of those financial assets. This disclosure shall include the reasons for derecognising those financial assets.
ANALYSIS

Response to Question 1

Paragraphs 3.3.1, 3.3.2 and 3.3.3 of Ind AS 109 relate to the derecognition of financial liabilities. The fact pattern relates to a substantial modification of a financial asset.

In accordance with Ind AS 109:3.2.3, an entity should derecognise a financial asset when, and only when:

a) the contractual rights to the cash flows from the financial asset expire; or

b) it transfers the financial asset as set out in Ind AS 109:3.2.4 and 3.2.5, and the transfer qualifies for derecognition in accordance with Ind AS 109:3.2.6.

For modifications of financial assets (e.g., a renegotiation of the asset’s contractual cash flows), derecognition can occur when then contractual cash flows expire or are transferred. In the given fact pattern, the contractual cash flows have neither expired as contemplated in 3.2.3 (a), nor are they transferred as contemplated in 3.2.3 (b). As per the fact pattern, the cash flow has been modified.

Ind AS 109:5.4.3 contains requirements on accounting for the modification of a financial asset when its contractual cash flows are renegotiated or otherwise modified, and the asset is not derecognised. In those cases, the entity should recalculate the gross carrying amount of the financial asset and recognise a modification gain or loss in profit or loss. The gross carrying amount is recalculated as the present value of the renegotiated or modified contractual cash flows, discounted at the financial asset’s original effective interest rate (or credit–adjusted effective interest rate for purchased or originated credit–impaired financial assets) or, when applicable, the revised effective interest rate calculated in accordance with Ind AS 109.6.5.10. Any costs or fees incurred adjust the carrying amount of the modified financial asset and are amortised over the remaining term of the modified financial asset.

The question that needs to be answered is whether X should apply the simpliciter modification requirement as per Ind AS 109:5.4.3 or derecognise the financial asset and recognise a new financial asset.

Clause 3.3.2 of Ind AS 109, with respect to substantial modification, applies to financial liabilities. Ind AS 109 does not contain substantive guidance on when a modification of a financial asset should result in derecognition from a lender’s perspective. IFRIC concluded that analogy, nonetheless, can be applied to financial asset from the substantial modification requirements applicable to financial liability. Though the IFRIC decision was made in the context of IAS 39, it would equally apply to IFRS 9 (Ind AS 109). In our fact pattern, there is a substantial modification, because there is a substantial sacrifice compared to the original receivable, there is an introduction of significant new features into the instrument (EMI’s), and a significant extension to the term of the instrument.

Basis the above, X does not apply the modification requirement as per Ind AS 109:5.4.3 but applies the significant modification requirement by analogy to the requirements applicable to a financial liability. Consequently, X will derecognise the receivable and recognise the new receivable which will comprise of the EMI’s discounted at a rate that reflects the current market assessment of the time value of money and the risks that are specific to the cash flows for that customer (i.e., using the prevailing market interest rate for a trade receivable determined based on the customer’s credit rating and the contracted EMI tenure). The receivable recognised at the date of restructuring will be reversed and new receivables representing discounted EMIs will be recognised, and the difference will be recognised in the profit and loss account. The LPS will not be recognised as its collection is already subsumed in the restructured EMIs to be received from the customer. If LPS is recognised it may erroneously end up grossing up of the financial income and loss on restructuring of trade receivable.

Response to Question 2

The loss on substantial modification of trade receivable computed as the difference between the carrying amount of old trade receivable and the new trade receivable is recognised as “losses arising from the derecognition of trade receivable on substantial modification” under Finance Cost in the Statement of Profit and Loss with detailed note explaining the modification. This is in line with paragraph 82 of Ind AS 1 and paragraph 20A of Ind AS 107. Though paragraph 82 requires such disclosure on the face of the P&L, keeping in mind the materiality, it may be acceptable to include the loss under finance cost and make such disclosures by way of a note. The ‘new’ trade receivable will be classified as current and non-current as per the requirement of Ind AS 1, considering the EMI period outstanding. Interest income on the new trade receivable is recognised at the EIR [i.e., discount rate used for discounting the EMI cash flow] in the Statement of Profit and Loss over the EMI period.

Impact of Shareholders’ Rights on Classification of Financial Instruments

This article discusses the impact of shareholders’ rights on classifying an instrument as debt or equity.

QUESTION 1

The unconditional right of an entity to avoid delivering cash or another financial asset in settlement of an obligation is crucial in differentiating a financial liability from an equity instrument. The right to declare dividends and/or redeem capital is reserved for the members of the entity in general meeting, under the Companies Act. The effect of such a right may be that the members collectively can require payment of a dividend or buy back capital irrespective of the wishes of management. Even where management has the right to prevent a payment declared by the members, the members will generally have the right to appoint the management, and can therefore appoint management that will not oppose an equity distribution declared by the members or prevent a buy-back of capital. This raises the question whether an entity whose members have such rights should classify all its distributable retained earnings as a financial liability, on the grounds that the members could require earnings to be distributed as dividend, or equity capital (or a portion of it) as financial liability because the shareholders have a right to be repaid, at any time. Whether shareholders rights to enforce dividend payments or buy-back of equity capital would result in the dividend liability being classified as financial liability even prior to dividend declaration or whether entire or portion (depending on the rights of the shareholders as enshrined in the Companies Act) of ordinary equity capital would be classified as financial liability?

QUESTION 2

Entity A has two classes of shares – O shares (basic ordinary shares) and B shares (preference shares held by two venture capital entities). The terms of the B shares are such that, if the entity initiates an IPO, the B shares are repaid in cash or a variable number of O shares. Also, if the entity has not initiated an IPO by a specified date, the B shareholders can call a meeting of the preference shareholders and propose a resolution for an IPO. If the resolution is passed by the preference shareholders, the entity must initiate an IPO. A vote of the ordinary shareholders is not required. Financial decisions affecting entity A are normally made by the Ordinary Shareholders in a general shareholders’ meeting. The preference shareholders do not participate in the normal decisions affecting the financial policies of the entity. Whether the B shares are classified as equity or a financial liability?

APPLICABLE REQUIREMENTS IN Ind AS ACCOUNTING STANDARDS

1.    The fundamental principle in Ind AS 32 for distinguishing a financial liability from an equity instrument is in paragraph 19 of Ind AS 32, which states that:

If an entity does not have an unconditional right to avoid delivering cash or another financial asset to settle a contractual obligation, the obligation meets the definition of a financial liability […].

2.    Paragraph AG26 of Ind AS 32 explains that:

When preference shares are non-redeemable, the appropriate classification is determined by the other rights that attach to them. […] When distributions to holders of the preference shares, whether cumulative or non-cumulative, are at the discretion of the issuer, the shares are equity instruments. […].

3.    Paragraph 16C of Ind AS 32: Some financial instruments include a contractual obligation for the issuing entity to deliver to another entity a pro rata share of its net assets only on liquidation. The obligation arises because liquidation either is certain to occur and outside the control of the entity (for example, a limited life entity) or is uncertain to occur but is at the option of the instrument holder. As an exception to the definition of a financial liability, an instrument that includes such an obligation is classified as an equity instrument if it has all the following features:

(a) It entitles the holder to a pro rata share of the entity’s net assets in the event of the entity’s liquidation. The entity’s net assets are those assets that remain after deducting all other claims on its assets. A pro rata share is determined by:

i. dividing the net assets of the entity on liquidation into units of equal amount; and

ii. multiplying that amount by the number of the units held by the financial instrument holder.

(b) The instrument is in the class of instruments that is subordinate to all other classes of instruments. To be in such a class the instrument:

i. has no priority over other claims to the assets of the entity on liquidation, and

ii. does not need to be converted into another instrument before it is in the class of instruments that is subordinate to all other classes of instruments.

(c) All financial instruments in the class of instruments that is subordinate to all other classes of instruments must have an identical contractual obligation for the issuing entity to deliver a pro rata share of its net assets on liquidation.

4. Paragraph 25 of Ind AS 32: A financial instrument may require the entity to deliver cash or another financial asset, or otherwise to settle it in such a way that it would be a financial liability, in the event of the occurrence or non-occurrence of uncertain future events (or on the outcome of uncertain circumstances) that are beyond the control of both the issuer and the holder of the instrument, such as a change in a stock market index, consumer price index, interest rate or taxation requirements, or the issuer’s future revenues, net income or debt-to-equity ratio. The issuer of such an instrument does not have the unconditional right to avoid delivering cash or another financial asset (or otherwise to settle it in such a way that it would be a financial liability). Therefore, it is a financial liability of the issuer unless:

(a) ……

(b) the issuer can be required to settle the obligation in cash or another financial asset (or otherwise to settle it in such a way that it would be a financial liability) only in the event of liquidation of the issuer; or

(c) ……………

RESPONSE TO QUESTION 1

This issue was brought to the IFRS Interpretations Committee in January 2010. The Committee observed that IAS 32 contains no requirements for assessing whether a decision of shareholders is treated as a decision of the entity. The Interpretations Committee identified that diversity may exist in practice in assessing whether an entity has an unconditional right to avoid delivering cash, if the contractual obligation is at the ultimate discretion of the issuer’s shareholders, and consequently whether a financial instrument should be classified as a financial liability or equity. However, the Interpretations Committee concluded that the Board’s then current project on financial instruments with characteristics of equity was expected to address the distinction between equity and non–equity instruments on a timely basis, and that the Interpretations Committee would therefore not add this to its agenda. The Board is currently considering several IAS 32 practice issues, including those raised above.

Though there is no specific guidance or clauses under Ind AS 32 with respect to the same, in the author’s view, an action reserved for the entity’s shareholders in general meeting, is effectively an action of the entity itself. It is therefore at the discretion of the entity itself (as represented by the members in general meeting) that retained earnings are  paid out as a  dividend or capital be redeemed. If on the other hand, decisions by the shareholders are not made as part of the entity’s corporate governance decision making process but made in their capacity as holders of particular instruments, the shareholders should be considered as separate from the entity. Accordingly, in the case where an action is reserved for the entity’s shareholders in a general meeting referred to above, such earnings are classified as equity, and not as a financial liability, until they become a legal liability of the entity. Similarly, the ordinary equity capital is classified as equity rather than a financial liability, until the time the appropriate formalities are completed and the buy-back become a financial liability of the entity.

RESPONSE TO QUESTION 2

If the decisions are not made as part of the entity’s normal decision-making process for similar transactions (for example, one shareholder or a class of shareholders can make the decision, and this is not the process that the entity generally follows to make financial decisions), the shareholders are viewed as separate and distinct from the entity.

The preference shareholders have a collective right to cause the entity to initiate an IPO that can be exercised at a meeting of the preference shareholders alone. However, this right is not exercised in the normal decision- making forum for similar transactions, because decisions affecting financial policies of the entity are made by ordinary shareholders in general meeting. A decision made solely by preference shareholders is not the normal decision-making process for similar transactions. The entity cannot avoid the payment of cash (or a variable number of shares), because the preference shareholders can cause the entity to initiate an IPO (which, in turn, will trigger redemption of their interest in cash or in a variable number of shares). Thus, the preference shares are classified as a financial liability.

If the decisions are made as a part of the entity’s normal decision-making process for similar transactions, the shareholders are considered to be part of the entity. For example, if under the Companies Act, an entity’s equity instruments or a portion of it, can be redeemed by the ordinary shareholders through a collective decision, the shares would be classified as equity. For example, just because the equity shareholders have a collective right to force a buy-back of shares, does not make equity capital a financial liability, because those decisions are taken by the shareholders as part of the entity and in the entity’s normal decision-making process.

CONCLUSION

Ind AS 32 includes no requirements on classifying a financial instrument when a contractual obligation to deliver cash is at the discretion of the issuer’s shareholders. It also includes no application guidance on determining which decisions are beyond the control of the entity and which are treated as decisions of the entity.

Though the above position in Response 1 and Response 2 are not coded in Ind AS 32, this practice is very commonly and consistently applied globally.

Examples of other circumstances include the following:

a.  an entity issues a preference share that requires the entity to pay coupons only if the entity pays dividends on its ordinary shares. Dividend payments on ordinary shares require shareholders’ approval via a simple majority vote at a general meeting.

b. a financial instrument that requires the entity to redeem it in cash if a change of control of the entity occurs. Change of control must be approved by a simple majority of ordinary shareholders in a general meeting.

c.  an entity receives venture capital funding from investors by issuing preference shares convertible to ordinary shares. The preference shareholders are entitled to priority payments and to vote on particular decisions of the entity. These preference shareholders also share in the proceeds of a sale of the business through various exit mechanisms (trade sale, share sale or IPO). Decisions about the sale of the business are voted on by all shareholders with voting rights, including preference shareholders.

d.  Classification of shares issued by a SPAC (Special Purpose Acquisition Companies).

In all the above cases, the specific facts and circumstances need to be carefully evaluated and may require the exercise of judgment. The decision as to whether the instrument is classified as a financial liability or an equity will depend upon whether the decision is made as part of the entity’s normal decision making process as a part of the entity or separate from the entity.

A contractual provision that requires settlement of a financial instrument only in the event of liquidation of the issuer does not usually result in financial liability classification for that instrument. This is because classifying such an instrument as a financial liability based only on there being an obligation arising on liquidation would be inconsistent with the going concern assumption. A contingent settlement provision that provides for payment in cash or another financial asset only on liquidation of the issuer is similar to an equity instrument that has priority in liquidation, and therefore is ignored in classification. [Ind AS 32.25(b), see above].

However, the entity’s liquidation date may be predetermined; alternatively, the holder of such an instrument may have the right to liquidate the issuer of the instrument. In those cases, the exception above does not generally apply and financial liability classification may be required. [Ind AS 32.16C, 25(b), see above].

Financial liability classification is not generally appropriate when ordinary shareholders collectively have the right to force the liquidation of the entity. This is because the ordinary shareholders’ right to liquidate the entity at a general meeting would generally be considered a part of the normal or ordinary governance processes of the entity. Therefore, the ordinary shareholders acting through the general meeting would be considered to be acting as part of the entity.

Onerous Contracts – Amendments to Ind AS 37

This article explains the recent amendment to Ind AS 37 Provisions, Contingent Liabilities and Contingent Assets with respect to the measurement of onerous contracts.

An onerous contract is defined under paragraph 10 of Ind AS 37 as “a contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it.”

Paragraph 68 further elaborates, “The unavoidable costs under a contract reflect the least net cost of exiting from the contract, which is the lower of the cost of fulfilling it and any compensation or penalties arising from failure to fulfil it.”

The example below explains the above requirements.

EXAMPLE – Measurement of Onerous Contract

Let’s say, the revenue on a contract is Rs. 100, cost of the contract is Rs. 120, and cost of exiting or cancelling the contract is a penalty of Rs. 10. In this case, if the contract is executed, the cost of fulfilling the contract is Rs. 20, but if the contract is cancelled, the cost is Rs. 10. Therefore, a provision for an onerous contract of Rs. 10 is made, being lesser of Rs .20 and Rs. 10. On the other hand, if the cost of the contract is Rs. 120, and cost of exiting or cancelling the contract is a penalty of Rs. 30, a provision of Rs. 20 is made, being lesser of Rs. 20 and Rs. 30.

Prior to the amendment, there was no clarity on how the cost of fulfilling the contract would be determined. Paragraph 68A was added to Ind AS 37 and paragraph 69 was modified to provide that clarity.

Amendment vide MCA Notification No. G.S.R 255 (E) dated 23rd March, 2022

68A The cost of fulfilling a contract comprises the costs that relate directly to the contract. Costs that relate directly to a contract consist of both:

a. the incremental costs of fulfilling that contract — for example, direct labour and materials; and

b. an allocation of other costs that relate directly to fulfilling contracts – for example, an allocation of the depreciation charge for an item of property, plant and equipment used in fulfilling that contract among others.

Amendment

69 Before a separate provision for an onerous contract is established, an entity recognises any impairment loss that has occurred on assets used in fulfilling the contract.

The Amendment shall bring the much-needed uniformity and clarity while assessing the cost of fulfilling a contract and the allocation of common cost, e.g., management and supervision time. Besides, it will also clarify that, before an onerous contract provision is established, an entity should recognise any impairment loss on the asset used to fulfil the contract. This will apply even when the asset is not dedicated exclusively to that contract, but is used across several contracts.

Let us understand with an example, how this amendment will help in uniformity of practice while calculating cost to fulfil a contract:

Example
– Measurement of onerous contract provision under pre-revised Ind AS 37

Entity A (Estimate of cost to fulfil a contract when
equipment is hired)

 

Entity B (Estimate of cost to fulfil a contract when
own asset is

used)

 

Entity C (Estimate of cost to fulfil a contract when
own asset is used)

 

 

R

 

R

 

R

Materials

100

Materials

100

Materials

100

Direct variable cost

50

Direct variable cost

50

Direct variable cost

50

Equipment

hiring cost

30

Use of own

equipment*

–

Use of own

equipment**

25

Total

180

Total

150

Total

175

Contract

revenue

150

Contract

revenue

150

Contract

revenue

150

Onerous

contract

provision

30

Onerous

contract

provision

–

Onerous

contract

provision

25

* same equipment is used in other contracts as well
and depreciation has not been considered by
the Entity for cost estimate

**same equipment is used in other contracts as well
and depreciation has been considered by
the Entity for cost estimate

As can be seen from the above example, in the pre-revised Ind AS 37, the difference in practices yielded different results, when an entity used third party equipment as against its own equipment. Revised Ind AS 37, will require common costs such as the depreciation cost to be allocated for determining the cost. This will ensure that the onerous contract provision considers all costs when determining onerous contract provision. Additionally, in pre-revised Ind AS 37, entities that used own equipment, could establish onerous provisions differently, depending on whether or not they allocated depreciation to the contract. Under revised Ind AS 37, it is mandatory to allocate all common costs when determining onerous contract provision. The above example under pre-revised Ind AS 37 will be recast as follows under revised Ind AS 37.

Example
– Measurement of onerous contract provision under revised Ind AS 37

Entity A (Estimate of cost to fulfil a contract when
equipment is hired)

 

Entity B (Estimate of cost to fulfil a contract when
own asset is

used)

 

Entity C (Estimate of cost to fulfil a contract when
own asset is used)

 

 

R

 

R

 

R

Materials

100

Materials

100

Materials

100

Direct variable cost

50

Direct variable cost

50

Direct variable cost

50

Equipment

hiring cost

30

Use of own

equipment*

25

Use of own

equipment*

25

Total

180

Total

175

Total

175

Contract

revenue

150

Contract

revenue

150

Contract

revenue

150

Onerous

contract

provision

30

Onerous

contract

provision

25

Onerous

contract

provision

25

* same equipment is used in other contract as well
and depreciation has been considered by
the Entity for cost estimate as required under revised paragraph 68A of Ind
AS 37

An entity shall apply the amendments for annual reporting periods beginning on or after 1st April 2022. An entity shall apply those amendments to contracts for which it has not yet fulfilled all its obligations at the beginning of the annual reporting period in which it first applies the amendments (the date of initial application). The entity shall not restate comparative information. Instead, the entity shall recognise the cumulative effect of initially applying the amendments as an adjustment to the opening balance of retained earnings or other component of equity, as appropriate, at the date of initial application.

Accounting of Production-Linked Incentives (PLI)

INTRODUCTION
To incentivise and promote production, growth and capital investment in the country, the Indian government introduced PLI schemes for various industries.  Under the scheme, a cash incentive is given each year for a certain number of years (e.g., five years in the case of the white goods industry), basis fulfilment of specific conditions and the incentive amounts are determined as a percentage of incremental sales. There are several conditions, but the two most important conditions relate to cumulative investment and incremental sales (over the base year).  

The qualifying investments include plant and machinery and capital investment in research and development but exclude, for example, land.  Incremental sales are determined basis consolidated financial statements, including global sales; however, the capital investment and production should occur in India.  

The grant is provided each year, provided the conditions relating to cumulative investment and incremental sales are met for that year. In the case of white goods, if the grant for Year 1 is earned because the entity fulfilled the cumulative investment and incremental sales condition in that year, but the entity subsequently exits from the scheme, the grant earned in earlier years is clawed back.  However, in the case of pharmaceutical sector, the requirements are not free from doubt. For example, consider the following FAQ regarding the PLI scheme, which applies to pharmaceutical companies.

Q – “What if part assets are purchased initially and then later after two years these were sold by the company (reason could be new technology, new equipment with better capacity is available)

A – Gross Investment value of the said sold assets would be deducted from the Cumulative Investment for that year in which sale is made.”

While the above FAQ suggests that if part assets are sold subsequently, it will not result in a clawback of grant earned in earlier years, there is no clarity on what happens if the entire cumulative investment is disposed of.  

In the analysis below, both scenarios have been covered, i.e., grants earned in earlier years may or may not be clawed back if the cumulative investment is subsequently disposed of or the entity exits from the PLI scheme. Additionally, the analysis below will equally apply to whether the investment is entirely front-loaded or staggered over time.

QUESTIONS

Assuming for simplicity, the entity avails the PLI grant by making the qualifying investment in plant and machinery for manufacturing eligible products, the following questions arise:

1. Is the PLI grant a capital (fixed asset) or revenue-related grant?

2. The conditions related to cumulative investment and incremental sales are tested on an annual basis.  How is the grant recognised each quarter?

TECHNICAL REFERENCES

Ind AS 20, Accounting for Government Grants and Disclosure of Government Assistance

Paragraph 3

Grants related to assets are government grants whose primary condition is that an entity qualifying for them should purchase, construct or otherwise acquire long-term assets. Subsidiary conditions may also be attached restricting the type or location of the assets or the periods during which they are to be acquired or held.

Grants related to income are government grants other than those related to assets.

Paragraph 12

Government grants shall be recognised in profit or loss on a systematic basis over the periods in which the entity recognises as expenses the related costs for which the grants are intended to compensate.

Paragraph 19

Grants are sometimes received as part of a package of financial or fiscal aids to which a number of conditions are attached. In such cases, care is needed in identifying the conditions giving rise to costs and expenses which determine the periods over which the grant will be earned. It may be appropriate to allocate part of a grant on one basis and part on another.

Paragraph 7

Government grants, including non-monetary grants at fair value, shall not be recognised until there is reasonable assurance that:

(a) the entity will comply with the conditions attaching to them; and

(b) the grants will be received.

Illustrative Examples for IAS 34, Interim Financial Reporting

Paragraph B23     

Volume rebates or discounts and other contractual changes in the prices of raw materials, labour, or other purchased goods and services are anticipated in interim periods, by both the payer and the recipient, if it is probable that they have been earned or will take effect. Thus, contractual rebates and discounts are anticipated but discretionary rebates and discounts are not anticipated because the resulting asset or liability would not satisfy the conditions in the Conceptual Framework that an asset must be a resource controlled by the entity as a result of a past event and that a liability must be a present obligation whose settlement is expected to result in an outflow of resources.


ANALYSIS

Is the PLI grant a capital (fixed asset) related grant or revenue related grant?

The equivalent international standard to Ind AS 20, namely, IAS 20, Accounting for Government Grants and Disclosure of Government Assistance, was adopted in April, 2001.  The standard is archaic and does not deal with complex grants presently given across the globe. Therefore, applying the standard is not a straightforward exercise, particularly when there are multiple conditions that need capital investment as well as production and sales to take place. With regards to the PLI scheme, whether the grant is a capital or revenue grant, there could be multiple views, which are discussed below:

View A – PLI is a capital (fixed asset) grant

One may argue that the PLI grant is a capital grant, basis the following arguments:

  • Without the acquisition of the plant and machinery, the grant would not have been available. The condition relating to incremental sales is only incidental, as the acquisition of plant and machinery would ensure that there would be production and incremental sales that logically follows the capital investment. Only an irrational entity would acquire plant and machinery and not use them for the production of goods.

  • Paragraph 3 of Ind AS 20 states that grants related to assets are government grants whose primary condition is that an entity qualifying for them should purchase, construct or otherwise acquire long-term assets. Subsidiary conditions may also be attached, restricting the type or location of the assets or the periods during which they are to be acquired or held. One may argue that the starting point is the acquisition of the plant and machinery, and therefore that is a primary condition. The requirement relating to incremental sales is merely a subsidiary condition; therefore the grant qualifies as a capital grant, basis the definition in paragraph 3.

  • Paragraph 12 of Ind AS 20 states that government grants shall be recognised in profit or loss on a systematic basis over the periods in which the entity recognises as expenses the related costs for which the grants are intended to compensate.  Since the grant is production-linked, it could be assumed that the grant compensates for the depreciation incurred on the plant and machinery.

  • In some PLI schemes, for example, in the white goods industry, the grant is clawed back if the entity exits the scheme. Therefore, it is necessary not only to acquire the plant and machinery but also to use and hold it for a certain number of years.

The counterargument to the above is as follows:

  • There is no requirement in some of the PLI schemes to hold on to the plant and machinery for the entire period of the grant. Additionally, if the capital investment is sold or disposed of in subsequent years, the grant relating to earlier years is not clawed back. For example, subsequent disposal of part assets in the case of pharmaceutical companies does not result in a clawback of grants earned in earlier years. Consequently, it may be argued that the grant is not a capital grant.

  • Though the standard defines what a primary condition is, from the PLI scheme, it is not clear whether the asset acquisition is indeed the primary condition. Therefore, it would not be appropriate to conclude that acquisition of the plant and machinery is the primary condition, and incremental sales is a subsidiary condition.

  • The grant is not specifically meant to subsidise depreciation. The grant conditions require conditions to be fulfilled each year and are not a straightforward grant provided for the acquisition of an asset.  The grant conditions require the plant to operate and the manufactured goods to be sold at a certain level, fuelling economic buoyancy.  

View B – PLI is a revenue grant

One may offer the following arguments to support the view that the grant is a revenue grant.

  • Very often, the acquisition and use of plant and machinery may not translate into incremental sales because the demand for the underlying products may have diminished, or a catastrophe such as Covid may restrict economic activity. Hence it is not appropriate to trivialise the condition relating to incremental sales, and one may argue that incremental sales is the primary condition.  In other words, incremental sales could be a very constraining condition and hence could be treated as a primary condition.

  • Each year, the grant is received only if the entity is able to achieve incremental sales. The grant amount is determined as a percentage of incremental sales, thereby suggesting that incremental sales are a very important condition for determining the grant amount and qualifying for the grant.  Because prominence is given to incremental sales for earning the grant each year, the grant is treated as a revenue grant.

  • Each year is treated as a separate unit for the purposes of determining and receiving the grant amount. For example, in the case of the pharmaceutical industry, the grant received each year is not clawed back in subsequent years if the conditions in those years are not met or the investment already made is partly sold or disposed of. Because the grant is meant to operate for each year, the most appropriate accounting would be to record the grant for each year if the eligibility conditions for those years are fulfilled.

The counterargument for this view is the same arguments provided in support of View A.

View C – PLI is a combination of capital and revenue grant

The grant seems to be a mixture of both capital and revenue conditions, and hence in accordance with paragraph 19, the same would be allocated between capital and revenue grant.  However, the counterargument for this view is that there is no clear basis for allocating the grant between capital and revenue grant, and any forced allocation may be arbitrary and highly subjective.

HOW IS THE GRANT RECOGNISED EACH QUARTER?

At each quarter end, the entity will not know whether it would fulfil all the conditions relating to the grant by the end of the year or over the grant period, unless the conditions are all met by that quarter end.  Applying Paragraph B23 of IAS 34, the entity will have to anticipate each quarter end, whether it would achieve all the grant-related conditions by the end of the year or over the grant period.  Though Illustrative Examples are not included in Ind AS 34, the example in IAS 34 can be treated as authoritative literature in the absence of any contrary requirement under Ind AS. Applying Paragraph 7 of Ind AS 20 and Paragraph B 23 of IAS 34, the entity would recognise the grant in each quarter, provided there is reasonable assurance and probability that the grant would be received and would not have to be reversed in a subsequent quarter/year.

CONCLUSION

For arguments already provided above, the author believes that on the first question, View C is not advisable. In the absence of clear guidance in the standard, there could be a choice between View A and View B. In making such an evaluation, the entity needs to carefully evaluate all the conditions relating to the grant, as well as its ability to fulfil all the conditions, particularly where non-fulfilment of such conditions may result in a clawback of the grant earned in earlier years.  Additionally, different considerations may apply when the cumulative investment is made in other than plant and machinery, for example, in research and development.

The entity should recognise the grant at each quarter end, provided the probability criterion is met. The entity should be careful while recognising the grant at each quarter end and ensure that the grant recognised in a quarter does not have to be reversed in a subsequent quarter or a subsequent year because the conditions that were anticipated to be fulfilled are not eventually fulfilled or the entity decides to exit the scheme, resulting in a clawback of grant earned in earlier years.

SALE OF A STAKE IN A SUBSIDIARY BY A PARENT WITHOUT LOSS OF CONTROL

This article deals with the accounting of the sale of a stake in a subsidiary by the parent, in the Consolidated Financial Statements (CFS) of the parent.

CASE – Accounting of the Sale of a Stake in a Subsidiary by a Parent Without Loss Of Control

FACTS

  • A Ltd. (‘Parent’) acquired a 100% controlling stake in B Ltd. (‘Subsidiary’) for a cash consideration of Rs. 12,500 crores. On the date of acquisition, B Ltd.’s identifiable net assets at fair value were Rs. 10,000 crores. Goodwill of Rs. 2,500 crores was recognised in the CFS of the parent.

  • In a subsequent year, A Ltd. sells a 25% interest in B Ltd. to outside investors / non-controlling interests (NCI) for a cash consideration of Rs. 3,500 crores.

  • A Ltd. still maintains a 75% controlling interest in B Ltd., i.e. A Ltd. continues to control B Ltd. even after the sale of a 25% stake in B Ltd.

  • For simplicity, it is assumed that there has been no change in the net assets of the subsidiary since the acquisition till the date of sale of 25% stake by A Ltd.

  • There are no call/put options with NCI and/or parent.

ISSUE
How should the parent’s sale of a stake in the subsidiary without a loss of control be accounted for in the CFS of A Ltd.?

RESPONSE
Accounting Standard References

Ind AS 110, Consolidated Financial Statement

Paragraph 23
Changes in a parent’s ownership interest in a subsidiary that do not result in the parent losing control of the subsidiary are equity transactions (i.e. transactions with owners in their capacity as owners).

Paragraph B96
When the proportion of the equity held by non-controlling interests changes, an entity shall adjust the carrying amounts of the controlling and non-controlling interests to reflect the changes in their relative interests in the subsidiary. The entity shall recognise directly in equity any difference between the amount by which the non-controlling interests are adjusted and the fair value of the consideration paid or received, and attribute it to the owners of the parent.

Ind AS 103, Business Combinations

Paragraph 19

For each business combination, the acquirer shall measure at the acquisition date components of non-controlling interest in the acquiree that are present ownership interests and entitle their holders to a proportionate share of the entity’s net assets in the event of liquidation at either:
(a) fair value; or
(b) The present ownership instruments’ proportionate share in the recognised amounts of the acquiree’s identifiable net assets.

All other components of non-controlling interests shall be measured at their acquisition-date fair values, unless another measurement basis is required by Ind AS.

ANALYSIS
Changes in a parent’s ownership interest in a subsidiary that do not result in the parent losing control of the subsidiary are equity transactions (i.e., transactions with owners in their capacity as owners) as per Para 23 of Ind AS 110.

Paragraph B96 of Ind AS 110 states that the entity shall recognise directly in equity any difference between the amount by which the NCI are adjusted and the fair value of the consideration paid or received, and attribute it to the owners of the parent.

An entity shall adjust the carrying amounts of the controlling (100% going down to 75%) and non-controlling interests (0% going up to 25%) to reflect the changes in their relative interests in the subsidiary. However, Ind AS 110 does not provide guidance on the amount at which the NCI should be measured. Paragraph 19 of Ind AS 103 has specific requirements on measuring NCI in a business combination, which is not relevant for changes in NCI in a post-business combination situation.

In the author’s view, in absence of specific guidance in Ind AS 110, the following approaches may be applied:

  • Approach 1: NCI is recognised at a proportionate share of the carrying amount of the identifiable net assets, excluding goodwill. There is no adjustment to the carrying amount of goodwill because control over the subsidiary has been retained by parent.

  • Approach 2: NCI is recognised at a proportionate share of the carrying amount of the identifiable net assets, including goodwill. There is no adjustment to the carrying amount of goodwill because control over the subsidiary has been retained by parent.

  • Approach 3: NCI is recognised at the fair value of the consideration received. No gain/loss recognised in equity of the parent for the sale of a stake in a subsidiary without loss of control.

  • Approach 4: NCI is recognised at the fair value of the consideration received less the proportionate goodwill amount. Gain/loss is recognised in equity of the parent for the sale of a stake in subsidiary for the proportionate goodwill amount.

Approach 1

The accounting entry by A Ltd, in its CFS, for the sale of 25% stake in the subsidiary is illustrated below:

Particulars

R crores

Fair value of the consideration received

3,500

NCI recognised (25% × 10,000) *

2,500

Gain recognised in equity of the parent

1,000
* NCI is measured based on their share of identifiable assets (excluding goodwill).

Approach 2

The accounting entry by A Ltd, in its CFS, for the sale of 25% stake in the subsidiary is illustrated below:

Particulars

R crores

Fair value of the consideration received

3,500

NCI recognised (25% × 12,500) *

3,125

Gain recognised in equity of the parent

375

* NCI is measured based on their share of identifiable assets (including goodwill).

Approach 3

NCI is measured initially at the fair value of the consideration received, i.e. Rs 3,500 crores, which is the amount of cash received from the NCI. No gain or loss is attributed to the parents equity.

Particulars

R crores

Fair value of the consideration received

3,500

NCI recognised (100% × 3,500)

3,500

Gain recognised in equity of the parent

Nil


Approach 4

NCI is measured initially at the fair value of the consideration received, i.e. Rs. 3,500 crores less proportionate goodwill amount, i.e., Rs. 625 crores (25% × 2,500). Therefore, NCI is recognised at Rs. 2,875 crores. The gain/loss recognised in equity of the parent for the sale of a stake in the subsidiary is for the proportionate goodwill amount, i.e. Rs. 625 crores.

Particulars

R crores

Fair value of the consideration received

3,500

Gain recognised in equity of the parent,
i.e. proportionate goodwill attributable to minority interests (25% × 2,500)

  625

NCI recognised

2,875

CONCLUSION
Ind AS does not provide guidance on the amount at which NCI is recognised to reflect the change in interests without loss of control. In the author’s view, there may be different approaches possible for recognition of NCI. An entity should choose an accounting policy to be applied consistently to sales and purchases of equity interests in subsidiaries when control exists before and after the transaction.

The author believes Approach 1 is the preferred approach because in this approach, the NCI is allocated the value of the net assets proportionate to their shareholding. This approach excludes goodwill, which is attributable to the controlling shareholder, and which arose as a result of a past acquisition. However, other approaches should not be ruled out.

A policy, once chosen, should be consistently applied for similar transactions. Under any of the approaches illustrated above, there should neither be any impact /adjustment to the Statement of profit and loss nor to the already recognised goodwill amount.

ACCOUNTING OF WARRANTS ISSUED BY SUBSIDIARY TO PARENT

This article deals with accounting of a derivative instrument issued by a Subsidiary to a Parent, in the separate financial statements of the Parent and the Subsidiary.

FACTS

•    A Ltd holds a 51% stake in B Ltd and has the ability to control all the relevant activities of B Ltd.
•    B Ltd (‘Issuer’ or ‘Subsidiary’) issues 1,000 warrants to A Ltd (‘Holder’ or ‘Parent’) on a preferential basis. Each warrant is issued at a price of INR 100. Each warrant is convertible into 1 equity share of B Ltd (i.e., the fixed conversion ratio of 1:1).
•    An amount equivalent to 5% of the warrant Issue Price shall be payable at the time of subscription /allotment of each warrant and the balance of 95% shall be payable by the Warrant holder on the exercise of the warrant.
•    The warrant is gross settled (i.e., the warrant cannot be net settled). The issuer doesn’t have any contractual or constructive obligation to redeem /buy back warrants. Gross settled means that the contract will be settled by transfer of the underlying and the consideration; whereas, net settled means that the contract will be settled by settling the difference in cash, for example, a warrant to buy a share at INR 100, will be settled by receiving/paying INR 10 in cash, if the value of the share on the date of settlement is INR 110.
•    The Holder is entitled to exercise the warrants, in one or more tranches, within a period of 18 (Eighteen) months from the date of allotment of the Warrants.
•    In case the Holder does not exercise the warrants within a period of 18 (Eighteen) months from the date of allotment of such warrants, the unexercised warrants shall lapse, and the amount paid by the Holders on such Warrants shall stand forfeited by Issuer.
•    The holder of warrants until the exercise of the conversion option and allotment of Equity Shares does not give the warrant Holder thereof any rights (e.g., voting right, right to dividend, etc.,) akin to that of ordinary shareholder(s) of the B Ltd.
•    The warrant issued by B Ltd is at the money and the Parent intends to eventually exercise all the warrants.
•    The warrants do not currently give the present access to returns associated with an underlying ownership interest, for example, ownership interest akin to a share.
•    As per the accounting policy followed by the Parent, it accounts for investment in the subsidiary at cost as per Ind AS 27 less impairment (if any).

ISSUE

How are these warrants, in nature of derivative, be accounted for, in the Standalone Financial Statements (SFS) of A Ltd and B Ltd?

RESPONSE

Accounting Standard References

“Ind AS 27 Separate Financial Statements

Paragraph 10

When an entity prepares separate financial statements, it shall account for investments in subsidiaries, joint ventures and associates either:

(a) at cost, or
(b) in accordance with Ind AS 109………….

Ind AS 109 Financial Instruments

Paragraph 2.1

This Standard shall be applied by all entities to all types of financial instruments except:
(a) those interests in subsidiaries, associates and joint ventures that are accounted for in accordance with Ind AS 110 Consolidated Financial Statements, Ind AS 27 Separate Financial Statements or Ind AS 28 Investments in Associates and Joint Ventures. However, in some cases, Ind AS 110, Ind AS 27 or Ind AS 28 require or permit an entity to account for an interest in a subsidiary, associate or joint venture in accordance with some or all of the requirements of this Standard. Entities shall also apply this Standard to derivatives on an interest in a subsidiary, associate or joint venture unless the derivative meets the definition of an equity instrument of the entity in Ind AS 32 Financial Instruments: Presentation.

Appendix A

Definition of derivative
A financial instrument or other contract within the scope of this Standard with all three of the following characteristics.
(a) 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’).
(b) 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.
(c) it is settled at a future date.

Ind AS 32 Financial Instruments: Presentation
AG 27 The following examples illustrate how to classify different types of contracts on an entity’s own equity instruments:
(a) A contract that will be settled by the entity receiving or delivering a fixed number of its own shares for no future consideration, or exchanging a fixed number of its own shares for a fixed amount of cash or another financial asset, is an equity instrument………..”

This is generally referred to as meeting the fixed for fixed test.

ANALYSIS

•    The warrant meets the definition of a derivative in accordance with Appendix A of Ind AS 109.
•    The warrant is classified as Equity as per AG 27 of Ind AS 32 by B Ltd/Issuer in its separate financial statements because it meets the fixed for fixed test.
•    From A Ltd’s perspective, because the warrant meets the definition of Equity from the perspective of B Ltd, it would meet the definition of Equity from the perspective of A Ltd also. Consequently, in the separate financial statements of A Ltd, the warrants will be treated as an investment in the equity instrument of the Subsidiary B Ltd.
•    As per paragraph 2.1 of Ind AS 109, derivatives that provide interest in a subsidiary and meet the test of equity classification are accounted for in accordance with Ind AS 27, rather than Ind AS 109.
•    If the instrument either “meets the definitions of equity as per Ind AS 32 from the issuer’s perspective (i.e., subsidiary)” or “currently gives the present access to returns associated with an underlying ownership interest”, then it can be said to be part of the holder’s investment in subsidiary and therefore accounted for under Ind AS 27. However, where the instrument fails to meet the definition of equity from the issuer’s perspective (i.e., a liability of the subsidiary), it shall be classified as financial assets by the Parent and accounted for under Ind AS 109.
•    The warrant meets the definition of equity from a subsidiary’s perspective and hence the warrant is accounted as per Ind AS 27 by parent.

CONCLUSION

The warrant is accounted for as an equity instrument in the separate financial statements of the subsidiary. The warrant, therefore, from the parent’s perspective, is an investment in equity of the subsidiary, which will be accounted for either in accordance with Ind AS 27 or Ind AS 109 (see paragraph 10 of Ind AS 27). The Parent has an accounting policy of applying Ind AS 27 to investments made in the subsidiary in the separate financial statements. Therefore, the warrant is accounted by the Parent as per Ind AS 27, at cost being consideration of 5% paid on initial subscription/allotment till the time warrant are exercised, less impairment if any. On exercise of the warrant, the cost of equity share allocated shall be the total consideration paid for a warrant (i.e., 5% paid on initial subscription/allotment plus 95% paid on exercise of warrant). This is in accordance with the accounting policy followed by the Parent. However, the Parent can also choose to follow an accounting policy of accounting for the equity investment in a subsidiary as per Ind AS 109.

AUDITORS’ RESPONSIBILITY WHEN APPOINTED DATE IS NOT AS PER IND AS STANDARDS

INTRODUCTION
Numerous merger schemes between common control entities include an appointed date from which the merger is to be accounted. Strictly speaking the ‘appointed date’ mentioned in the scheme may not be in compliance with the ‘acquisition date’ as per Ind AS 103, Business Combinations. In such a case, what is the role of the auditor in the audit report to the financial statements and the audit certificate, which accompanies the scheme filed by the Company with the Court?

ISSUE

Parent entity has two Subsidiaries, namely B and C, which have been subsidiaries for several years. C merges with B. The appointed date specified in the scheme is 1st April, 2021. The Court approved the scheme in March 2022. The Company intends to account for the merger scheme in accordance with ITFG Bulletin 9, Issue 2 from the appointed date. The Company will not restate the comparative numbers. In such circumstances, how should the auditor report the matter in the auditor’s certificate and the audit report?

RESPONSE

Definitions

Common control business combination (Ind AS 103 Appendix C, Business Combinations of Entities under Common Control)
 
Common control business combination means a business combination involving entities or businesses in which all the combining entities or businesses are ultimately controlled by the same party or parties both before and after the business combination, and that control is not transitory.

Appointed date (Section 232(6) of Companies Act)

The scheme under this section shall clearly indicate an appointed date from which it shall be effective and the scheme shall be deemed to be effective from such date and not at a date subsequent to the appointed date.

Acquisition date (Ind AS 103, Business Combinations)

The acquirer shall identify the acquisition date, which is the date on which it obtains control of the acquiree. (Paragraph 8)

The date on which the acquirer obtains control of the acquiree is generally the date on which the acquirer legally transfers the consideration, acquires the assets and assumes the liabilities of the acquiree—the closing date. However, the acquirer might obtain control on a date that is either earlier or later than the closing date. For example, the acquisition date precedes the closing date if a written agreement provides that the acquirer obtains control of the acquiree on a date before the closing date. An acquirer shall consider all pertinent facts and circumstances in identifying the acquisition date. (Paragraph 9)

WHY APPOINTED DATE AND ACQUISITION DATE MAY NOT COINCIDE?
When a merger scheme is filed with the NCLT, it will include an appointed date, i.e. the date from which the scheme will be effective. On the other hand, the acquisition date is a date when the last of the important formalities with respect to the business combination is completed, for example, such date may be the date when the NCLT finally approves the scheme. The appointed date as per the Companies Act is a retrospective date, whereas the acquisition date as per Ind AS is a prospective date, and hence the two dates may not coincide. However, it is possible to file a scheme with the NCLT such that the appointed date can be identified as the date when the NCLT approves the scheme. In such a case, the appointed date and the acquisition date may be the same.

IND AS TRANSITION FACILITATION GROUP (ITFG), CLARIFICATION BULLETIN 9 (ISSUE 2)
As per Appendix C, Business Combinations of Entities under Common Control of Ind AS 103, Business Combinations, in case of common control business combinations, the assets and liabilities of the combining entities are reflected at their carrying amounts. For this purpose, should the carrying amount of assets and liabilities of the combining entities be reflected as per the books of the entities transferred or the ultimate parent in the following situations:

Situation 1: A Ltd. has two subsidiaries B Ltd. and C Ltd. B Ltd. merges with C Ltd.

In accordance with the above, it may be noted that the assets and liabilities of the combining entities are reflected at their carrying amounts. Accordingly, in accordance with Appendix C of Ind AS 103, in the separate financial statements of C Ltd., the carrying values of the assets and liabilities as appearing in the standalone financial statements of the entities being combined i.e., B Ltd. & C Ltd. in this case shall be recognised.

The Ministry of Corporate Affairs (MCA) vide General Circular 9/2019 dated 21st August, 2019 clarified as follows:

Several queries have been received in the Ministry with respect to interpretation of the provision of section 232(6) of the Companies Act, 2013 (Act). Clarification has been sought on whether it is mandatory to indicate a specific calendar date as ‘appointed date’ in the schemes referred to in the section. Further, requests have also been received to confirm whether the ‘acquisition date’ for the purpose of Ind-AS 103 (Business Combinations) would be the ‘appointed date’ referred to in section 232(6).

The MCA clarified in the circular: The provision of section 232(6) of the Act enables the companies in question to choose and state in the scheme an ‘appointed date’. This date may be a specific calendar date or may be tied to the occurrence of an event such as grant of license by a competent authority or fulfilment of any preconditions agreed upon by the parties, or meeting any other requirement as agreed upon between the parties, etc., which are relevant to the scheme.

The ‘appointed date’ identified under the scheme shall also be deemed to be the ‘acquisition date’ and date of transfer of control for the purpose of conforming to accounting standards (including Ind-AS 103 Business Combinations).

MCA notification dated 16th February, 2015 issued for notification of Ind AS standards:

General Instruction – (1) Indian Accounting Standards, which are specified, are intended to be in conformity with the provisions of applicable laws. However, if due to subsequent amendments in the law, a particular Indian Accounting Standard is found to be not in conformity with such law, the provisions of the said law shall prevail and the financial statements shall be prepared in conformity with such law.

Ind AS 103 Business Combinations – Appendix C, Business Combinations of Entities under Common Control:

9. The pooling of interest method is considered to involve the following: ……… (iii) The financial information in the financial statements in respect of prior periods should be restated as if the business combination had occurred from the beginning of the preceding period in the financial statements, irrespective of the actual date of the combination.

Standard on Auditing (SA) 706 (Revised), Emphasis of Matter Paragraphs and Other Matter Paragraphs in the Independent Auditor’s Report:

8. If the auditor considers it necessary to draw users’ attention to a matter presented or disclosed in the financial statements that, in the auditor’s judgment, is of such importance that it is fundamental to users’ understanding of the financial statements, the auditor shall include an Emphasis of Matter paragraph in the auditor’s report.

ANALYSIS OF THE ABOVE REQUIREMENTS

The above requirements can be summarised as follows:

1. When a subsidiary merges into a fellow subsidiary, the balances in the separate financial statements will be used for merger accounting in accordance with the pooling method as per Ind AS 103, and as clarified in ITFG 9. A point to note is that views expressed by the ITFG represent the views of the members of the Ind AS Transition Facilitation Group (ITFG) and are not necessarily the views of the Ind AS (IFRS) Implementation Committee or the Council of the Institute. Since the ITFG view is not the view of the Council, it may open up other options for accounting, for example, in the instant case, some may argue, that rather than using the balances in the separate financial statements for applying the pooling method, the balances in the consolidated financial statements relating to the transferor subsidiary may be used.

2. As per Paragraph 9 of Ind AS 103, the date of acquisition is the date when the last of the important formalities are completed. In the instant case, that date is the date of the Court order (March, 2022).

3. The merger accounting is done at the date of acquisition. However, in accordance with Paragraph 9 of Appendix C, in the case of common control transactions, the comparative numbers are restated, and the accounting is done as if the acquisition occurred at the beginning of the preceding period, in the instant case, at 1st April, 2020.

4. However, since a subsequent law can override accounting standards, the MCA General Circular of 21st August, 2019 will apply, and the merger accounting can be carried out at the appointed date, i.e., 1st April, 2021.

5. In accordance with Standards on Auditing 706, an emphasis of matter paragraph in the audit report should be included when a matter is not a subject matter of qualification, but nonetheless is a significant matter that is fundamental to the understanding of the financial statements. Similar disclosure should be made by the auditor with respect to the auditor’s certificate on the scheme of merger. An example of an emphasis of matter is presented below.

Emphasis of matter paragraph in the Auditors Report:

As per the Scheme of Merger, the accounting treatment in the financial statements of the Company has been given effect from the Appointed Date 1st April, 2021, which is in compliance with the MCA General Circular dated 21st August, 2019.  However, being a common control business combination, Ind AS 103 Business Combinations requires the transferee company to account for the business combination from the earliest comparative period, i.e., 1st April, 2020.  Our opinion is not qualified in respect of this matter.

CONCLUSION
Law overrides accounting standards. Therefore, the MCA General Circular with regards to using the appointed date as the acquisition date will prevail for common control business combinations. However, the author believes that since the MCA circular may not be strictly in compliance with Ind AS standards, a matter of emphasis paragraph should be included by the auditor in the audit report and the audit certificate on the scheme of merger, if the appointed date is used as a surrogate for the acquisition date.

NON-GAAP PRESENTATION OF OPERATING SEGMENTS

INTRODUCTION

Financial statements represent only one of several reports used by entities to communicate decision-useful information. ‘Key performance measures’ beyond the ones reported in the financial statements add value to users and enhances the users’ ability to predict future earnings.

International Organisation of Securities Commission (IOSCO) guidelines require entities not to present Alternate Performance Measures (APMs), another way of describing Non-GAAP information, with more prominence than the most directly comparable GAAP measure. Additionally, APMs should not, in any way, confuse or obscure the presentation of the GAAP measures. The European Securities and Markets Authority (ESMA) has also issued similar guidelines. There are no guidelines issued by the Indian standard-setting authority on using Non-GAAP information in the financial statements. Financial statements presented under Ind AS and Schedule III framework will not comply with those frameworks if information not required therein is disclosed in the financial statements.

Interestingly, there is one exception to using Non-GAAP measures in financial statements. APMs that form part of segment disclosures under Ind AS 108 Operating Segments are excluded from these restrictions. Ind AS 108 allows the use of measures other than the measures applied in the preparation of financial statements, provided the information generated by using these measures is the one that the Chief Operating Decision Maker (‘CODM’) uses to evaluate the performance of segments and allocate resources to them.

This article looks at practical examples of how Indian and global entities have applied this.

EXTRACTS OF IND AS 108 OPERATING SEGMENTS

21 …….., an entity shall disclose the following for each period for which a statement of profit and loss is
presented:

a. ……….;

b. information about reported segment profit or loss, including specified revenues and expenses included in reported segment profit or loss, segment assets, segment liabilities and the basis of measurement, as described in paragraphs 23–27; and

c. 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 as described in paragraph.

Information about profit or loss, assets and liabilities

23. An entity shall report a measure of profit or loss for each reportable segment. An entity shall report a measure of total assets and liabilities for each reportable segment if such amounts are regularly provided to the chief operating decision maker. …….

Measurement.

25. The amount of each segment item reported shall be the measure reported to the chief operating decision maker for the purposes of making decisions about allocating resources to the segment and assessing its performance. Adjustments and eliminations made in preparing an entity’s financial statements and allocations of revenues, expenses, and gains or losses shall be included in determining reported segment profit or loss only if they are included in the measure of the segment’s profit or loss that is used by the chief operating decision maker. Similarly, only those assets and liabilities that are included in the measures of the segment’s assets and segment’s liabilities that are used by the chief operating decision maker shall be reported for that segment. If amounts are allocated to reported segment profit or loss, assets or liabilities, those amounts shall be allocated on a reasonable basis.

26.    If the chief operating decision maker uses only one measure of an operating segment’s profit or loss, the segment’s assets or the segment’s liabilities in assessing segment performance and deciding how to allocate resources, segment profit or loss, assets and liabilities shall be reported at those measures. If the chief operating decision maker uses more than one measure of an operating segment’s profit or loss, the segment’s assets or the segment’s liabilities, the reported measures shall be those that management believes are determined in accordance with the measurement principles most consistent with those used in measuring the corresponding amounts in the entity’s financial statements.

27.    An entity shall 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:

a.    the basis of accounting for any transactions between reportable segments.

b.    the nature of any differences between the measurements of the reportable segments’ profits or losses and the entity’s profit or loss before income tax expense or income and discontinued operations (if not apparent from the reconciliations described in paragraph 28). Those differences could include accounting policies and policies for allocation of centrally incurred costs that are necessary for an understanding of the reported segment information.

c.    the nature of any differences between the measurements of the reportable segments’ assets and the entity’s assets (if not apparent from the reconciliations described in paragraph 28). Those differences could include accounting policies and policies for allocation of jointly used assets that are necessary for an understanding of the reported segment information.

d.    the nature of any differences between the measurements of the reportable segments’ liabilities and the entity’s liabilities (if not apparent from the reconciliations described in paragraph 28). Those differences could include accounting policies and policies for allocation of jointly utilised liabilities that are necessary for an understanding of the reported segment information.

e. …………..

f. 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 assets to that segment.

Reconciliations

28. An entity shall provide reconciliations of all of the following:

a. the total of the reportable segments’ revenues to the entity’s revenue.

b. the total of the reportable segments’ measures of profit or loss to the entity’s profit or loss before tax expense (tax income) 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.

c. the total of the reportable segments’ assets to the entity’s assets if the segment assets are reported in accordance with paragraph 23.

d. the total of the reportable segments’ liabilities to the entity’s liabilities if segment liabilities are reported in accordance with paragraph 23.

e. 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.

ANALYSIS OF IND AS 108 REQUIREMENTS

Segment disclosures in the financial statements are those that an entity’s CODM uses to measure the segment’s performance and allocate the entity’s resources.

The measures used for determining segment revenue, segment profit or loss, and segment assets and liabilities need not be the same as those used to prepare financial statements. In other words, the accounting policies or basis used for preparing segment disclosures and those applied in preparing financial statements could differ.

If the CODM uses more than one measure of an operating segment’s profit or loss, the segment’s assets or the segment’s liabilities, the reported measures shall be those that management believes are determined in accordance with the measurement principles most consistent with those used in measuring the corresponding amounts in the entity’s financial statements.

An entity shall reconcile the segment disclosures to the financial statement balances. The differences between the segment disclosures and the financial statements shall be appropriately identified and explained. This is an important point. The logical interpretation of this is that information that cannot reconcile to financial statements should not be provided in segment disclosures; for example, the company’s operational data, such as the number of visitors on the company’s website, should not be provided in the segment disclosures.

ANALYSIS OF SEGMENT DISCLOSURES (INCLUDED IN ANNEXURE) THAT USE ALTERNATE PERFORMANCE MEASURES

1. For purposes of reporting to the CODM, certain promotion expenses, including upfront cash incentives, loyalty programs costs for customer inducement and acquisition costs for promoting transactions across various booking platforms, are reported by Yatra and Make-my-trip as a reduction of revenue (under IFRS/Ind AS financial statements), are added back to the respective segment revenue lines and marketing and sales promotion expenses.

2. In the case of Air-China, inter-segment sales are grossed up against the respective segment and not eliminated to disclose the segment revenue.

3. In the case of Akzo Nobel, EBITDA is presented for segments. In addition to excluding depreciation and amortization, certain identified items, such as special charges and benefits, effects of acquisitions and divestments, restructuring and impairment charges, effects of legal, environmental and tax cases, are also excluded from determining segment-wise EBITDA. Performance measures such as return on sales and operating income as a percentage of revenue are also disclosed in the segment presentation.

4. In the case of Bayer Group, leases continue to be presented as operating leases rather than being capitalized as required under IFRS 16 Leases. Additionally, EBIT, EBITDA before special items, EBITDA margin before special items, ROCE, net cash provided by operating activities, capital expenditures, R&D expenses, etc. are disclosed in the segment disclosures.

5. In the case of Cnova, revenue in the segment disclosures is grossed up, and the gross merchandise value (GMV) is disclosed. Disclosure of GMV in the financial statements is inappropriate. However, GMV should be disclosed in the segment disclosures if that is how the CODM is evaluating the company for internal purposes.

6. For segment reporting purposes, Wipro has included the impact of ‘Foreign exchange gains net’ in revenues (which is reported as a part of ‘Other income’ in the consolidated statement of profit and loss).

CONCLUSION

The use of Non-GAAP measures or APMs though not very frequent, are not uncommon globally or in India. Ind AS 108 requires the use of APMs for segment disclosures if that is how the CODM evaluates the segment for internal purposes. The use of APMs in segment disclosures seems to be on the rise globally.

ANNEXURE

1. AIR CHINA – F.Y. 2020 (IFRS)

Operating segments

The following tables present the Group’s consolidated revenue and (loss)/profit before taxation regarding the Group’s operating segments in accordance with the Accounting Standards for Business Enterprises of the PRC (“CASs”) for the years ended 31 December 2020 and 2019 and the reconciliations of reportable segment revenue and (loss)/profit before taxation to the Group’s consolidated amounts under IFRSs:

Year ended 31 December 2020 Airline operations RMB’000 Other

operations

RMB’000

 Elimination

RMB’000

 Total

RMB’000
Revenue

Sales to external customers

  

66,343,963

  

3,159,786

  

–

  

69,503,749
Inter-segment sales 171,659 6,406,908 (6,578,567) –
Revenue for reportable segments under CASs and IFRSs 66,515,622 9,566,694 (6,578,567) 69,503,749
Segment loss before taxation

Loss before taxation for reportable segments under CASs

  

(18,129,295)

  

(62,012)

  

(283,213)

  

(18,474,520)
Effect of differences between IFRSs and CASs 8,114
Loss before taxation for the year under IFRSs (18,466,406)
  1. AKZO NOBEL N.V. – F.Y. 2021 (IFRS)The business units in the operating segment Performance Coatings are presented per market.

    The tables in this Note include Alternative Performance Measures (APM’s). Refer to Note 4 for further information on these APM’s.

    Information per reportable segment.

Revenue (third parties) Amortization and depreciation Operating income Identified items1 Adjusted operating income2 EBITDA3 Adjusted EBITDA4 ROS%5 OPI Margins6
2021 2021 2021 2021 2021 2021 2021 2021 2021
In € millions 3,979 (154) 640 42 598 794 745 15.0 16.1
Decorative Paints 5,603 (160) 650 2 648 810 807 14.1 11.6
Performance Coatings 5 (37) (172) (18) (154) (135) (115)
Corporate and other 9,587 (351) 1,118 26 1,092 1,469 1,436 12.9 11.7
  1. Identified items are special charges and benefits, results on acquisitions and divestments, major restructuring and impairment charges, and charges and benefits related to major legal, environmental and tax cases. The identified items, in this note exclude the items outside operating income.2.    Adjusted operating income is operating income excluding identified items.

    3.    EBITDA is operating income excluding depreciation and identified items.

    4.    Adjusted EBITDA is operating income excluding amortization, depreciation and identified items.

    5.    ROS% is calculated as adjusted operating income (operating income excluding identified items) as a percentage of revenues from third parties. ROS% for Corporate and other is not shown as this is not meaningful.

    6.    OPI margin is calculated as operating income as a percentage of revenues from third parties. OPI margin for Corporate and other is not shown, as this is not meaningful.

    Note 4

    In presenting and discussing Akzo Nobel’s segmental operating results, management uses certain alternative performance measures not defined by IFRS, which exclude the so-called identified items. Identified items are special charges and benefits, results on acquisitions and divestments, major restructuring and impairment charges, and charges and benefits related to major legal, environmental and tax cases. These alternative performance measures should not be viewed in isolation as alternatives to the equivalent IFRS measures and should be used as supplementary information in conjunction with the most directly comparable IFRS measures. Alternative performance measures do not have a standardized meaning under IFRS and therefore may not be comparable to similar measures presented by other companies. Where a non-financial measure is used to calculate an operational or statistical ratio, this is also considered an alternative performance measure. The following tables reconcile the alternative performance measures used in the segment information to the nearest IFRS measure.

2021 Continuing Operations Discontinued Operations Total
Operating Income 1,118 1,118
APM adjustments to operating income
Transformation costs 28 28
Brazil ICMS case (42) (42)
UK Pensions past service credit (23) (23)
Acquisition related costs 11 11
Total APM adjustments  (identified items) to operating income (26) (26)
Adjusted operating income 1,092 – 1,092
Profit for the period attributable to shareholders of the company 823 6 829
Adjustments to operating income (26) (26)
Adjustments to interest (29) (29)
Adjustments to income tax (15) (15)
Adjustments to discontinued operations – (8) (8)
Total APM adjustments – (8) (8)
Adjusted profit for the period attributable to shareholders of the company 753 (2) 751
  1. BAYER – F.Y. 2021 (IFRS)Segment reporting

    At Bayer, the Board of Management – as the chief operating decision maker – allocates resources to the operating segments and assesses their performance. The reportable segments and regions are identified, and the disclosures selected, in line with the internal financial reporting system (management approach) and based on the Group accounting policies outlined in Note [3].

    The segment data is calculated as follows:
    • The intersegment sales reflect intra-Group transactions effected at transfer prices fixed on an arm’slength basis.
    • The net cash provided by operating activities is the cash flow from operating activities as defined in IAS 7 (Statement of Cash Flows).
    • Leases between fully consolidated companies continue to be recognized as operating leases under IAS 17 within the segment data in the consolidated financial statements of the Bayer Group even after the first-time application of IFRS 16 as of January 1, 2019. This does not have any relevant impact on the respective key data used in the steering of the company and internal reporting to the Board of Management as the chief operating decision maker.

    Key Data by segment

Reconciliations Group
Crop Science Pharmaceuticals Consumer Health All other segments Enabling Functions and Consolidations
€ million 2021 2021 2021 2021 2021 2021
Net sales (external) 20,207 18,349 5,293 203 29 44,081
Currency- and portfolio-adjusted change1 + 11.1% + 7.4% +6.5% -11.6% +8.9%
Inter segment sales 12 22 (34)
Net sales (total) 20,219 18,371 5,293 203 (5) 44,081
EBIT1 (495) 4,469 808 (27) (1,402) 3,353
EBITDA before special items1 4,698 5,779 1,190 95 (583) 11,179
EBITDA margin before special items1 23.2% 31.5% 22.5% 25.4%
ROCE1 -0.9% 18.6% 6.4% – 3.8%
Net cash provided by operating activities 1,272 3,493 1,030 144 (850) 5,089
Capital expenditures (newly capitalized) 1,240 1,308 207 93 156 3,004
Depreciation, amortization and impairments 1,435 1,001 336 70 214 3,056
of which impairment losses/impairment loss reversals (822) 130 5 1 2 (684)
Clean depreciation and amortization1 2,278 986 336 70 214 3,884
Research and development expenses 2,029 3,139 199 4 41 5,412

Reconciliations

The reconciliation of EBITDA before special items, EBIT before special items and EBIT to Group income before income taxes is given in the following table:

Reconciliation of Segments’ EBITDA Before Special Items to Group Income Before Income Taxes.

€ million 2021
EBITDA before special items of segments 11,762
EBITDA before special items of Enabling Functions and Consolidation (583)
EBITDA before special items1 11,179
Depreciation, amortization and impairment losses/loss reversals before special items of segments (3,670)
Depreciation, amortization and impairment losses/loss reversals before special items of Enabling Functions and Consolidation (214)
Depreciation, amortization and impairment losses/loss reversals before special items (3,884)
EBIT before special items of segments 8,092
EBIT before special items of Enabling Functions and Consolidation (797)
EBIT before special items1 7,295
Special items of segments (3,337)
Special items of Enabling Functions and Consolidation (605)
Special items1 (3,942)
EBIT of segments 4,755
EBIT of Enabling Functions and Consolidation (1,402)
EBIT1 3,353
Financial result (1,307)
Income before income taxes 2,046
  1. For definition see A 2.3 “Alternative Performance Measures Used by the Bayer Group.”

4. YATRA – F.Y. 2021 (IFRS)

Reconciliation of information on Reportable Segments to IFRS measures:

Air Ticketing Hotels and Packages Others Total
March 31, 2021 March 31, 2021 March 31, 2021 March 31, 2021
Segment revenue 1,487,465 372,807 220,583 2,080,855
Less: customer inducement and acquisition costs** (594,426) (199,409) (15,752) (809,587)
Revenue 893,039 173,398 204,831 1,271,268
Unallocated expenses (2,646,401)
Less : customer inducement and acquisition costs** 809,587
Unallocated expenses (1,836,814)

Notes:

**For purposes of reporting to the CODM, certain promotion expenses including upfront cash incentives, loyalty programs costs for customer inducement and acquisition costs for promoting transactions across various booking platforms, which are reported as a reduction of revenue, are added back to the respective segment revenue lines and marketing and sales promotion expenses. For reporting in accordance with IFRS, such expenses are recorded as a reduction from the respective revenue lines. Therefore, the reclassification excludes these expenses from the respective segment revenue lines and adds them to the marketing and sales promotion expenses (included under Unallocated expenses).

5. MAKE MY TRIP – F.Y. 2021 (IFRS)

Information about reportable segments

For the year ended March 31

Reportable segments
Air ticketing Hotels and packages Bus ticketing All other segments** Total
2021 2021 2021 2021 2021
Consolidated revenue 57,013 67,976 24,895 13,556 163,440
Add: customer inducement costs recorded as a reduction of revenue* 23,513 18,652 667 76 42,098
Less: Service cost** 293 19,146 2,712 66 22,217
Adjusted margin 80,233 67,482 22,850 13,566 184,131

Notes:
* For purposes of reporting to the CODM, the segment profitability measure i.e., Adjusted Margin is arrived by adding back certain customer inducement costs including customers incentives, customer acquisition cost and loyalty programs costs, which are recorded as a reduction of revenue and reducing service cost.
**Certain loyalty program costs excluded from service cost amounting to USD 91 (March 31, 2020: USD 5,053 and March 31, 2019: USD 2,467) for “All other segments”.

Assets and liabilities are used interchangeably between segments and these have not been allocated to the reportable segments.

6. CNOVA – F.Y. 2020 (IFRS)

Note 6 Operating segments

In accordance with IFRS 8 – Operating Segments, segment information is disclosed on the same basis as the Group’s internal reporting system used by the chief operating decision maker (the Chief Executive Officer) in deciding how to allocate resources and in assessing performance.

The Group only has one reportable segment “E-commerce”. This segment is comprising Cdiscount. C-Logistics, Cnova N.V. holding company and other subsidiaries of Cnova and corresponds to the consolidated financial statements of Cnova.

Management assesses the performance of this segment on the basis of GMV, operating profit /loss before strategic and restricting, litigation, impairment and disposal of assets costs and EBITDA. EBITDA (earnings before interest, taxes, depreciation and amortization) is defined as Operating Profit/(Loss) before strategic and restricting, litigation, impairment and disposal of assets costs plus recurring depreciation and amortization expense. Segment assets and liabilities are not specifically reported internally for management purposes, however as they correspond to consolidated balance sheet they are disclosed elsewhere in the financial statements.

Segment information is determined on the same basis as the consolidated financial statements.

€ thousands 2019 2020
GMV 3,899,181 4,207,366
Operating profit/(loss) before strategic and restructuring, litigation, impairment and disposal of assets costs 14,639 53,096
EBITDA 82,073 133,307
  1. WIPRO – F.Y.2021 (Ind AS)  Notes in Segment disclosures:
    a. …..
    b. For the purposes of segment reporting, the Company has included the impact of “Foreign exchange gains, net” of R2,995 and R3,169 for the year ended March 31, 2021 and 2020 respectively, in revenues (which is reported as a part of ‘Other income’ in the consolidated statement of profit and loss).

CORRIGENDUM

The following corrigendum is issued w.r.t the March 2022 BCAJ article ‘CARO 2020 Series: New Clauses and Modifications – Resignation of Statutory Auditors and CSR’:

a.    On pages 17 and 18, the amended CSR rules mentioned as notified on 22nd January, 2022 should read as 22nd January 2021.

b.    In the table on page 18, the sentence ‘Further, a mandatory impact assessment needs to be done by a Monitoring Agency in case of companies with mandatory spending of Rs. 10 crores or more in the three immediately preceding financial years for individual project outlays in excess of Rs.1 crores as per the amended Rules.’ should read as ‘Further, a mandatory impact assessment needs to be done by a Monitoring Agency in case of companies with mandatory spending of Rs. 10 crores or more in the three immediately preceding financial years and for individual project outlays in excess of Rs.1 crores as per the amended Rules.

c.    On page 17, CDR Registration Number should read as CSR Registration Number.

We sincerely regret the inadvertent errors.

BCAJ Team

ASSET ACQUISITIONS AND DEFERRED TAXES

This article deals with a scenario concerning the creation of deferred taxes where the shares of a company are acquired, and the acquisition is classified as an asset acquisition.

BACKGROUND
•    A Ltd acquires 100% shares of B Ltd, having one Building (a PPE) and accumulated loss of INR 30 for a cash consideration of INR 100.

•    This transaction is not a business combination (i.e., the transaction is accounted for as an asset acquisition).

•    Tax rate applicable – 30%.

•    The carrying value and tax base of the Building in the standalone financial statement (SFS) of B Ltd is INR 80 and INR 70, respectively. The taxable temporary difference of INR 10 arose after the initial recognition of the Building by B Ltd, and accordingly, a deferred tax liability of INR 3 has been recognised.

•    B Ltd has accumulated a loss of INR 30, which it expects to be able to utilise and accordingly, a deferred tax asset of INR 9 has been recognised.

•    A Ltd also expects to be able to utilise all of the available losses of B Ltd, and it is probable that future taxable profit will be available against which the tax losses can be utilised.

•    The fair value of Building on the date of acquisition is INR 91.

ISSUE
Whether any deferred tax should be recognised in the consolidated financial statements (CFS) of A Ltd.?
RESPONSE

Ind AS References

Ind AS 103, Business Combinations

Paragraph 2 – This Ind AS does not apply to:
(a) ………..
(b) the acquisition of an asset or a group of assets that does not constitute a business. In such cases the acquirer shall identify and recognise the individual identifiable assets acquired (including those assets that meet the definition of, and recognition criteria for, intangible assets in Ind AS 38, Intangible Assets) and liabilities assumed. The cost of the group shall be allocated to the individual identifiable assets and liabilities on the basis of their relative fair values at the date of purchase. Such a transaction or event does not give rise to goodwill.

Ind AS 12, Income Taxes

Definitions
Para 5 – The following terms are used in this Standard with the meanings specified:
Deferred tax assets are the amounts of income taxes recoverable in future periods in respect of:

(a) deductible temporary differences;

(b) the carry forward of unused tax losses; and

(c) the carry forward of unused tax credits.

Taxable temporary differences
Para 15 – A deferred tax liability shall be recognised for all taxable temporary differences, except to the extent that the deferred tax liability arises from:

(a) the initial recognition of goodwill; or

(b) the initial recognition of an asset or liability in a transaction which:

(i) is not a business combination; and

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

Deductible temporary differences
Para 24 – A deferred tax asset shall be recognised for all deductible temporary differences to the extent that it is probable that taxable profit will be available against which the deductible temporary difference can be utilised, unless the deferred tax asset arises from the initial recognition of an asset or liability in a transaction that:

(a) is not a business combination; and

(b) at the time of the transaction, affects neither accounting profit nor taxable profit (tax loss).

ANALYSIS
• An entity recognises a deferred tax asset for unused tax losses/credits carried forward to the extent that it is probable that future taxable profits will be available against which the unused tax losses/credits can be utilised. In Author’s view, this principle should be applied to both:

• internally generated tax losses; and

• tax losses acquired in a transaction that is not a business combination.

• The initial recognition exception in paragraph 15 of Ind AS 12 applies only to deferred tax relating to temporary differences. It does not apply to tax assets, such as purchased tax losses that do not arise from deductible temporary differences. The definition of ‘deferred tax assets’ (see above) explicitly distinguishes between deductible temporary differences and unused losses and tax credits [Ind AS 12.5]. Therefore, the Author believes that on initial recognition, an entity should recognise a deferred tax asset for the acquired tax losses at the amount paid, provided that it is probable that future taxable profits will be available against which the acquired tax losses can be utilised. The deferred tax asset is then remeasured in accordance with the general measurement principles in Ind AS 12. Therefore, the Author believes that deferred tax assets of INR 9 on the accumulated loss of B Ltd is recognised by A Ltd in its CFS.

• The initial recognition exception applies to the difference between the cost of the Building in the CFS of A Ltd of INR 91 and its tax base of INR 70, in exactly the same way as if the property had been legally acquired as a separate asset rather than through the acquisition of the shares of B Ltd [Ind AS 12.15(b)]. Therefore, no deferred tax is recognised by A Ltd in respect of the Building at the time of its acquisition. At this point, A Ltd has an unrecognised taxable temporary difference of INR 21 (INR 91 less INR 70).

CONCLUSION
As can be seen from the above example, deferred taxes are not created on initial recognition of an asset. It does not matter whether the acquisition was by way of underlying shares of a company which owns the asset, or the asset is acquired directly. The response would be the same in either scenarios.

HOW PREVALENT IS THE CONCEPT OF DE FACTO CONTROL?

INTRODUCTION
An investor with less than a majority of the voting rights may have rights that are sufficient to give it power and the practical ability to direct the relevant activities of the investee unilaterally: typically known as ‘de facto control’. Concluding whether an entity has de facto control over another entity can at times be highly judgemental and challenging. This article considers the requirements of Ind AS 110 Consolidated Financial Statements, analyses them and lucidly summarizes the principles using live examples of de facto control applied by companies.

Extracts of Ind AS 110 Consolidated Financial Statements
B41 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.

B42 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:

(i) 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;

(ii) 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;

(iii) 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.

B43 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 in paragraph B42 (a)–(c) alone, that the investor has power over the investee.

Application examples

Example 4

An
investor acquires 48 per cent of the voting rights of an investee. The
remaining voting rights are held by thousands of shareholders, none
individually holding more than 1 per cent of the voting rights. None of the
shareholders has any arrangements to consult any of the others or make
collective decisions. When assessing the proportion of voting rights to
acquire, on the basis of the relative size of the other shareholdings, the
investor determined that a 48 per cent interest would be sufficient to give
it control. In this case, on the basis of the absolute size of its holding
and the relative size of the other shareholdings, the investor concludes that
it has a sufficiently dominant voting interest to meet the power criterion
without the need to consider any other evidence of power.

 

Example 5

Investor A holds 40 per cent of the voting rights of an
investee and

twelve other investors each hold 5 per cent of the
voting rights of the

investee. A shareholder
agreement grants investor A the right to appoint, remove and set the
remuneration of management responsible for directing the relevant activities.
To change the agreement, a two- thirds majority vote of the shareholders is
required. In this case, investor A concludes that the absolute size of the
investor’s holding and the relative size of the other shareholdings alone are
not conclusive in determining whether the investor has rights sufficient to
give it power. However, investor A determines that its contractual right to
appoint, remove and set the remuneration of management is sufficient to
conclude that it has power over the investee. The fact that investor A might not
have exercised this right or the likelihood of investor A exercising its
right to select, appoint or remove management shall not be considered when
assessing whether investor A has power.

B44 In other situations, it may be clear after considering the factors listed in paragraph B42 (a)–(c) alone that an investor does not have power.

Application example

Example 6

Investor A holds 45 per cent
of the voting rights of an investee. Two other investors each hold 26 per
cent of the voting rights of the investee. The remaining voting rights are
held by three other shareholders, each holding 1 per cent. There are no other
arrangements that affect decision-making. In this case, the size of investor
A’s voting interest and its size relative to the other shareholdings are
sufficient to conclude that investor A does not have power. Only two other
investors would need to co-operate to be able to prevent investor A from
directing the relevant activities of the investee.

B45 However, the factors listed in paragraph B42 (a)–(c) alone may not be conclusive. If an investor, having considered those factors, is unclear whether it has power, it shall consider additional facts and circumstances, such as whether other shareholders are passive in nature as demonstrated by voting patterns at previous shareholders’ meetings. This includes the assessment of the factors set out in paragraph B18 and the indicators in paragraphs B19 and B20. The fewer voting rights the investor holds, and the fewer parties that would need to act together to outvote the investor, the more reliance would be placed on the additional facts and circumstances to assess whether the investor’s rights are sufficient to give it power. When the facts and circumstances in paragraphs B18–B20 are considered together with the investor’s rights, greater weight shall be given to the evidence of power in paragraph B18 than to the indicators of power in paragraphs B19 and B20.

Application example

Example 7

An investor holds 45 per cent of the voting rights of
an investee. Eleven

other shareholders each hold 5 per cent of the voting
rights of the investee. None of the shareholders has contractual arrangements
to consult any of the others or make collective decisions. In this case, the
absolute size of the investor’s holding and the relative size of the other
shareholdings alone are not conclusive in determining whether the investor
has rights sufficient to give it power over the investee. Additional facts
and circumstances that may provide evidence that the investor has, or does
not have, power shall be considered.

 

Example 8

An investor holds 35 per
cent of the voting rights of an investee. Three other shareholders each hold
5 per cent of the voting rights of the investee. The remaining voting rights
are held by numerous other shareholders, none individually holding more than
1 per cent of the voting rights. None of the shareholders has arrangements to
consult any of the others or make collective decisions. Decisions about the
relevant activities of the investee require the approval of a majority of
votes cast at relevant shareholders’ meetings—75 per cent of the voting
rights of the investee have been cast at recent relevant shareholders’
meetings. In this case, the active participation of the other shareholders at
recent shareholders’ meetings indicates that the investor would not have the
practical ability to direct the relevant activities unilaterally, regardless
of whether the investor has directed the relevant activities because a
sufficient number of other shareholders voted in the same way as the
investor.

B46 If it is not clear, having considered the factors listed in paragraph B42 (a)–(d), that the investor has power, the investor does not control the investee.

ANALYSIS OF THE DE FACTO CONTROL EXAMPLES
As can be seen from the above provisions, the requirements are set out more like principles, and there are no bright-line tests, making the decision on de facto control extremely judgemental. When it is not clear whether the investor has de facto control, the default position is that the investor does not control the investee.

The following conclusions can be drawn from the examples provided under Ind AS 110:

• In Example 4, the investor holds 48% voting rights, and the remaining 52% is widely spread. Here, the conclusion is straightforward. In practice, the starting point for determining de facto control is 45% voting rights, when the remaining 55% is widely spread. However, that does not mean that a 40% voting right with the remaining 60% voting rights widely spread will straight-away disqualify. A 40% voting right may qualify as de facto control if other facts and circumstances indicate that the investor has the practical ability to direct the relevant activities unilaterally of the other entity. For example, the investor may have some formal agreements of support from other major investors, or it may have contractual rights to appoint, remove and remunerate the key management personnel. Here, the emphasis is on contractual rights and not that the investor appoints, removes or remunerates the key management personnel, even without those contractual rights.

• In Example 5, the investor has 40% voting rights, with the remaining 60% voting rights held by 12 investors equally, i.e. 5% each. Typically, the investor in such circumstances will not have de facto control. However, in this example, the investor has contractual rights to appoint, remove and remunerate the decision-makers of the investee and therefore exercises control through a combination of 40% voting rights and contractual rights. Sometimes, contractual rights may be to appoint and remove a majority of the board of directors that drive the relevant activities of the company, which would certainly provide the investor with control. Those contractual rights may either be entered into with all other investors or embedded in the articles of association or other constitutional documents, such as the shareholder’s agreement.

• In Example 6, the investor has 45% voting rights, with two other investors having 26% voting right each. If these two investors get together, the investors voting rights of 45% will not be sufficient to trump the 52% combined voting rights of the other two investors. It does not matter whether the two investors have an agreement or not between themselves to vote against the 45% investor. However, if the 45% investor has an agreement with one of the 26% investors to act in concert, then either the 45% investor or the 26% investor would have control which will depend upon which investor has agreed to support which other investor.

• In Example 7, an investor has 45% voting rights, and the remaining voting rights are held 5% each by 11 other investors. Additionally, there are no other contractual arrangements or matters that change the fact pattern. Here, the 45% investor cannot assume that two other investors holding 5% voting rights each may co-operate with him or have co-operated with him in the past, and as a result, the 45% investor has de facto control. In this example, the 45% investor would not have de facto control, despite a significant size of the investment, absent other facts and circumstances that may change the decision. Although the 45% size is large enough, it cannot be seen in isolation. When seen in the context of the shareholding of the other investors, and the dispersion, and absent any contractual arrangements, the accounting conclusion is that the 45% investor does not have control.

• In Example 8, the investors voting rights of 35% is considered to be of a small size in the context of significant participation by other shareholders in the general body meetings, as well as the existence of three major investors holding 5% each, with which the investor does not have any contractual arrangements. It does not matter that the investor has been able to exercise his voting powers to his advantage for several years; but that alone will not mean that the investor can consolidate the investee as a subsidiary. If this example was extended such that 34% other investors vote at general body meetings, it may indicate the 35% investor exercising control (35% > 34%, total voting is 69%). However, it is highly unlikely that the investee would qualify as a subsidiary for the 35% investor, given that the size of the investment is relatively very low and the presence of other significant investors. Even if the significant investors did not exist, the 35% investor would not qualify for de facto control, unless for example, there is absolutely poor participation at the general body meeting, say other investors holding not more than 10% voting rights vote, and there is no precedence in the past, of that having exceeded 15%.

As can be seen from the above, the principles of de facto control have to be applied to each fact pattern very carefully. Just because an investor is able to exercise his voting powers to his advantage, it does not on its own suggest that the investor should treat the investee as its subsidiary.

EXAMPLES OF DE FACTO CONTROL
A perusal of the examples below suggests that the investors holding should be significant to reach the de facto threshold; in most cases, it is around 45% or more. Other facts and circumstances would have also played a critical role in deciding on de facto control. In the absence of that information, it may not be appropriate to conclude basis the examples exhibited below.

CHOLAMANDALAM
FINANCIAL HOLDINGS LIMITED

 

The Company holds 45.47% of
the total shareholding in CIFCL as at March 31, 2021 (45.50% as at March 31,
2020) and has de-facto control as per the principles of Ind AS 110 and
accordingly CIFCL has been considered as a subsidiary in Ind AS Financial
Statements.

(Source:
2020-21 Annual Report)

TATA
COMMUNICATIONS

 

Tata Sons Pvt Limited is
controlling Tata Communication by virtue of holding 48.90%.

 

On 28 May 2018, Tata Sons
Private Limited (‘TSPL’) and its wholly owned subsidiary, Panatone Finvest
Limited (‘Panatone’), increased their combined stake in the Company to 48.90%
there by gaining de-facto control as per Ind-AS. Accordingly, the Company has
classified TSPL and Panatone as “Controlling Entities” and disclosed
subsidiaries, joint ventures and associates of Controlling Entities and their
subsidiaries as the ‘Affiliates’ of the Controlling entities, effective this
date.

(Source:
2019-20 Annual Report)

 

GODREJ
INDUSTRIES LIMITED

 

During the year, Godrej
Properties Limited has allotted 25,862,068 equity shares (Previous Year:
22,629,310 equity shares) of face value of Rs 5 each through Qualified
Institutions Placement. This has resulted in the dilution of equity holding
of the Company from 49.36% to 44.76%. The Company (GIL) has power and de
facto control over Godrej Properties Limited (GPL) (even without overall
majority of shareholding and voting power). Accordingly, there is no loss of
control of GIL over GPL post the QIP and GIL continues to consolidate GPL as
a subsidiary.

(Source:
2020-21 Annual Report)

RPSG
VENTURES

 

Parent- under de facto
control as defined in Ind-AS 110

 

 

 

 

 

 

 

 

 

 

(Source:
2020-21 Annual Report)

 

BOMBAY
BURMAH TRADING CORPORATION LIMITED

 

The Company along with its
Subsidiaries holds 39.67% of the paid up Equity Share Capital of Bombay
Dyeing & Manufacturing Corporation (BMDC), a Company listed on the Bombay
Stock Exchange. Based on legal opinion and further based on internal
evaluation made by the Company, there is no de facto control of the Company
over BDMC.

(Source:
2019-20 Annual Report)

 

BRITISH
AMERICAN TOBACCO

 

Investments in associates
and joint ventures – On 30 July 2004, the Group completed the agreement to
combine the US domestic business of Brown & Williamson (B&W), one of
its subsidiaries, with R.J. Reynolds. This combination resulted in the
formation of RAI, which was 58% owned by R.J. Reynolds’ shareholders and 42%
owned by the Group. The Group has concluded that it does not have de facto
control of RAI because of the operation of the governance agreement between
the Group and RAI which ensures that the Group does not have the practical
ability to direct the relevant activities of RAI; in particular, the Group
cannot nominate more than five of the Directors (out of 13 or proportionally
less if there are less than 13 Directors) unless it owns 100% of RAI or some
other party owns more than 50%. In addition, there are no other contractual
arrangements which would give the Group the ability to direct RAI’s
operations. Manufacturing and cooperation agreements between RAI and the
Group have been agreed on an arm’s length basis.

(Source:
2015 Annual Report)

CONCLUSION
In India, several companies have significant promoter ownership, though the promoters may not hold a clear absolute majority, such as a shareholding greater than 50%. Therefore, the concept of de facto control becomes all the more important. As can be seen from the above discussion, even if a promoter is able to exercise his voting powers to his advantage, it may not be appropriate to conclude that the investee is a subsidiary with respect to that promoter unless the absolute and relative size of the holding held by the promoter is substantial, and there are other facts and circumstances including the extent of dispersion of other holdings or contractual arrangements, that suggest that the promoter has control over the investee.  

ACCOUNTING FOR SPONSORSHIP ARRANGEMENTS

INTRODUCTION
Companies may enter into sponsorship agreements for World Cup events or Olympic games as a means of building their brands or advertising their products. Consider a scenario, where an entity enters into an arrangement with the owners of the Cricket World Cup event to use the World Cup brand in its products or activities for one year ending one month after the event is concluded. To gain that right, the entity pays INR 100 million.

Question 1
On Day 1, Should the entity account for this amount as an intangible asset or advance against future sales promotion expenses?

Question 2
Assume that the entity shall exploit the brand for the entire year starting from the date of acquisition and ending one month after the event is concluded. How will the INR 100 million be debited to profit and loss, when the amount is capitalised as an intangible asset and when it is presented as an advance? Will the P&L charge differ under either approach?

Accounting Standard References from Ind AS 38 Intangible Assets

Paragraph 8
An intangible asset is an identifiable non-monetary asset without physical substance.

An asset is a resource: (a) controlled by an entity as a result of past events; and (b) from which future economic benefits are expected to flow to the entity.

Paragraph 29
“Examples of expenditures that are not part of the cost of an intangible asset are:
(a) costs of introducing a new product or service (including costs of advertising and promotional activities);
(b)…….
(c)………..”

Paragraph 69
“……Other examples of expenditure that is recognised as an expense when it is incurred include:
(a) ………
(b) …..
(c) expenditure on advertising and promotional activities (including mail order catalogues).
(d) …………….”

Paragraph 70
Paragraph 68 does not preclude an entity from recognising a prepayment as an asset when payment for goods has been made in advance of the entity obtaining a right to access those goods. Similarly, paragraph 68 does not preclude an entity from recognising a prepayment as an asset when payment for services has been made in advance of the entity receiving those services.

Paragraph 97
The depreciable amount of an intangible asset with a finite useful life shall be allocated on a systematic basis over its useful life. Amortisation shall begin when the asset is available for use, i.e., when it is in the location and condition necessary for it to be capable of operating in the manner intended by management. ……….The amortisation method used shall reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity. If that pattern cannot be determined reliably, the straight-line method shall be used.

Response to Question 1
View A: INR 100 million should be recognised as an intangible asset
The sponsorship arrangement can be accounted for as an acquisition of a right to use the World Cup brand, and therefore can be recognized as an asset. The right to use the Cricket World Cup Brand represents a license to use a brand for a defined period, in this case, one year.

The definition of an intangible asset requires that the asset is identifiable, controlled by the entity, and that future economic benefits are expected to flow to the entity from the use of the asset. These requirements are met, as the asset is identifiable through a contractual right, the entity has control over the licence and future economic benefits will flow to the entity from that licence.

View B: INR 100 million should be recognised as an advance for future services to be received
Paragraph 29 of Ind AS 38, provides examples of costs that do not form part of the cost of an intangible asset. One of the examples is the cost of introducing a new product or service including cost of advertising and sales promotion expenses. This requirement seems to suggest that sales promotion activities are expenditure and are not capitalised as intangible asset. The benefit of the sales promotion activity is to enhance the value of the brand and the customer relationship of the entity, which in turn generates revenue. As the brand and customer relationship of the entity are internally generated brands, and are not recognised as assets of the company, expenses to enhance those internally generated intangibles should not be recognised as an intangible asset. Additionally, the Cricket World Cup brand will not be used in isolation but will be used in conjunction with the entity’s brand, and therefore the arrangement is a co-branding arrangement.

In substance, the right to use the World Cup Brand is no different from an advertising activity, that enhances the value of the entity’s brand value. This is an internally generated brand and should not be capitalised as an intangible asset. Till such time the services are received; INR 100 million should be presented as an advance (or prepaid expense) in accordance with paragraph 70.

Response to Question 2
Basis paragraph 97 the intangible asset is amortized from the date the asset is available for use till the date the license is used, i.e., amortisation ends one month after the event is concluded. The amortisation method used shall reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity. If that pattern cannot be determined reliably, the straight-line method shall be used. The pattern of consumption will be significant when the actual event is unfolding; however, because it cannot be estimated reliably, the amortisation will happen on a straight-line basis, over the one-year period of the licence.

When INR 100 million is presented as an advance, the expensing will not be different from the one that is undertaken with respect to amortisation of intangible assets. Typically, for a supply of services, an expense is recognised when the entity receives the services. Services are received when they are performed by a supplier in accordance with a contract which is equally over the contractual period of one year, as the World Cup brand is utilised over that period.

CONCLUSION
The question raised in this article is a very interesting question with respect to whether a payment for future services constitutes an advance for a service or an intangible asset. Under the present case, the author believes that the argument to capitalize the INR 100 million as an intangible asset is much stronger, because the payment represents a payment for acquiring a licence to use the World Cup Brand. Additionally, it may be noted that many global companies have capitalised such payments under IFRS as intangible assets. However, the other view of presenting the payment as an advance, cannot be ruled out.

With regards to the expensing in the profit or loss, the charge will generally be agnostic to whether the payment is capitalised as an intangible asset or presented as an advance. If presented as an advance, the cash outflow will be classified as operating, and if presented as intangible asset, the cash outflow will be classified as investing. As regards EBITDA, it will be higher (favourable) when the payment is treated as an intangible compared to when presented as an advance, because EBITDA will not include the amortisation charge, but expensing of the advance will be included in the EBITDA.

SHARE ISSUE COSTS Vs. SHARE LISTING EXPENSES

Initial Public Offer (IPO) costs involve a combination of share issue costs and listing expenses. Share issue costs are debited to equity whereas listing expenses are charged to the P&L. Therefore, it becomes important to allocate the total costs incurred in an IPO to share issue costs and other than share issue costs, i.e., listing expenses.

‘An entity typically incurs various costs in issuing or acquiring its own equity instruments. Those costs might include registration and other regulatory fees, amounts paid to legal, accounting, and other professional advisers, printing costs and stamp duties. The transaction costs of an equity transaction are accounted for as a deduction from equity to the extent they are incremental costs directly attributable to the equity transaction that otherwise would have been avoided. The costs of an equity transaction that is abandoned are recognised as an expense’. [Ind AS 32.37].

An entity issues new equity shares and may simultaneously list them. In such a case, a portion (e.g., accountants’ fees relating to prospectus), or the entire amount of certain costs (e.g., cost of handling share applications) should be recognised in equity.

The Table below provides a basis of allocation:

Type
of cost

Allocation
(share-issue,
listing or both?)

Stamp duties for shares, fees for legal and tax advice related
to share issue

Share issue

Underwriting fees

Share issue

Listing fees paid to stock exchange / regulator

Listing

Accountants’ fees relating to
prospectus

Both – in practice IPO documents
typically relate both to the share offer and the listing

Valuation fees in respect of valuation of shares

Share issue

Valuation fees in respect of
valuation of assets other than shares (e.g., property) if the valuation is
required to be disclosed in the prospectus

Both, because IPO documents typically
relate to both the share offer and the listing. However, if the valuation is
not required to be disclosed in the prospectus, such costs are not directly
attributable to the IPO and should be expensed

Tax and legal entity restructuring costs in anticipation of the
IPO

P&L Expense. Corporate restructurings are undertaken as a
housekeeping matter to facilitate the listing process and are not directly
attributable to the issue of new shares

Legal fees other than those relating
to restructuring in IPO above

Both – legal advice is typically
required both for the offer of shares to the public and for the listing
procedures to comply with the requirements established by the relevant
securities regulator / exchange. However, some legal fees may relate
specifically to share issue or to listing

Prospectus design and printing costs

Both – although in cases where most prospectus copies are sent
to potential  new shareholders, the
majority of such costs might relate to the share issue

Sponsor’s fees

Both – to the extent the sponsor’s
activities relate to identifying potential new shareholders and persuading
them to invest, the cost relates to the share issue. The activities of the
sponsor related to compliance with the relevant stock exchange requirements
should be expensed in P&L

‘Roadshow’ and advertising costs

Although the ‘roadshow’ might help to sell
the offer to potential investors and hence contributes to raising equity, it
is usually also a general promotional activity. Therefore, the same needs to
be allocated between share issue costs and listing expenses

Merchant Bankers / Manager’s costs

Both – they need to be allocated on a
rational basis between share issue costs and listing expenses

Costs of general advertising aimed at enhancing the entity’s
brand; and fees paid to the public relations firm for enhancing the image and
branding of the entity as a whole

These are not related to issuance of equity shares and should be
charged to P&L

‘Transaction costs that relate to the issue of a compound financial instrument are allocated to the liability and equity components of the instrument in proportion to the allocation of proceeds. Transaction costs that relate jointly to more than one transaction (for example, costs of a concurrent offering of some shares and a stock exchange listing of other shares) are allocated to those transactions using a basis of allocation that is rational and consistent with similar transactions.’ [Ind AS 32.38]. Another basis may also be appropriate if those can be justified in the given situation. Cost of listing existing shares will be charged to P&L. Cost of issuing new shares will have to be allocated to listing expenses (charged to P&L) and share issue costs (charged to equity).

An allocation between listing and issue of shares should not result in the costs attributed to either of the two components being greater than the costs that would be incurred if either were a stand-alone transaction. Significant judgement may be involved in determining the allocation. The IFRS Interpretations Committee (IAS 32 Transaction Costs to be Deducted from Equity, September, 2008) discussed this issue and noted that judgement may be required to determine which costs relate solely to activities other than equity transactions – e.g., listing existing shares – and which costs relate jointly to equity transactions and other activities. The IFRIC decided not to add this issue to its agenda.

An IPO may involve selling the shares of existing investors, such as in an Offer for Sales (OFS). All or a portion of allocated costs may be reimbursed by the existing investors, irrespective of whether the IPO is successful or not. For example, if INR 100 is incurred with respect to OFS shares and INR 60 is reimbursed, the entity will charge INR 40 to the P&L, this being in
the nature of listing shares that are already issued. When shares are listed without any additional issue of share capital (i.e., a placing of existing shares), no equity transaction has occurred and, consequently, all expenses should be recognised in profit or loss as incurred.

Example – Accounting for IPO costs

List Co is seeking a listing on the stock exchange; 1/3rd of the shares is fresh issuance, the other 1/3rd is the sale of shares of existing investor under OFS, and the remaining 1/3rd relates to already existing shares of the promoter that will survive the listing of the entity.

List Co incurs a total expenditure of INR 99 and receives reimbursement of INR 20 from OFS investors. Of the INR 99, the total listing cost (on the basis of allocation) is INR 60. The Table below presents the allocation of the cost and the amounts to be charged to share issue costs in equity and the amount to be charged to P&L, being in the nature of listing expenses:

 

 

New
shares

INR

Existing
shares

INR

New
shares

INR

Total cost allocated @ 1/3rd each

33

33

33

Reimbursement from OFS investors

–

–

(20)

Listing expenses charged to P&L

20

(1/3rd share of
INR 60)

33

33

Share issue costs charged to equity

13

–

–

Based on the above, the total cost incurred by List Co is INR 99, of which INR 20 is reimbursed by the OFS investor. Therefore, List Co incurs a net cost of INR 79. Of the INR 79, only INR 13 relates to share issuance and is debited to equity, and the remaining INR 66 relates to listing and should be charged to P&L. INR 66 can also be determined by aggregating the amounts in the 2nd last row.

Costs that are related directly to a probable future equity transaction should be recognised as a prepayment (asset) in the statement of financial position. The costs should be transferred to equity when the equity transaction is recognised or recognised in profit or loss if the issue or buy-back is no longer expected to be completed.

Sometimes, merchant bankers are paid contingent fees linked to a successful IPO. These costs need to be provided for as the services are received if the IPO event is probable and outflow of resources is expected.

It may also be noted that in the cash flow statement the costs should be included as follows:
(i) costs which have been expensed – in operating cash flows,
(ii) costs deducted from equity – in financing cash flows.

At a particular reporting date, the IPO may be in progress. To the extent the costs incurred are identified as listing expenses, the same should be charged to P&L. To the extent the costs are identified as share issue costs, the same may be parked in an advance account if the IPO is probable. Once the IPO occurs and shares are issued, the advance amount should be debited to equity. If the IPO is not probable, or was probable but is no longer probable, then the entire expenses should be charged to P&L.

ACCOUNTING OF COMPLEX CONVERTIBLE BONDS WITH A CALL OPTION

A convertible bond instrument may have additional derivatives, such as a call or a put option. The accounting of such instruments can get very complex with regard to determining the values of and thereafter accounting for the host instrument, the equity element and the call option. The example in this article explains the concept in a very simplified manner.

EXAMPLE – MULTIPLE DERIVATIVES

Facts

• A Ltd. has issued Optionally Convertible Debentures (OCD) amounting to INR 300 crores to B Ltd. on the following terms:

  •  Tenure: 4 years
  •  Coupon: Nil
  • IRR: 15% p.a.

    
• During the tenure of the OCDs, A Ltd. can call the OCD and redeem it with the stated IRR.
• The market rate for similar debt without conversion feature is 17% p.a.
• B Ltd. can also ask for conversion at any time before maturity based on the following formula:

  •  No. of equity shares = (Investment amount + applicable IRR) divided by (Face value of equity share; i.e.,

INR 10)
• If redemption or conversion doesn’t happen before maturity, then the OCDs will be redeemed mandatorily at maturity.

How is this instrument accounted for in the books of A Ltd. in the following two scenarios?
Scenario A – If B Ltd. opts for conversion before maturity at end of year 1.
Scenario B – B doesn’t opt for conversion and OCDs are redeemed at maturity.

Response

Let us first consider the relevant provisions under the Standards before we attempt to solve the problem.

Ind AS 32 Financial Instruments: Presentation

19. If an entity does not have an unconditional right to avoid delivering cash or another financial asset to settle a contractual obligation, the obligation meets the definition of a financial liability, except …………….

29. An entity recognises separately the components of a financial instrument that (a) creates a financial liability of the entity and (b) grants an option to the holder of the instrument to convert it into an equity instrument of the entity. For example, a bond or similar instrument convertible by the holder into a fixed number of ordinary shares of the entity is a compound financial instrument. From the perspective of the entity, such an instrument comprises two components: a financial liability (a contractual arrangement to deliver cash or another financial asset) and an equity instrument (a call option granting the holder the right, for a specified period of time, to convert it into a fixed number of ordinary shares of the entity). The economic effect of issuing such an instrument is substantially the same as issuing simultaneously a debt instrument with an early settlement provision and warrants to purchase ordinary shares, or issuing a debt instrument with detachable share purchase warrants. Accordingly, in all cases, the entity presents the liability and equity components separately in its balance sheet.

32. Under the approach described in paragraph 31, the issuer of a bond convertible into ordinary shares first determines the carrying amount of the liability component by measuring the fair value of a similar liability (including any embedded non-equity derivative features) that does not have an associated equity component. The carrying amount of the equity instrument represented by the option to convert the instrument into ordinary shares is then determined by deducting the fair value of the financial liability from the fair value of the compound financial instrument as a whole.

Ind AS 109 Financial Instruments

B 4.3.5 (e) A call, put, or prepayment option embedded in a host debt contract or host insurance contract is not closely related to the host contract unless:

i. the option’s exercise price is approximately equal on each exercise date to the amortised cost of the host debt instrument or the carrying amount of the host insurance contract; or

ii. ………..

The assessment of whether the call or put option is closely related to the host debt contract is made before separating the equity element of a convertible debt instrument in accordance with Ind AS 32.

DAY 1 ACCOUNTING

Compound financial instrument (see paragraphs 19, 29 and 32 of Ind AS 32)
• The OCD issued by A Ltd. is a compound financial instrument. The host instrument will be classified as liability, since there is contractual obligation to pay cash toward interest (i.e., guaranteed IRR of 15% p.a.) and principal repayment that issuer A Ltd. cannot avoid. The equity conversion option is accounted as equity.
• The equity conversion option can’t be considered as closely related to the host instrument, because an equity conversion option is not a normal feature of a typical debt instrument, so it needs to be separated. The usual treatment for an instrument with these terms is to conclude that the ‘fixed for fixed’ criterion is met. This is because the number of shares is predetermined at the outset and the only variable is the passage of time. Accordingly, conversion option is classified as equity on Day 1.
• During the life of the host bond, expectations about early conversion should not be taken into account when estimating the cash flows used to apply the effective interest rate. The early conversion option is a characteristic of the equity component (the conversion option) and not of the host liability. The estimated cash flows used to apply the effective interest rate method are, therefore, the contractual cash flows based on the contractual final maturity of the host liability. The Effective Interest Rate (EIR) is 17% p.a.

Early call option to redeem OCD [see paragraph B4.3.5(e) of Ind AS 109]
• The call option’s exercise price is set at par value of OCD plus stated IRR till the date of exercise of call option. Therefore, at each exercise date the option’s exercise price is likely to be approximately equal to the amortised carrying amount of the OCDs plus the equity conversion option. Therefore, the call option is closely related to the host debt instrument. As a result, the call option is not separately accounted for but it remains part of the liability component. The assessment of whether the call option is closely related to the host debt contract is made before separating the equity element of a convertible debt instrument in accordance with Ind AS 32.

Date

Particulars

Amount
(rounded off in crores)

Day 1

Bank

300

 

 

To Equity (balancing figure representing residual interest)

 

20

 

To Debenture (future cash flows discounted at 17%)

 

280

 

(Initial recognition of the financial instrument
in the nature of a compound instrument comprising of elements of debt and
equity)

 

 

     
Subsequent accounting

Date

Particulars

Amount
(rounded off in crores)

End of Year 1

Interest on Debentures

48

 

 

To Debenture (classified under ‘Liability component of compound financial
instrument’)

 

48

 

(Interest recognised in P&L at EIR of 17%;
i.e. 280*17%)

 

 

Scenario A – If B Ltd. opts for conversion at end of Year 1
If B Ltd. opts for conversion before maturity – Since conversion was allowed under the original terms of instrument, the entity should determine the amortised cost of liability component using the original EIR till the conversion date. It will derecognise the liability component and recognise it as equity. There is no gain or loss on early conversion.    

Date

Particulars

Amount
(rounded off in crores)

End of Year 1

Debenture [280+48]

328

 

 

To Equity share capital

 

328

 

(Conversion of OCD into equity shares of the
company)

 

 

Scenario B – If B doesn’t opt for conversion and OCDs are redeemed at maturity

Date

Particulars

Amount
(rounded off in crores)

Year 1-4

Interest on debentures (cumulative interest for 4 years)

245

 

 

To Debenture

 

245

 

(Interest recognised in P&L at EIR of 17%)

 

 

 

 

 

 

End of Year 4

Debenture [280+245]

525

 

 

To Bank

 

525

 

(Being debentures redeemed)

 

 

KEY TAKEAWAYS:

  •  In the case of a compound financial instrument, the instrument has to be separated for the liability and equity component;
  • The instrument may have additional derivatives, such as a put or a call option. The accounting of such derivatives will depend upon whether those are closely related to the liability component. If the option is closely related to the liability component it is not separated from the liability component. On the other hand, if the option is not closely related to the liability component, it is separately accounted for and marked to market at each reporting date, till such time as it is finally settled;
  • On settlement of the compound financial instrument, the equity element (INR 20) recognised initially, may be transferred to retained earnings.

 

REVENUE ADJUSTMENT ON ACCOUNT OF TRANSFER PRICING

BACKGROUND
The finalisation of transfer price between an assessee and the Income-tax Authorities with respect to related party transactions could take several years. In the meantime, the related party transactions are priced on a provisional basis. This article deals with the accounting of the adjustments required when there is finality on the transfer pricing between the assessee and the Income-tax Authorities.

ISSUE

  •  An Indian subsidiary bills the parent and recognises revenue for services provided @ 10% margin;
  •  Three years later, the Income-tax Department settles transfer pricing @ 15% margin as per the Advance Pricing Agreement (APA);
  •  The parent contributes to the subsidiary the 5% difference for the past three years, let’s say, INR 100;
  •  Whether INR 100 is an equity contribution by the parent to the subsidiary in the books of the subsidiary under AS?
  •  What are the disclosures required in the financial statements of the subsidiary?


REFERENCES

Paragraph 11 Ind AS 32 – Financial Instruments: Presentation
An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.

Paragraph 51 Ind AS 115 – Revenue from Contracts with Customers
An amount of consideration can vary because of discounts, rebates, refunds, credits, price concessions, incentives, performance bonuses, penalties or other similar items. The promised consideration can also vary if an entity’s entitlement to the consideration is contingent on the occurrence or non-occurrence of a future event. For example, an amount of consideration would be variable if either a product was sold with a right of return or a fixed amount is promised as a performance bonus on achievement of a specified milestone.

Ind AS 12 Appendix C – Uncertainty over Income-tax treatments
4. This Appendix clarifies how to apply the recognition and measurement requirements in Ind AS 12 when there is uncertainty over income-tax treatments. In such a circumstance, an entity shall recognise and measure its current or deferred tax asset or liability applying the requirements in Ind AS 12 based on taxable profit (tax loss), tax bases, unused tax losses, unused tax credits and tax rates determined applying this Appendix.

Ind AS 115 – Revenue from Contracts with Customers
118  An entity shall provide an explanation of the significant changes in the contract asset and the contract liability balances during the reporting period. The explanation shall include qualitative and quantitative information. Examples of changes in the entity’s balances of contract assets and contract liabilities include any of the following:
(a) …….;
(b) cumulative catch-up adjustments to revenue that affect the corresponding contract asset or contract liability, including adjustments arising from a change in the measure of progress, a change in an estimate of the transaction price (including any changes in the assessment of whether an estimate of variable consideration is constrained) or a contract modification;
(c) ………………….;
(d) ………………….; and
(e) …………………….

119 An entity shall disclose information about its performance obligations in contracts with customers, including a description of all of the following:
(a) …………..;
(b) the significant payment terms (for example, when payment is typically due, whether the contract has a significant financing component, whether the consideration amount is variable and whether the estimate of variable consideration is typically constrained in accordance with paragraphs 56 – 58);
(c) ………………..;
(d) …………………; and
(e) ……………………

122 An entity shall explain qualitatively whether it is applying the practical expedient in paragraph 121 and whether any consideration from contracts with customers is not included in the transaction price and, therefore, not included in the information disclosed in accordance with paragraph 120. For example, an estimate of the transaction price would not include any estimated amounts of variable consideration that are constrained (see paragraphs 56 – 58).

126  An entity shall disclose information about the methods, inputs and assumptions used for all of the following:
(a) determining the transaction price, which includes, but is not limited to estimating variable consideration, adjusting the consideration for the effects of the time value of money and measuring non-cash consideration;
(b) assessing whether an estimate of variable consideration is constrained;
(c) allocating the transaction price, including estimating stand-alone selling prices of promised goods or services and allocating discounts and variable consideration to a specific part of the contract (if applicable); and
(d) ………………..

RESPONSE


The APA between the Indian subsidiary and the Income-tax Authorities will require the Indian subsidiary to raise an invoice for the amounts under-invoiced earlier. The Indian subsidiary will now have to bill the difference in margin of 5% to the parent entity, i.e., INR 100. The parent entity will have to remit this amount to the Indian subsidiary. If the parent does not remit this amount to the subsidiary, it would be treated as a deemed loan to the parent in the hands of the subsidiary, and the subsidiary will have to pay tax on deemed interest income.

As per paragraph 11 of Ind AS 32, an equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. They are, therefore, non-reciprocal in nature. In the fact pattern, the invoicing of the incremental 5% margin, INR 100, is not a non-reciprocal transfer. The parent is transferring INR 100 to the Indian subsidiary because it was under-invoiced in the past. In accordance with paragraph 51 of Ind AS 115, this would constitute variable consideration and the billing by the subsidiary to the parent company would be included in the current year revenue of the subsidiary as a cumulative catch-up adjustment. This will not constitute a prior-period error as there was no error in the given fact pattern. The earlier years invoicing was provisional and the final invoicing, once a conclusion was reached with the Income-tax Authorities, was based on the contractual arrangement between the parent and the subsidiary. The final billing of an additional INR 100 reflected the arrangement between the parent and the subsidiary as a supplier and a customer, rather than in the capacity as a shareholder.

Appendix C of Ind AS 12 – Uncertainty over Income-tax treatments applies when the uncertainty is with respect to income-tax treatment by Income-tax Authorities. From the perspective of the subsidiary, there is no uncertainty over income-tax treatments since it is fully compensated by the parent as per their agreement. However, there is uncertainty over variable consideration. Therefore, from a disclosure perspective in the financial statements of the subsidiary, the disclosure as required by paragraphs 118, 119, 122 and 126 of Ind AS 115 will be required.

CSR – WHETHER A DAY 1 OBLIGATION?

BACKGROUND
The main provisions of section 135 of the Companies Act, 2013 as amended can be summarised as under:
* Certain specified companies are required to spend 2% of the average net profit made in the immediately preceding three years on CSR activities as specified in the relevant schedule;
* Earlier, in case of unspent CSR amounts, Boards were required to specify the reasons for not spending the amount in the Board report;
* On the basis of the recent amendment notified in the Official Gazette, in case of unspent CSR amounts, the companies are required to transfer these to a separate government fund within six months of the expiry of the financial year, unless that unspent amount pertains to ongoing CSR projects;
* In case of unspent CSR amounts pertaining to ongoing CSR projects, the companies are required to transfer such amounts within a period of thirty days from the end of the financial year to a special account opened
with a scheduled bank and to be called ‘Unspent Corporate Social Responsibility Account’; such amount shall be spent by the company within a period of three financial years from the date of such transfer, failing which they are required to transfer the unspent CSR amount in a separate government fund;
* Further, if the company spends an amount in excess of its obligation in a year, the excess amount so incurred can be set off against the CSR obligation of the immediately succeeding three financial years subject to certain conditions.

QUESTION

On the basis of this amendment, the company has a clear statutory obligation as at balance sheet date to transfer the unspent amount to the government fund / special account; accordingly, a liability for unspent amount needs to be recognised in the financial statements. If the company decides to adjust such excess incurred amount against future obligation, then to the extent of such excess an asset as prepaid expense needs to be recognised in the financial statements.

How should the amount required to be spent on CSR in a financial year be accounted for? Can it be recognised evenly over the four quarters or on an as-incurred basis, or should the obligation be provided for on Day 1 of the financial year?

RESPONSE

The following references in Ind AS 37, Provisions, Contingent Liabilities and Contingent Assets are relevant for the purpose of responding to the question.

Definitions under Paragraph 10

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.

An obligating event is an event that creates a legal or constructive obligation that results in an entity having no realistic alternative to settling that obligation.

Appendix C Levies

1. A government may impose a levy on an entity. An issue arises when to recognise a liability to pay a levy that is accounted for in accordance with Ind AS 37, Provisions, Contingent Liabilities and Contingent Assets.

4. For the purposes of this Appendix, a levy is an outflow of resources embodying economic benefits that is imposed by governments on entities in accordance with legislation (i.e. laws and / or regulations), other than:
a)    those outflows of resources that are within the scope of other Standards (such as income taxes that are within the scope of Ind AS 12, Income Taxes); and
b)    fines or other penalties that are imposed for breaches of the legislation.

8. The obligating event that gives rise to a liability to pay a levy is the activity that triggers the payment of the levy, as identified by the legislation. For example, if the activity that triggers the payment of the levy is the generation of revenue in the current period and the calculation of that levy is based on the revenue that was generated in a previous period, the obligating event for that levy is the generation of revenue in the current period. The generation of revenue in the previous period is necessary, but not sufficient, to create a present obligation.
    
11. The liability to pay a levy is recognised progressively if the obligating event occurs over a period of time (i.e., if the activity that triggers the payment of the levy, as identified by the legislation, occurs over a period of time). For example, if the obligating event is the generation of revenue over a period of time, the corresponding liability is recognised as the entity generates that revenue.

ANALYSIS

On the basis of paragraph 4, Appendix C Levies, CSR liability is a levy. The obligating event for incurring CSR expenditure occurs on Day 1 of the financial year, because if the company is in existence on that day and had an average net profit in the preceding three financial years, the liability is crystallised. The company is liable to incur the CSR expenditure, even if later during the financial year it was wound up or merged with another company or incurred heavy losses.

Accordingly, although the CSR expenditure would be incurred throughout the financial year, the obligating event that gives rise to the CSR liability isthe existence of the company on Day 1 of the financial year, and the average net profit of the preceding three financial years of the Company should be a positive number. This analysis is clear from a combined reading of Paragraphs 8 and 11 of Appendix C Levies.

The expenditure on the CSR liability may occur evenly or unevenly throughout the financial year. That is of no relevance to the recognition of the liability. The liability will be recognised on Day 1 of the financial year. The actual expenditure is the adjustment of the already crystallised CSR liability.

Even if a company does not incur the expenditure in the financial year, it will have to transfer the unspent amount to an ‘Unspent CSR’ account. Such amount shall be spent by the company in pursuance of its obligation towards the CSR policy within a period of three financial years from the date of such transfer, failing which, the company shall transfer the same to a Fund specified in Schedule VII within a period of thirty days from the date of completion of the third financial year.

CONCLUSION


Currently there appears to be a mixed practice on when a CSR liability is recognised. Some listed companies recognise the liability on Day 1, whereas others recognise the liability over four quarterly periods. This has to change, and the CSR liability should be recognised on Day 1 of the financial year. For companies that are not listed and do not present quarterly accounts, this issue will be largely theoretical.  

DEFERRED TAX LIABILITY ON GOODWILL DUE TO AMENDMENT IN FINANCE ACT, 2021

As per an amendment carried out by the Finance Act, 2021, from 1st April, 2020 (F.Y. 2020-21), goodwill (including existing goodwill) of a business or profession will not be considered as a depreciable asset and depreciation on the same would not be allowed as a tax deduction. Whilst depreciation of goodwill is no longer tax-deductible, the tax goodwill balance is tax-deductible when the underlying business is sold on a slump sale basis – except where goodwill has not been acquired by purchase from previous owner. This article deals with the accounting for the deferred tax liability (DTL) on account of abolition of goodwill depreciation for tax purposes consequent to the Finance Act amendment.

ISSUE
An entity acquired a business on a slump sale basis and recorded goodwill in its stand-alone accounting books maintained under Ind AS, which was hitherto deductible for tax purposes. On 1st April, 2020 the carrying amount of goodwill in the balance sheet was INR 1,000 and the tax written down value (tax base) for tax purposes was INR 750. Consequently, a DTL was recorded on INR 250 (INR 1,000 carrying amount-INR 750 tax base) by applying the applicable tax rate on INR 250. From 1st April, 2020, with the amendment coming into effect, the amount of INR 750 is no longer tax-deductible (other than in a slump sale). Whether an additional DTL is required to be created on the difference of INR 750, i.e., carrying amount (INR 1,000) minus tax base (zero) minus already existing DTL on temporary difference (INR 250) in the preparation of Ind AS financial statements for the year ended 31st March, 2021)?

RESPONSE
To address the above question, the following paragraphs in Ind AS 12 Income Taxes are relevant:

Paragraph 15
A deferred tax liability shall be recognised for all taxable temporary differences, except to the extent that the deferred tax liability arises from:
a. the initial recognition of goodwill; or
b. the initial recognition of an asset or liability in a transaction which:
i. is not a business combination; and
ii. at the time of the transaction, affects neither accounting profit nor taxable profit (tax loss).

Paragraph 51
The measurement of deferred tax liabilities and deferred tax assets shall reflect the tax consequences that would follow from the manner in which the entity expects, at the end of the reporting period, to recover or settle the carrying amount of its assets and liabilities.

Paragraph 51A
In some jurisdictions, the manner in which an entity recovers (settles) the carrying amount of an asset (liability) may affect either or both of:
    
a. the tax rate applicable when the entity recovers (settles) the carrying amount of the asset (liability); and
b. the tax base of the asset (liability).

In such cases, an entity measures deferred tax liabilities and deferred tax assets using the tax rate and the tax base that are consistent with the expected manner of recovery or settlement.

Paragraph 60
The carrying amount of deferred tax assets and liabilities may change even though there is no change in the amount of the related temporary differences. This can result, for example, from:
(a) a change in tax rates or tax laws;
(b) a reassessment of the recoverability of deferred tax assets; or
(c) a change in the expected manner of recovery of an asset.

The resulting deferred tax is recognised in profit or loss, except to the extent that it relates to items previously recognised outside profit or loss (see paragraph 63).

ANALYSIS & CONCLUSION
Temporary differences may arise as a result of changes in tax legislation in a variety of ways, for example, when an allowance for depreciation of specified assets is amended or withdrawn [Ind AS 12.60]. The initial recognition exception in [Ind AS 12.15] does not apply in respect of temporary differences that arise as a result of changes in tax legislation. It can only be applied when an asset or a liability is first recognised. Any change in the basis on which an item is treated for tax purposes alters the tax base of the item concerned. For example, if the Government decides that an item of intangible assets that was previously tax-deductible is no longer eligible for tax deductions, the tax base of the intangible assets is reduced to zero. Accordingly, under Ind AS 12 any change in tax base normally results in an immediate adjustment of any associated deferred tax asset or liability and the recognition of a corresponding amount of deferred tax income or expense. In our example, DTL would be created on the additional temporary difference of INR 750, caused by the change in tax law, and which did not arise on initial recognition.

The measurement of deferred tax assets or liabilities reflects management’s intention regarding the manner of recovery of an asset or settlement of a liability. [Ind AS 12.51, 51A]. Some companies may argue that the goodwill continues to be tax deductible if the acquired business were to be sold on a slump sale basis in the future. Consequently, they argue that no additional temporary difference is created as a result of not allowing the amortisation of goodwill for tax deduction. In other words, in our example, they argue, the tax-deductible goodwill (the tax base) continues to be stated at INR 750 because the business along with the underlying goodwill could be sold in the future and tax deduction availed. As a result, there is no additional temporary difference, and therefore no additional DTL is required to be created. This position is not acceptable because where the entity expects to recover the goodwill’s carrying amount through use a temporary difference arises in use. If, however, a number of years after acquiring the business the entity changes its intended method of recovering the goodwill from use to sale, the tax base of the goodwill reverts to its balance tax deductible amount (i.e., INR 750 in our example).

The goodwill’s carrying amount needs to be tested for impairment annually and whenever there is an indication that it might be impaired. Any impairment loss is recognised immediately in profit or loss. Some companies may argue that there might not appear to be an expectation of imminent recovery through use if goodwill impairment is not expected in the foreseeable future. In other words, they argue that goodwill is a non-consumable asset, like land. Such an argument is too presumptuous and does not fit well with the principles in Ind AS 12, particularly paragraph 15 which requires DTL to be recognised on all taxable temporary differences, subject to the initial recognition exception.

Under Ind AS, goodwill is not amortised for accounting purposes but that does not mean that goodwill arising in a business combination is not consumed. It may not be apparent that goodwill is consumed because new goodwill replaces the old goodwill that is consumed. If goodwill is amortised for tax purposes, but no impairment is recognised for accounting purposes, any temporary differences arising between the (amortised) tax base and the carrying amount will have arisen after the goodwill’s initial recognition; so, they should be recognised.

The expected manner of recovery should be considered more closely. When a business is acquired, impairment of the goodwill might not be expected imminently; but it would also be unusual for a sale to be expected imminently. So, it might be expected that the asset will be sold a long way in the future; in that case, recovery through use over a long period (that is, before the asset is sold) should be the expected manner of recovery. If however, the plan is to sell the business (along with the underlying goodwill) in the near term, the expected manner of recovery would be sale. If this was indeed the case, and can be clearly demonstrated, DTL should not be created as a result of change in the tax law. This is because the tax base, INR 750 in our example, continues to remain at INR 750 as this amount would be tax-deductible as cost of acquisition of the underlying business, in the sale transaction which is expected to occur in the near term.

During 2009 and 2010 the IASB received representations from various entities and bodies that it was often difficult and subjective to determine the manner of recovery of  certain categories of assets for the purposes of IAS 12. This was particularly the case for investment properties accounted for at fair value under IAS 40 which are often traded opportunistically, without a specific business plan, but yield rental income until disposed of. In many jurisdictions rental income is taxed at the standard rate, while gains on asset sales are tax-free or taxed at a significantly lower rate. The principal difficulty was that the then extant guidance (SIC 21 – Income Taxes – Recovery of Revalued Non-Depreciable Assets) effectively required entities to determine what the residual amount of the asset would be if it were depreciated under IAS 16 rather than accounted for at fair value, which many regarded as resulting in nonsensical tax effect accounting. To deal with these concerns, in December, 2010 the IASB amended IAS 12 so as to give more specific guidance on determining the expected manner of recovery for non-depreciable assets measured using the revaluation model in IAS 16 and for investment properties measured using the fair value model in IAS 40. An indefinite-life intangible asset (that is not amortised because its useful economic life cannot be reliably determined) is not the same as a non-depreciable asset to which this amendment would apply. Similar considerations apply to goodwill.  

ACCOUNTING BY HOLDERS OF CRYPTO ASSETS

According to a crypto research agency CREBACO, Indian crypto investments by October, 2021 had increased to over US $10 billion, with 105 million Indians, i.e., approximately 7.90% of India’s total population, owning cryptocurrency. Currently, numerous cryptocurrencies, crypto coins and crypto tokens are in circulation. Some cryptocurrencies such as Bitcoin are also used as an alternative to money, though its main use is as investment in an asset class. At the time of writing, over 12,000 different cryptocurrencies, crypto coins and crypto tokens were traded or listed on various crypto exchanges across the globe.

This article discusses the accounting by holders of crypto assets under Ind AS. A question arises that if crypto assets are not legal tenders, then would they fulfil the definition of asset in the first place. In accordance with the Conceptual Framework for Financial Reporting under Ind AS issued by the ICAI ‘An asset is a present economic resource controlled by the entity as a result of past events. An economic resource is a right that has the potential to produce economic benefits.’ The crypto assets are capable of producing economic benefits because they can be sold at a price and the economic benefits can be realised. Therefore, they would meet the definition of an asset under the Conceptual Framework.

The IFRS Interpretation Committee (IC) in its Agenda decision titled Holdings of Cryptocurrencies in June, 2019 defined a cryptocurrency as a crypto asset with all of the following characteristics: ‘(a) a digital or virtual currency recorded on a distributed ledger that uses cryptography for security, (b) not issued by a jurisdictional authority or other party, and (c) does not give rise to a contract between the holder and another party’. Bitcoin, for example, would meet this definition. Cryptocurrencies represent a subset of crypto assets. The terms and applications of the crypto assets vary widely and could change over time. The terms and conditions and the purpose for which they are held by the holders will determine the accounting consequences.

Some crypto assets entitle the holder to an underlying good or service from an identifiable counter-party. For example, some crypto assets entitle the holder to a fixed weight of gold from a custodian bank. In those cases, the holder can obtain economic benefits by redeeming the crypto asset for the underlying. While not money as such, these crypto assets share many characteristics with representative money. Other crypto assets (e.g., Bitcoin) do not entitle the holder to an underlying good or service and have no identifiable counter-party. The holder of such a crypto asset has to find a willing buyer who will accept the crypto asset in exchange for cash, goods or services to realise any economic benefits from the crypto asset.

An entity can directly hold its crypto assets in its own ‘wallet’ or may hold it indirectly. For example, an entity holding an economic interest in crypto assets in the shared wallet of a crypto asset exchange may have an indirect holding of the crypto assets through a claim on the exchange. In this case, in addition to the underlying crypto asset volatility, the holder would also be exposed to counter-party performance risk (i.e., the possibility that the exchange is not holding sufficient crypto assets to cover all customer claims). The holder would need to analyse carefully, among other things, its claim on the crypto exchange to evaluate the nature of the assets held to determine the appropriate accounting treatment.

CAN CRYPTOCURRENCY OR CRYPTO ASSET BE CLASSIFIED AS CASH?
Ind AS 32 indicates that cash represents the medium of exchange and is, therefore, the basis on which all transactions are measured and recognised in the financial statements. The description of cash in Ind AS 32 suggests that cash is expected to be used as a medium of exchange (i.e., used in exchange for goods or services) and as the monetary unit in pricing goods or services to such an extent that it would be the basis on which all transactions are measured and recognised in financial statements (i.e., it could act as the functional currency of an entity). Currently, it is unlikely that any crypto asset would be considered a suitable basis for measuring and recognising all the items in an entity’s financial statements.

At present, crypto assets are not used as a medium of exchange except for Bitcoins to a very limited extent; however, the acceptance of a crypto asset by a merchant is not mandated in most jurisdictions. While some governments are reported to be considering issuing their own crypto assets or supporting a crypto asset issued by another party, at the time of writing El Salvador is the only country that has passed legislation that treats Bitcoin as legal tender (alongside US dollars).

The price of crypto assets is highly volatile when compared to a basket of fiat currencies. Hence, no major Governments or economic actors have stored their wealth in crypto assets. Crypto assets continue to remain a speculative investment. If, in the future, a crypto asset attains such a high level of acceptance and stability that it exhibits the characteristics of cash, a holder would need to consider whether that crypto asset represents a medium of exchange and unit of account to such an extent that it could act as the basis on which the holder recognises and measures all transactions in its financial statements (i.e., it could act as the functional currency of an entity). In 2019, the IFRS Interpretation Committee (IC) confirmed that crypto assets currently do not meet the definition of cash equivalents because they are generally, among other things, not convertible to known amounts of cash, nor are they subject to an insignificant risk of change in value.

CAN CRYPTO ASSETS QUALIFY AS FINANCIAL INSTRUMENTS?
Ind AS 32 defines a financial instrument as any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. The first part of the definition of a financial instrument requires the existence of a contract or contractual relationship between parties. A contract is defined by Ind AS 32 as an agreement between two or more parties that has clear economic consequences which the parties have little, if any, discretion to avoid, usually because the agreement is enforceable by law.

Crypto assets generally do not entitle the holder to underlying goods, services or financial instruments and have no identifiable counter-party and consequently would not meet the definition of a contract and qualify as a financial instrument. For example, the individual parties involved in the Bitcoin blockchain do not have a contractual relationship with any other participant in the Bitcoin blockchain. That is, by virtue of owning a Bitcoin, the holder does not have an enforceable claim on Bitcoin miners, exchanges, holders, or any other party. Such holders need to find a willing buyer to realise economic benefits from holding their Bitcoin.

WILL CRYPTO ASSET QUALIFY AS EQUITY INSTRUMENT?
Ind AS defines an equity instrument as any contract that evidences a residual interest in the assets of an entity after deducting all its liabilities. Although the value of a crypto asset may correlate to the popularity of an underlying platform on which it is used, that, by itself, does not represent a contractual right to a residual interest in the net assets of the platform. Therefore, a crypto asset will not qualify as an equity instrument.

WILL CRYPTO ASSET QUALIFY AS A DERIVATIVE INSTRUMENT?
Ind AS 109 defines a derivative as a financial instrument or other contract within the scope of Ind AS 109 with all three of the following characteristics:
* Its value changes in response to the change in an ‘underlying’ that is not specific to a party to the contract;
* 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;
* It is settled at a future date.

Crypto assets that are not contractual themselves could still be the subject of a contract, for example, a binding agreement to buy Bitcoin from a certain counter-party would constitute a contract, even though the Bitcoin itself does not represent a contractual relationship. Therefore, agreements entered ‘off the chain’ to buy or sell crypto assets would qualify as contracts.

Some contractual rights to buy or sell non-financial items that can be settled net in cash, or for which the non-financial items are readily convertible to cash, are accounted for as if they were financial instruments (i.e., a derivative). A contractual right to buy or sell crypto assets (e.g., a Bitcoin forward entered with an investment bank) could be a derivative even if the crypto asset itself is not a financial instrument, provided the crypto asset is readily convertible to cash or the contract can be settled net in cash. This is like the accounting for commodity contracts that are held in a trading business model (e.g., forward silver contracts may fall within the scope of Ind AS 109, although silver itself is not a financial instrument).

WILL CRYPTO ASSET QUALIFY AS INVENTORY?
Although it is often assumed to be the case, Ind AS 102 does not require inventory to be tangible. The standard defines inventory as an asset:
* Held for sale in the ordinary course of business;
* In the process of production for such sale; or
* In the form of materials or supplies to be consumed in the production process or in the rendering of services.

In practice, crypto assets are generally not used in the production of inventory and, thus, would not be considered materials and supplies to be consumed in the production process. Therefore, to this extent crypto assets do not qualify as an item of inventory.

Crypto assets could also be held for sale in the ordinary course of business, for example, by a commodity broker-trader, in which case it would qualify as an item of inventory. Whether crypto assets are held for sale in the ordinary course of business would depend on the specific facts and circumstances of the holder. Normally, Ind AS 102 requires measurement at the lower of cost and net realisable value. However, commodity broker-traders who acquire and sell crypto assets principally to generate profit from fluctuations in price or broker-traders’ margin have the choice to measure their crypto asset inventories at fair value less costs to sell with any change in fair value less costs to sell being recognised in profit or loss in the period of the change.

WILL CRYPTO ASSET QUALIFY AS INTANGIBLE ASSETS?
Ind AS 38 defines an asset as ‘a resource controlled by an entity as a result of past events; and from which future economic benefits are expected to flow to the entity’. Ind AS 38 describes four essential features of an intangible asset:
Control – Control is the power to obtain the future economic benefits of an item while restricting the access of others to those benefits. Control is normally evidenced by legal rights, but Ind AS 38 is clear that they are not required where the entity is able to control access to the economic benefits in another way. Ind AS 38 notes that, in the absence of legal rights, the existence of exchange transactions for similar non-contractual items can provide evidence that the entity is nonetheless able to control the future economic benefits expected.
Future economic benefits – Many crypto assets do not provide a contractual right to economic benefits. Instead, economic benefits are likely to result from a future sale, to a willing buyer, or by exchanging the crypto asset for goods or services.
Lacks physical substance – As crypto assets are digital representations, they are by nature without physical substance.
Identifiable – In order to be identifiable, an intangible asset needs to be separable (capable of being sold or transferred separately from the holder) or result from contractual or other legal rights. As most crypto assets can be freely transferred to a willing buyer, they would generally be considered separable.

Crypto assets generally meet the relatively wide definition of an intangible asset as they are identifiable, lack physical substance, are controlled by the holder, and give rise to future economic benefits for the holder. The IFRS Interpretation Committee (IC) confirmed in 2019 that crypto assets would generally qualify as an intangible asset, subject to consideration of detailed facts and circumstances.

CONCLUSION
The accounting of cryptocurrency by holders in most cases would qualify as an intangible asset. However, given the numerous versions of cryptocurrency and other innovations, such as an exchange traded fund of crypto, the accounting conclusion may not be fairly straight forward. One will have to carefully analyse the features and the terms and conditions of the crypto to determine the accounting conclusion. Besides, the accounting would be different for a trader of crypto as against an investor in crypto.

EQUIPMENT INSTALLED AT CUSTOMER PREMISES – WHETHER LEASE OR NOT?

To determine whether a contractual arrangement contains a lease under Ind AS 116 Leases, can be very tricky and complex. This is particularly true for equipment installed at the customer’s premises such as a solar panel or a set-top box. This article includes an example of a set-top box to explain the concept in a simple and lucid manner.

The provisions in Ind AS 116 Leases relevant to analysing whether an arrangement contains a lease are given below:

9 At inception of a contract, an entity shall assess whether the contract is, or contains, a lease. A contract is, or contains, a lease if the contract conveys the right to control the use of an identified asset for a period of time in exchange for consideration.

B9 To assess whether a contract conveys the right to control the use of an identified asset for a period of time, an entity shall assess whether, throughout the period of use, the customer has both of the following:
(a) the right to obtain substantially all of the economic benefits from use of the identified asset; and
(b) the right to direct the use of the identified asset.

B14 Even if an asset is specified, a customer does not have the right to use an identified asset if the supplier has the substantive right to substitute the asset throughout the period of use. A supplier’s right to substitute an asset is substantive only if both of the following conditions exist:
(a) the supplier has the practical ability to substitute alternative assets throughout the period of use (for example, the customer cannot prevent the supplier from substituting the asset and alternative assets are readily available to the supplier or could be sourced by the supplier within a reasonable period of time); and
(b) the supplier would benefit economically from the exercise of its right to substitute the asset (i.e., the economic benefits associated with substituting the asset are expected to exceed the costs associated with substituting the asset).

B17 If the asset is located at the customer’s premises or elsewhere, the costs associated with substitution are generally higher than when located at the supplier’s premises and, therefore, are more likely to exceed the benefits associated with substituting the asset.

B24 A customer has the right to direct the use of an identified asset throughout the period of use only if either:
a. the customer has the right to direct how and for what purpose the asset is used throughout the period of use; or
b. the relevant decisions about how and for what purpose the asset is used are predetermined and:

i. the customer has the right to operate the asset (or to direct others to operate the asset in a manner that it determines) throughout the period of use, without the supplier having the right to change those operating instructions; or
ii. the customer designed the asset (or specific aspects of the asset) in a way that predetermines how and for what purpose the asset will be used throughout the period of use.

B25 A customer has the right to direct how and for what purpose the asset is used if, within the scope of its right of use defined in the contract, it can change how and for what purpose the asset is used throughout the period of use. In making this assessment, an entity considers the decision-making rights that are most relevant to changing how and for what purpose the asset is used throughout the period of use. Decision-making rights are relevant when they affect the economic benefits to be derived from use. The decision-making rights that are most relevant are likely to be different for different contracts, depending on the nature of the asset and the terms and conditions of the contract.

B26 Examples of decision-making rights that, depending on the circumstances, grant the right to change how and for what purpose the asset is used, within the defined scope of the customer’s right of use, include:
a. rights to change the type of output that is produced by the asset (for example, to decide whether to use a shipping container to transport goods or for storage, or to decide upon the mix of products sold from retail space);
b. rights to change when the output is produced (for example, to decide when an item of machinery or a power plant will be used);
c. rights to change where the output is produced (for example, to decide upon the destination of a truck or a ship, or to decide where an item of equipment is used); and
d. rights to change whether the output is produced, and the quantity of that output (for example, to decide whether to produce energy from a power plant and how much energy to produce from that power plant).

B 30 A contract may include terms and conditions designed to protect the supplier’s interest in the asset or other assets, to protect its personnel, or to ensure the supplier’s compliance with laws or regulations. These are examples of protective rights. For example, a contract may (i) specify the maximum amount of use of an asset or limit where or when the customer can use the asset, (ii) require a customer to follow particular operating practices, or (iii) require a customer to inform the supplier of changes in how an asset will be used. Protective rights typically define the scope of the customer’s right of use but do not, in isolation, prevent the customer from having the right to direct the use of an asset.

EXAMPLE – SET-TOP BOX
In the telecom industry, assets such as mobile phones and set-top boxes would generally be considered as low value and therefore the telecom entities can avail the recognition exemption under Ind AS 116. This example is used to merely illustrate the concept of ‘how and for what purpose’ with regard to equipment installed at customer premises. Additionally, it is also relevant to entities where it is determined that the assets are not low in value, for example, a solar panel or where the entity chooses not to avail the low value exemption.

FACT PATTERN
Telco, a well-integrated internet, telephony and content services provider, installs a set-top box to be placed in the customer’s premises. Telco offers two kinds of set-top boxes which in turn are dependent on the services required by the customer:
(a) The set-top box has no use to the customer other than to receive the requested television, internet, or telephony services. Telco has pre-programmed the set-top box to deliver the specified services and controls what content or internet speed is delivered. The set-top box has no additional functionality and the customer cannot use it to receive any other services from any other service provider.
(b) Other set-top boxes have multiple features. The most sophisticated ones offer a wide range of functionality, including the ability to record and replay, reminders for programmes or to access content and services provided by third parties.

The asset is an identified asset as per paragraph 9 of Ind AS 116. The customer obtains substantially all of the economic benefits from the use of the set-top box as per paragraph B9 of Ind AS 116. Assume that either the set-top is not low value, or the customer does not avail the low value exemption. In such a case, whether the arrangement above contains a lease as defined under Ind AS 116?

ANALYSIS
Firstly, the asset is an identified asset in accordance with Ind AS 116.9. Secondly, the supplier does not have a substantial substitution right in accordance with paragraph B14 and B17, because it would not be economically beneficial for the supplier to replace the equipment located in the premises of the customer. Lastly, the customer obtains substantially all of the economic benefits from the use of the set-top box as per paragraph B9.

We now proceed to consider whether or not the customer directs how and for what purpose the equipment is used.

Whether or not the customer directs how and for what purpose the equipment is used in accordance with Ind AS 116.B24(a) depends on its functionality. For simple set-top boxes, with no functionality for the customer other than to receive the requested services, it can be argued that the customer does not direct how and for what purpose they are used. The customer has no more control over the set-top box than he would over similar equipment located elsewhere, including at the operator’s premises. Can it be argued that the customer has the right to direct the use of the equipment because its use is predetermined, and the customer has a right to operate the asset, because the customer can switch it on or off and can choose which programmes to watch [see Ind AS 116.B24(b)]? The author believes that merely being able to switch on or switch off the set-top box does not mean that the customer is operating the identified asset. Therefore, he believes that there is no lease in the extant case.

The more functionality the set-top box has for the customer, the more likely it is that the customer has the right to direct its use, and therefore the arrangement contains a lease. However, there is no ‘bright-line’ test and judgement will need to be applied in determining the point at which the customer is considered to direct how and for what purpose the equipment is used, and therefore whether the arrangement contains a lease.

CONCLUSION
The author believes that the arrangements involving set-top boxes with limited functionality will not constitute a lease. On the other hand, an arrangement where the underlying asset is a set-top box with multiple functionalities may constitute a lease. Each entity will need to apply judgement to make that determination.

FAQs ON AMENDED SCHEDULE III-DIVISION II RELATED TO ‘APPLICABILITY’

The Ministry of Corporate Affairs (MCA) notified the amendments to Schedule III to the Companies Act, 2013 on 24th March, 2021. There are a few questions regarding the broader issue of applicability of the amendments. These are listed below and so are the responses thereto which are the personal views of the author.

The responses are provided with reference to Division II of Schedule III that applies to non-NBFC companies following Ind AS, but may mutatis mutandis apply to Division I (applicable to entities applying AS) and Division III (applicable to NBFC entities applying Ind AS) of Schedule III as well. The ICAI has issued an Exposure Draft (ED) for public comments on the Guidance Note on Schedule III. The discussions in this article are largely consistent with the ED.

Whether the amended Schedule III applies to consolidated financial statements (CFS), those that are prepared on an annual basis, or a complete set prepared for interim purpose?

Attention is drawn to the guidance available in the pre-amended Schedule III Guidance Note of the ICAI. Paragraph 12.1 of the pre-amended Schedule III Guidance Note states as follows: ‘However, due note has to be taken of the fact that the Schedule III itself states that the provisions of the Schedule are to be followed mutatis mutandis for a CFS. MCA has also clarified vide General Circular No. 39/2014 dated 14th October, 2014 that Schedule III to the Act read with the applicable Accounting Standards does not envisage that a company while preparing its CFS merely repeats the disclosures made by it under stand-alone accounts being consolidated. Accordingly, the company would need to give all disclosures relevant for CFS only.’

The Guidance Note further elaborates on what is to be included and what needs to be excluded in the CFS. However, those inclusions / exclusions are not based on clear and consistent principles. A somewhat similar position is also taken in the ED. However, those are subject to further discussions and may undergo a change in the final Guidance Note. Therefore, which additional Schedule III disclosures are to be included or excluded in the CFS will involve a lot of judgement and guesswork till such time as the ICAI publishes its Guidance Note on the amended Schedule III.

The author believes that since most of the incremental disclosures in the amended Schedule III are regulatory in nature and beyond the requirements of accounting standards, those should not be mandated to CFS which are prepared on an annual basis or a complete CFS set prepared for an interim purpose. Alternatively, the ICAI may consider the application of the principle of materiality, which should be applied by each entity, considering their facts and circumstances. The ICAI may only provide broad guidelines on how the materiality principle will apply, without being prescriptive.

In accordance with amended Schedule III an entity reclassifies lease liabilities presented as borrowings separately as lease liabilities, i.e., borrowings and lease liabilities are presented as separate sub-headings under financial liabilities. Should the entity present a third balance sheet in accordance with paragraph 40A of Ind AS 1, Presentation of Financial Statements?

As per paragraph 40A of Ind AS 1, an entity shall present a third balance sheet as at the beginning of the preceding period in addition to the minimum comparative financial statements if the retrospective application, retrospective restatement or the reclassification has a material effect on the information in the balance sheet at the beginning of the preceding period. If lease liabilities that were presented as borrowings, and under amended Schedule III, it is reclassified as current and non-current financial liabilities, the author does not believe that it is material enough that a third balance sheet would be required in such cases. Nonetheless, the author’s view is that the lease liabilities should be included in determining the debt-equity ratio which is required to be disclosed as per amended Schedule III. Since most of the other changes required under revised Schedule III are regulatory in nature and are additional information rather than reclassification, a third balance sheet may not be required.

In case a company has a non-31st March year-end, whether amended Schedule III shall apply to the 31st December, 2021 or the 30th September, 2021 year-end financial statements?

The MCA Notification that notifies the amendment to Schedule III states that ‘the Central Government makes the following further amendments in Schedule III with effect from 1st day of April, 2021.’ This creates confusion whether the amendments apply for the financial years beginning on or after 1st April, 2021 or the financial years that end after 1st April, 2021. The author’s view is that the amendments shall apply to financial statements relating to the financial year beginning on or after 1st April, 2021 for the following three reasons:

• Firstly, the amendments are made to align with CARO’s requirement and CARO 2020 is applicable for the financial year beginning on or after 1st April, 2021.
• Secondly, the amendments also align with the Companies (Accounts) Amendments Rules, 2021 which are applicable for the financial year commencing on or after 1st April, 2021. Consequently, amended Schedule III will not apply to the 31st December, 2021 or the 30th September, 2021 year-end financial statements.
• Lastly, going by recent experience, the regulators’ intent is to apply amendments on a prospective basis rather than on a retrospective basis.

Whether amended Schedule III applies to stand-alone interim financial statements that commence on or after 1st April, 2021?

The relevant paragraphs of Ind AS 34 Interim Financial Reporting are quoted below:

‘9. If an entity publishes a complete set of Financial Statements in its interim financial report, the form and content of those statements shall conform to the requirements of Ind AS 1 for a complete set of Financial Statements.
10. If an entity publishes a set of condensed Financial Statements in its interim financial report, those condensed statements shall include, at a minimum, each of the headings and sub-totals that were included in its most recent annual Financial Statements and the selected explanatory notes as required by this Standard. Additional line items or notes shall be included if their omission would make the condensed interim Financial Statements misleading.’

Based on the above, if a complete set of stand-alone interim financial statements is presented, all amended Schedule III disclosures are required, including their comparatives. When condensed financial statements are presented as interim financial statements, critical Accounting Standard disclosures that were not included in the last set of published financial statements are required to be provided. Distinction needs to be made between regulatory disclosures required as per Schedule III and those required by Accounting Standards. Therefore, considering the amended disclosures under Schedule III are other than accounting standard disclosures, these are not required to be included in condensed interim financial statements; but may be provided voluntarily.

With regard to quarterly and half-yearly SEBI results – SEBI LODR requires Schedule III format to be used for SEBI results. Schedule III amendments make no changes in the format of Statement of Profit and Loss. However, there are a few new line items inserted, or the grouping is changed in the format of the Balance Sheet, for example, lease liabilities to be shown as current and non-current financial liabilities on the face of the balance sheet, security deposits given to be shown under other financial assets instead of loans, current maturities of long-term borrowings to be shown separately within borrowings under the heading current liabilities instead of other financial liabilities, etc. These format changes need to be made in half-yearly results since the SEBI format is aligned to the Schedule III format. Comparative figures also need to be re-grouped / re-classified, wherever required, with appropriate notes.

Whether comparative numbers are required for interim or annual financial statements for periods / year commencing on or after 1st April, 2021 and contain the amended Schedule III disclosures in the current year / period for the first time?

Schedule III, Ind AS 34 Interim Financial Reporting, Conceptual framework for Financial Reporting under Ind AS and Ind AS 1 Presentation of Financial Statements, require comparative numbers to be presented. Comparative numbers are required for stand-alone financial statements, CFS, full set of interim financial statement and condensed interim financial statement.

CONCLUSION

The process of gathering the information for the incremental Schedule III disclosures and providing comparative numbers in the initial year or period of implementing amended Schedule III will be a cumbersome and onerous exercise, particularly aging
analysis of receivables, payables, or capital work in progress. Additionally, many of the disclosure requirements may be required at the CFS level. Therefore, proper planning and system modification is advised to comply with the amended Schedule III.

GROSS VS. NET REVENUE RECOGNITION

The analysis of gross vs. net revenue recognition under Ind AS 115 Revenue from Contracts with Customers can be a highly complex and judgemental exercise. This analysis particularly impacts new-age digital, internet-based companies across several sectors. The revenue number in the P&L is very crucial, because the valuation of the entity is largely dependent upon it. In this article, we look at this issue under different scenarios, using a base set of facts. The views expressed herein are strictly the personal views of the author under Ind AS standards. Additional evaluation and consideration may be required with regards to IFRS standards, particularly the views of the regulator where a filing is considered.

Accounting Standard references – Ind AS 115 Revenue from Contracts with Customers

Revenue
Revenue is defined as ‘Income arising in the course of an entity’s ordinary activities’.

Customer
As per paragraph 6 of Ind AS 115, ‘A customer is a party that has contracted with an entity to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration.’

Consideration payable to customer
As per paragraph 70 of Ind AS 115, ‘Consideration payable to a customer includes cash amounts that an entity pays, or expects to pay, to the customer (or to other parties that purchase the entity’s goods or services from the customer). Consideration payable to a customer also includes credit or other items (for example, a coupon or voucher) that can be applied against amounts owed to the entity (or to other parties that purchase the entity’s goods or services from the customer). An entity shall account for consideration payable to a customer as a reduction of the transaction price and, therefore, of revenue unless the payment to the customer is in exchange for a distinct good or service (as described in paragraphs 26-30) that the customer transfers to the entity. If the consideration payable to a customer includes a variable amount, an entity shall estimate the transaction price (including assessing whether the estimate of variable consideration is constrained) in accordance with paragraphs 50-58.’

As per paragraph 71 of Ind AS 115, ‘If consideration payable to a customer is a payment for a distinct good or service from the customer, then an entity shall account for the purchase of the good or service in the same way that it accounts for other purchases from suppliers. If the amount of consideration payable to the customer exceeds the fair value of the distinct good or service that the entity receives from the customer, then the entity shall account for such an excess as a reduction of the transaction price. If the entity cannot reasonably estimate the fair value of the good or service received from the customer, it shall account for all of the consideration payable to the customer as a reduction of the transaction price.’

Basis of Conclusion in IFRS 15

Ind AS 115 does not contain the basis of conclusion of IFRS 15. However, since the two standards are the same, the IFRS 15 basis of conclusion can be used for interpretation of Ind AS 115.

BC
255

In
some cases, an entity pays consideration to one of its customers or to its
customer’s customer (for example, an entity may sell a product to a dealer or
distributor and subsequently pay a customer of that dealer or distributor).
That consideration might be in the form of a payment in exchange for goods or
services received from the customer, a discount or refund for goods or
services provided to the customer, or a combination of both

BC
257

The
amount of consideration received from a customer for goods or services, and
the amount of any consideration paid to that customer for goods or services,
could be linked even if they are separate events. For instance, a customer
may pay more for goods or services from an entity than it would otherwise
have paid if it was not receiving a payment from the entity. Consequently,
the boards decided that to depict revenue faithfully in those cases, any
amount accounted for as a payment to the customer for goods or services
received should be limited to the fair value of those goods or services, with
any amount in excess of the fair value being recognised as a reduction of the
transaction price

ANALYSIS

Step 1 – Who is the customer – merchant or wallet user?
As per the definition in paragraph 6, only the merchant should qualify as the customer of Pay Co and not the wallet user as in case of the wallet user, there is no consideration attached. However, in the case of those services wherein a fee is also charged from the wallet user, they, too, would be considered as customers of Pay Co.

Step 2 – Whether transaction with merchant and wallet user are distinct?

Based upon the contractual agreement, Pay Co earns commission from the merchant on every payment made through Pay Co’s platform. On the other hand, wallet users are offered incentives from time to time under different schemes launched by Pay Co. Generally, the incentives are offered as a promotional campaign for a short duration of time rather than on each transaction. The intent of cash-back / super cash offered is not to give discount / credits to the wallet user on a transaction-by-transaction basis, but to promote the usage of the payment platform. The cash-back offered to a wallet user can also be more than the commission earned from the merchant as the cash-backs are purely sales-focused and not for any particular transaction.

The contractual agreement with the merchant is long term in nature; however, the cash-backs offered to wallet users are offered only sporadically and completely unrelated to the merchant agreement. Additionally, the commission is earned by Pay Co from all its merchants; however, the cash-back / super cash is given only to a handful of wallet users. Hence, these are two distinct transactions with no relation to each other. In rare cases, the incentives provided to the wallet user are required as per the contract with the merchant; therefore, in such cases, the transaction with the merchant and the wallet user would not be considered as distinct.

Step 3 – Whether the incentives to the wallet user should be charged as marketing expense or netted off from the commission earned from the merchant?

It may be noted that there is no differential commission charged from merchants whose users are incentivised versus those whose users are not incentivised. Where Pay Co does not receive any consideration from the wallet user, the user is not considered as a customer of Pay Co and thus any cash-back / super cash offered to the user is treated as a marketing or promotional expense.

Where Pay Co charges a convenience fee from users, the user is considered as a customer of Pay Co based on the definition of customer under Ind AS 115. Consequently, any cash-back / super cash offered to the wallet user is recorded as reduction from revenue to the extent of the convenience fee earned from the wallet user. The super cash is netted of with revenue (as reduction) to the extent of revenue amount, i.e., only to the extent of convenience fee and any further amount of super cash on said transaction will be recorded as marketing expense and will not be adjusted against commission earned from the merchant, because the transaction with the merchant and with the wallet user are considered distinct / separate.

In a rare case, where the incentive is paid to the wallet user, on the basis of the agreement with the merchant, the same is deducted from revenue. If this results in negative revenue, the same is presented as marketing expenses, because revenue by definition cannot be a negative number.

The above principles are used in the Table below, and the responses to different scenarios are also depicted thereafter:

 

 

 

 

 

Figures
in INR

 

Scenario
A

Scenario
B

Scenario
C

Scenario
D

Scenario
E

Commission from merchant

100

100

100

100

100

Convenience fee

0

0

20

20

0

Cash-back / super cash

10

110

10

25

25

Contractual?

Yes

Yes

No

No

No

 

 

 

 

 

 

Revenue

90

0

110

100

100

Marketing expense

0

10

0

5

25

ANALYSIS OF SCENARIOS

In Scenario A, the cash-back / super cash is contractual, i.e., the incentive is paid to the wallet user as per the contractual terms with the merchant. The obligation to pay the incentive to the wallet user is not distinct or separate from the transaction with the merchant. Consequently, the incentive is reduced from revenue.

In Scenario B, the incentive is again contractual, therefore the incentive is reduced from revenue, which results in a negative revenue. The negative revenue of INR 10 is presented as marketing expense, because by definition revenue cannot be negative.

In Scenario C, the incentive is not contractual. A convenience fee is charged to the wallet user. Therefore, both the merchant and the wallet user are customers. The net revenue from the merchant customer is INR 100, the net revenue from the wallet user customer is INR 10 (20-10) and the total revenue is INR 110.

In Scenario D, the incentive is not contractual. A convenience fee is charged to the wallet user. Therefore, both the merchant and the wallet user are customers. The revenue from the merchant is INR 100, which is presented as revenue, and the revenue from the wallet user a negative revenue of INR 5 (20-25), which is presented as a marketing expense.

In Scenario E, only the merchant is the customer and INR 100 is the revenue. The INR 25 incentive paid to the wallet user is a marketing expense, because it is not paid to a customer or to the customer’s customer in a linear relationship.

CONCLUSION


Ind AS 115 does not establish clear-cut rules on several matters. For example, one may argue that negative revenue should be combined with positive revenue and the net number should be presented as revenue, instead of presenting negative revenue as an expense. These are matters on which the ICAI will need to develop a point of view.

CURRENT VS. NON-CURRENT CLASSIFICATION WHEN LOAN IS RESCHEDULED OR REFINANCED

This article deals with current vs. non-current classification where a loan is refinanced or the loan repayment is rescheduled subsequent to the reporting date but before the financial statements are approved for issue.

 QUERY

Entity Ze has a five-year bank loan that was outstanding at 31st March, 20X1, the reporting date. At the reporting date, the loan had already completed a term of four years and six months. Therefore, at 31st March, 20X1, the loan was repayable before 30th September, 20X1. On 30th June, 20X1, Entity Ze approved the financial statements for issue. However, after 31st March, 20X1 but before 30th June, 20X1, it signed an agreement with the bank to refinance the loan for another five years. The entity did not have discretion to refinance the loan at the reporting date. It was agreed between the bank and the entity post-31st March, 20X1 but before the financial statements were approved for issue. Entity Ze wants to classify this as a non-current liability. Is that an acceptable position?
 

RESPONSE

No. This is not an acceptable position. At 31st March, 20X1, Entity Ze should present the loan as current liability instead of as non-current liability.

References of the Standard

The following paragraphs of Ind AS 1 Presentation of Financial Statements are relevant:

 

69 An entity shall classify a liability as current when:

(a) it expects to settle the liability in its normal operating cycle;

(b) it holds the liability primarily for the purpose of trading;

(c) the liability is due to be settled within twelve months after the reporting period; or

(d) it does not have an unconditional right to defer settlement of the liability for at least twelve months after the reporting period (see paragraph 73). Terms of a liability that could, at the option of the counter-party, result in its settlement by the issue of equity instruments do not affect its classification.

An entity shall classify all other liabilities as non-current.

 

72 An entity classifies its financial liabilities as current when they are due to be settled within twelve months after the reporting period, even if:

a. the original term was for a period longer than twelve months, and

b. an agreement to refinance, or to reschedule payments, on a long-term basis is completed after the reporting period and before the financial statements are approved for issue.
 

73 If an entity expects, and has the discretion, to refinance or roll over an obligation for at least twelve months after the reporting period under an existing loan facility, it classifies the obligation as non-current, even if it would otherwise be due within a shorter period. However, when refinancing or rolling over the obligation is not at the discretion of the entity (for example, there is no arrangement for refinancing), the entity does not consider the potential to refinance the obligation and classifies the obligation as current.

 

74 Where there is a breach of a material provision of a long-term loan arrangement on or before the end of the reporting period with the effect that the liability becomes payable on demand on the reporting date, the entity does not classify the liability as current, if the lender agreed, after the reporting period and before the approval of the financial statements for issue, not to demand payment as a consequence of the breach.

 

75 However, an entity classifies the liability as non-current if the lender agreed by the end of the reporting period to provide a period of grace ending at least twelve months after the reporting period, within which the entity can rectify the breach and during which the lender cannot demand immediate repayment.

ANALYSIS

Paragraph 69 contains provisions relating to when a financial liability is presented as current. Paragraph 74 contains more of an exception to paragraph 69.

 

Paragraphs 74 and 75 of Ind AS 1 contain provisions relating to curing of a breach of a material provision of a loan. As per paragraph 74, a loan is presented as non-current if a breach of a material provision relating to a loan is cured after the end of the reporting period, but before the financial statements are approved for issue, such that the loan is no longer current.

 

As per paragraph 75, if the lender provides a grace period ending at least twelve months after the reporting period, within which a breach can be rectified, the loan is treated as non-current.

 

The fact pattern that is being dealt with is not relating to the curing of a breach. It is related to extension of the loan term that is otherwise current at the reporting date. With regard to this fact pattern, it is paragraphs 72 and 73 that apply rather than paragraphs 74 and 75. As per paragraph 72, the entity classifies its financial liabilities as current when they are due to be settled within twelve months after the reporting period, even if the original term was for a period longer than twelve months, and an agreement to refinance the loan on a long-term basis is completed after the reporting period and before the financial statements are approved for issue. Paragraph 73 confirms that if an entity did not have the refinancing or rescheduling rights prior to the reporting date, any refinancing or rescheduling agreement on a long-term basis post the reporting date but before the financial statements are approved for issue, the loan would not qualify as a non-current liability at the reporting date.

CONCLUSION

On the basis of the above, at 31st March, 20X1, Entity Ze should present the loan as current liability instead of as non-current liability. Post the reporting period, and after the loan is rescheduled or refinanced on a long-term basis, Entity Ze would present them as non-current.  

EVALUATING AN AGREEMENT – LEASE VS. IN-SUBSTANCE PURCHASE

INTRODUCTION
In some situations, a lease may effectively represent an in-substance purchase. The distinction between a lease and an in-substance purchase may have a significant impact with respect to the accounting, if variable payments are involved as well as with respect to presentation and disclosures. This distinction is critical in the case of aircraft, ships, etc. This article delves into this issue and provides relevant guidance.

FACTS

Consider the following fact pattern:
1. As per local safety legislation, Machine X can be used only for ten years, after which it must be sold to recyclers for scrapping.
2. Ze Co (hereinafter referred to as ‘Lessee’) acquires Machine X on lease for a non-cancellable lease term of ten years from Ed Co (hereinafter referred to as ‘Lessor’).
3. Fixed lease payments are made at the beginning of each year over the lease term. There are no variable lease payments.
4. As per the lease agreement, the Lessee has an option to buy Machine X at INR 1,000 at the end of the tenth year.
5. The legal title of Machine X is transferred to the Lessee at the end of the tenth year, if the Lessee exercises the option to purchase Machine X.
6. The fair value of Machine X if it is to be sold as scrap is likely to be several times more than INR 1,000.
7. The Lessor is not responsible for any malfunctioning of the Machine X during the lease period.

Whether this arrangement would constitute an in-substance purchase or lease from the perspective of the Lessee? How does the Lessor account for such a transaction?

References to Accounting Standards
IFRS 16 Leases provides guidance in the Basis of Conclusion and is reproduced below. It may be noted that Ind AS 116 Leases does not include any Basis of Conclusion, but the Basis of Conclusion under IFRS can be applied as the best available guidance.

IFRS 16 Basis of Conclusion

BC138 The IASB considered whether to include requirements in IFRS 16 to distinguish a lease from the sale or purchase of an asset. The IFRS Interpretations Committee had received questions about whether particular contracts that do not transfer legal title of land should be considered to be a lease or a purchase of the land.

BC139 The IASB decided not to provide requirements in IFRS 16 to distinguish a lease from a sale or purchase of an asset. There was little support from stakeholders for including such requirements. In addition, the IASB observed that:
a. the accounting for leases that are similar to the sale or purchase of the underlying asset would be similar to that for sales and purchases applying the respective requirements of IFRS 15 and IAS 16; and
b. accounting for a transaction depends on the substance of that transaction and not its legal form. Consequently, if a contract grants rights that represent the in-substance purchase of an item of property, plant and equipment, those rights meet the definition of property, plant and equipment in IAS 16 and would be accounted for applying that Standard, regardless of whether legal title transfers. If the contract grants rights that do not represent the in-substance purchase of an item of property, plant and equipment but that meet the definition of a lease, the contract would be accounted for applying IFRS 16.

BC140 IFRS 16 applies to contracts that convey the right to use an underlying asset for a period of time and does not apply to transactions that transfer control of the underlying asset to an entity – such transactions are sales or purchases within the scope of other Standards (for example, IFRS 15 or IAS 16).

ANALYSIS


When assessing the nature of a contract, an entity should consider whether the contract transfers control of the underlying asset itself as opposed to conveying the right to control the use of the underlying asset for a period of time. If so, the transaction is a sale or purchase within the scope of other standards (e.g., Ind AS 115 Revenue from Contracts with Customers or Ind AS 16 Property, Plant and Equipment). Consequently, if a contract grants rights that represent the in-substance purchase of an item of property, plant and equipment, such transaction may need to be presented as the purchase of the underlying asset (regardless of whether legal title transfers) either on deferred terms if entered into directly with the manufacturer or dealer of the asset, or together with the provision of financing if entered into with a financial institution which purchases the underlying asset on the entity’s behalf from a designated supplier.

Ind AS 115.33 defines control of an asset as the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset. Control includes the ability to prevent other entities from directing the use of, and obtaining the benefits from, an asset. The benefits of an asset are the potential cash flows (inflows or savings in outflows) that can be obtained directly or indirectly. When evaluating whether a customer obtains control of an asset, an entity shall consider any agreement to repurchase the asset (see Ind AS 115.B64–B76). In determining whether an agreement is a sale / purchase agreement or a lease, the appropriate criteria to be used are those shown in Ind AS 115 in relation to the transfer of control.

Additionally, if retaining title of the asset has no substance, there is sympathy to treating the transaction as an in-substance purchase of PP&E (Ind AS 16). However, if there is substance to the title of the asset remaining with the supplier, and ownership is only transferred at the end, Ind AS 116 accounting would be more appropriate as the customer has right-of-use but does not have ownership. If variable lease payments are present in the agreement, the supplier / lessor retains some risk which may point towards lease accounting.

Typically, in land use rights, where the seller retains title and there is no option for the Lessee to purchase the land, the author believes that the title would be critical in evaluating whether the arrangement is a lease or an in-substance purchase of land. For example, in a 99-year lease with no option to purchase the land at the end of the lease term, or option to purchase the land at its then fair value, it is difficult to think someone has sold the land because, even after 99 years that land is very likely to have significant value which will not be ‘kept’ by the buyer. In contrast, lease of LED lights to a retail department store may constitute an in-substance purchase for the store because the value of the LED lights is in its usage, rather than its value at the end of its useful life. So, invariably, it boils down to the assessment of significance of title.

CONCLUSION
In the above fact pattern, the effective utility of Machine X is its usage over ten years, after which it is sold as scrap. There is a purchase option at the end of the lease term that is most likely to be exercised by the Lessee, as the Lessee will stand to benefit from exercising that option. Lastly, it appears that the Lessor retains no risk as there are no variable payments in the arrangement nor is the Lessor responsible for malfunctioning of Machine X. The Lessee retains all the risks and rewards in substance and the absence of legal title during the lease term should not preclude the Lessee from classifying Machine X as an in-substance purchase rather than as a lease.

From the Lessor’s perspective, the arrangement will constitute a sale of Machine X under Ind AS 115 since the control criterion under Ind AS 115.33 would be met in this case. In determining the transaction price of the sale, the Lessor will have to separate the financing component and record the same as financing income over the lease period.

ACCOUNTING FOR CROSS HOLDING

INTRODUCTION

There is no existing guidance under Ind AS for the accounting of cross holdings. This article provides guidance on the accounting of cross holdings between two associate companies. Consider the following fact pattern:

Entity Ze has an associate Ve (20% of Entity Ve and significant influence).

Entity Ve has an associate Ze (20% of Entity Ze and significant influence).

Both Entity Ze’s and Entity Ve’s share capital is 200,000 shares at 1 unit each.

Entity Ze’s profit excluding its share in Ve = INR 1000; Entity Ve’s profit excluding its share in Ze = INR 1000.

ISSUES

•    How does an entity account for cross holdings in associates in accordance with paragraph 27 of Ind AS 28 Investments in Associates and Joint Ventures in the Consolidated Financial Statements?
•    Does an entity adjust EPS calculation for the cross holdings?

RESPONSE
References to Ind AS
Paragraph 26 of Ind AS 28 applies consolidation procedures to equity method of accounting as follows:

‘Many of the procedures that are appropriate for the application of the equity method are similar to the consolidation procedures described in Ind AS 110. Furthermore, the concepts underlying the procedures used in accounting for the acquisition of a subsidiary are also adopted in accounting for the acquisition of an investment in an associate or a joint venture.’

Paragraph 27 of Ind AS 28 states:

‘A group’s share in an associate or a joint venture is the aggregate of the holdings in that associate or joint venture by the parent and its subsidiaries. The holdings of the group’s other associates or joint ventures are ignored for this purpose. When an associate or a joint venture has subsidiaries, associates or joint ventures, the profit or loss, other comprehensive income and net assets taken into account in applying the equity method are those recognised in the associate’s or joint venture’s financial statements (including the associate’s or joint venture’s share of the profit or loss, other comprehensive income and net assets of its associates and joint ventures), after any adjustments necessary to give effect to uniform accounting policies (see paragraphs 35 and 36A).’

Paragraph B86 of Ind AS 110 Consolidated Financial Statements states:

‘Consolidated financial statements:… (c) eliminate in full intragroup assets and liabilities, equity, income, expenses and cash flows relating to transactions between entities of the group (profits or losses resulting from intragroup transactions that are recognised in assets, such as inventory and fixed assets, are eliminated in full).’

Paragraph 33 of Ind AS 32 Financial Instruments: Presentation states:

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

GROSS APPROACH
Entity Ze’s profit and Entity Ve’s profit are dependent on each other, which can be expressed by simultaneous equations as follows:

a = INR 1000 + 0.2b
b = INR 1000 + 0.2a

Solving the simultaneous equation results in:

a = INR 1250 and b = INR 1250

Therefore, Entity Ze’s profit is INR 1250, and Entity Ve’s profit is INR 1250.

NET APPROACH

This approach ignores the cross holding and simply takes up the investor’s share of the associate’s profit, excluding the equity income arising on the cross shareholding. Thus, the additional profit in the financial statements of both Entity Ze and Entity Ve is limited to INR 200 each (1000*20%).

A literal view of paragraph 27 of Ind AS 28 is that Entity Ze recognises its share of Entity Ve’s profits, including Entity Ve’s equity accounted profits. However, in the case of cross holdings this approach results in a portion of Ze’s profits being double counted. Consequently, the net approach, which only accounts for 20% of the associate’s profit, is more appropriate. In this fact pattern, the net approach results in Entity Ze and Entity Ve both recognising profit of INR 1200 (rather than INR 1250 as per the gross approach). The difference of INR 50 represents the equity effect of the cross holdings and therefore is not recognised in profit. In other words, the INR 50 represents (with respect to the associate that is preparing its consolidated accounts) a portion of its own profit being double counted.

Additionally, the equity method of accounting employs consolidation-type procedures such as the elimination of unrealised profits. Income arising on an investment held by a subsidiary in a parent is eliminated under paragraph B86(c) of Ind AS 110 Consolidated Financial Statements. Consequently, in applying consolidation procedures in equity accounting, income arising from associate’s investment in the investor should also be eliminated.

Consequently, the net approach is the only acceptable method.

EPS CALCULATION

The number of ordinary shares on issue is adjusted using the net approach. Consequently, an adjustment reduces the entity’s equity balance and its investment  in the associate by its effective 4% interest (20*20%) in its own shares. The result is similar to the treatment of treasury shares that are eliminated from equity and, accordingly, excluded in determining the EPS. In calculating earnings per share, the weighted average number of ordinary shares is reduced by the amount of the effective cross holding. Therefore, Entity Ze’s and Entity Ve’s ordinary shares are reduced to 192,000 (200,000*[100-4]; i.e. 96%) for the purpose of the earnings per share calculation.

Some may argue that the associate is not part of the group and therefore the shares held in the investor are not ‘treasury shares’ as defined in Ind AS 32. However, it may be noted that the view in the preceding paragraph does not rely on viewing the associate’s holding as treasury shares. Rather, it relies on the fact that Ind AS 28.26 states that many of the procedures that are appropriate for the application of the equity method are similar to the consolidation procedures described in Ind AS 110. If a subsidiary holds shares in a parent, these are eliminated under paragraph B86(c) of Ind AS 110. The same procedure should therefore apply to equity accounting.

Though this issue is discussed in the context of cross holdings between associates, it will apply equally to jointly controlled entities that are equity accounted.

HOW AND FOR WHAT PURPOSE?

The interpretation of ‘How and for what purpose’ to determine whether a contractual arrangement contains a lease under Ind AS 116 Leases can be very tricky and complex. This article includes an example to explain the concept in a simple and lucid manner.

The provisions in Ind AS 116 Leases relevant to analysing whether an arrangement contains a lease are given below:

9. At inception of a contract, an entity shall assess whether the contract is, or contains, a lease. A contract is, or contains, a lease if the contract conveys the right to control the use of an identified asset for a period of time in exchange for consideration.

B9 To assess whether a contract conveys the right to control the use of an identified asset for a period of time, an entity shall assess whether, throughout the period of use, the customer has both of the following:

(a) the right to obtain substantially all of the economic benefits from use of the identified asset; and

(b) the right to direct the use of the identified asset.

B24 A customer has the right to direct the use of an identified asset throughout the period of use only if either:

a. the customer has the right to direct how and for what purpose the asset is used throughout the period of use; or

b. the relevant decisions about how and for what purpose the asset is used are predetermined and:
 

i) the customer has the right to operate the asset (or to direct others to operate the asset in a manner that it determines) throughout the period of use, without the supplier having the right to change those operating instructions; or

ii) the customer designed the asset (or specific aspects of the asset) in a way that predetermines how and for what purpose the asset will be used throughout the period of use.

B25 A customer has the right to direct how and for what purpose the asset is used if, within the scope of its right of use defined in the contract, it can change how and for what purpose the asset is used throughout the period of use. In making this assessment, an entity considers the decision-making rights that are most relevant to changing how and for what purpose the asset is used throughout the period of use. Decision-making rights are relevant when they affect the economic benefits to be derived from use. The decision-making rights that are most relevant are likely to be different for different contracts, depending on the nature of the asset and the terms and conditions of the contract.
 

B26 Examples of decision-making rights that, depending on the circumstances, grant the right to change how and for what purpose the asset is used, within the defined scope of the customer’s right of use, include:

a. rights to change the type of output that is produced by the asset (for example, to decide whether to use a shipping container to transport goods or for storage, or to decide upon the mix of products sold from retail space);

b. rights to change when the output is produced (for example, to decide when an item of machinery or a power plant will be used);
 
c. rights to change where the output is produced (for example, to decide upon the destination of a truck or a ship, or to decide where an item of equipment is used); and

d. rights to change whether the output is produced, and the quantity of that output (for example, to decide whether to produce energy from a power plant and how much energy to produce from that power plant).

B30 A contract may include terms and conditions designed to protect the supplier’s interest in the asset or other assets, to protect its personnel, or to ensure the supplier’s compliance with laws or regulations. These are examples of protective rights. For example, a contract may (i) specify the maximum amount of use of an asset or limit where or when the customer can use the asset, (ii) require a customer to follow particular operating practices, or (iii) require a customer to inform the supplier of changes in how an asset will be used. Protective rights typically define the scope of the customer’s right of use but do not, in isolation, prevent the customer from having the right to direct the use of an asset.

Example – ‘How and for what purpose’ analysis in a hotel stay

Fact pattern

A customer books a room in a hotel for a one-day stay. As per the terms and conditions of the hotel, the customer cannot use the hotel for any illegal activities or cannot sub-lease the room. The room is a specific identified asset, the substitution rights (if any) are not substantive and the customer obtains significant economic benefits from occupying the room. Whether the arrangement between the hotel and the customer contains a lease?

Analysis

Having determined that the room is a specific identified asset, the substitution rights are not substantive and the customer obtains significant economic benefits from occupying the room; the next step in the lease analysis is whether the customer has the right to direct how and for what purpose the asset is used throughout the period of use, as required by B24.
 
The room can be used only for the purposes of room stay; it cannot be sub-let by the customer. To that extent, the how and for what purpose is predetermined. Additionally, the customer cannot use the room for illegal activities. Those are protective rights that the hotel has and do not impact the assessment of whether an arrangement contains a lease in accordance with B30.

The following how and for what purpose decisions are not predetermined and are controlled by the customer and affect the economic benefits to be derived by the customer from the use of the room during the period of stay:

  •        Use of air-conditioner or refrigerator or television or other devices in the room;
  •        Use the room to sleep or to make conference calls;
  •        Use the room to have lunch or dinner, etc.

Therefore, the customer has the right to direct how and for what purpose the asset is used (to the extent those are not predetermined) throughout the period of use (see B25).

CONCLUSION

The arrangement between the hotel and the customer contains a lease. The customer is a lessee and would be entitled to the exemption with respect to short-term lease or low value lease. Additionally, the lessee will have to comply with certain presentation and disclosure requirements as required by Ind AS 116.
 
The hotel (lessor) is not entitled to exemptions from short-term lease or low value lease. From the perspective of the hotel, the single-day lease would qualify as an operating lease. The lessor will have to comply with certain presentation and disclosure requirements as required by Ind AS 116.

Whilst the above example may not have any significant implications for the hotel or its customer, the example is provided to explain the concept of ‘How and for what purpose’ in evaluating whether a contract includes a lease arrangement.

Realisation is not acquisition of anything new, nor is it a new faculty. It is only removal of all camouflage

—  Ramana Maharshi

One who neglects or disregards the existence of earth, air, fire, water and vegetation disregards his own existence which is entwined with them

—  Mahavira

PRACTICAL GUIDANCE ON SIGNIFICANT INFLUENCE

There
are numerous situations where, concluding whether an investor exercises
significant influence over the investee and consequently whether the investee
is an associate of the investor, requires considerable judgement to be
exercised. When there is no significant influence, and an entity incorrectly
interprets the relationship to be that of significant influence, it will end up
wrongly consolidating (using the equity method) the entity in the consolidated
financial statements, rather than measuring it in accordance with Ind AS 109 – Financial
Instruments and vice versa.

 

In this
article, we discuss two examples. But before we do that, it is important to
understand the following key provisions in Ind AS 28 – Investments in
Associates and Joint Ventures which is reproduced below.

 

Paragraph
3 defines the following terms:

 

‘An associate is an entity over which the investor has significant
influence.’

 

‘Significant influence is the power to participate in the financial and
operating policy decisions of the investee but is not control or joint control
of those policies.’

 

Paragraph
5:

 

‘If an entity holds, directly or indirectly (e.g.
through subsidiaries), 20 per cent or more of the voting power of the investee,
it is presumed that the entity has significant influence, unless it can be
clearly demonstrated that this is not the case. Conversely, if the entity
holds, directly or indirectly (e.g., through subsidiaries), less than 20 per
cent of the voting power of the investee, it is presumed that the entity does not
have significant influence, unless such influence can be clearly demonstrated.
A substantial or majority ownership by another investor does not necessarily
preclude an entity from having significant influence.’

 

Paragraph
6:

 

‘The existence of significant influence by an entity is usually evidenced
in one or more of the following ways:

a)  representation on the board of
directors or equivalent governing body of the investee;

b)  participation in policy-making
processes, including participation in decisions about dividends or other
distributions;

c)  material transactions between the
entity and its investee;

d)  interchange of managerial
personnel; or

e)  provision of essential technical
information.’

 

Example 1A – Significant influence in a group structure

 

Fact Pattern

 

The
parent has two subsidiaries, Sub 1 and Sub 2. Sub 1 has a 16% ownership
interest in Sub 2. The group structure is as follows:

 

 

 

 

The
parent has appointed two executives of Sub 1 as Directors to the Board of Sub
2. Thanks to the number of Directors on the Board, the two Directors are able
to have an impact on Sub 2’s Board. The parent has the right to remove the two
executives from the Board at any time. Sub 1 has also been directed to manage
Sub 2 in a way that maximises the return for the parent, rather than for Sub 1.
The parent can amend this directive at any time. Whether Sub 1 has significant
influence over Sub 2?

 

Response

 

Ind AS
28:5 indicates that ‘[a] substantial or majority ownership by another investor
does not necessarily preclude an entity from having significant influence’. In
this fact pattern, however, Sub 1 does not have significant influence over Sub
2, because although Sub 1 can participate in policy-making decisions, the
parent can remove Sub 1’s executives from Sub 2’s Board at any time. Therefore,
Sub 1’s apparent position of significant influence over Sub 2 can be removed by
the parent and Sub 1 does not have the power to exercise significant influence
over Sub 2. Since Sub 1 does not have significant influence over Sub 2, Sub 2
is not an associate of Sub 1. It is actually the parent that has 100% control
over Sub 2, directly and indirectly through Sub 1.

 

Example 1B – Board
participation alone does not provide significant influence

 

Fact pattern

 

Internet
Ltd.’s Board is the ultimate decision-making authority and has ten Directors.
The shareholder analysis of Internet Ltd. shows the following shareholders.
Other shares are widely held by the public.

 

Shareholding

Board
representation

Viz Ltd.

38%

4

Fiz Ltd.

36%

4

Ke Ltd.

9%

1

Individual M (Managing Director of Internet Ltd.)
appointed by Viz Ltd.

6%

1

Others – widely held

11%

none

 

100%

10

 

Board
decisions are passed by a 70% majority of voting Directors. Is a 9%
shareholding and representation of one Director on the Board enough to provide
Ke Ltd. with significant influence?

 

Response

 

Whether
Ke Ltd. has significant influence is a matter of judgement. Ke Ltd. has only
one Director out of the ten. The Board is dominated by Viz and Fiz who can make
decisions without the agreement of the other Board members. Under Ind AS 28,
the Board representation is an indicator of significant influence. However, it
does not provide any further guidance on


how to evaluate the representation in the context of the size of the Board,
voting patterns, significant transactions, exchange of managerial personnel and
the like. Ke Ltd. only has 10% of the Board seats and believes this is not
enough to exercise significant influence, given the presence of the two major
investors and the Managing Director on the Board. Although Ke Ltd. participates
in the policy-making processes and decisions, that alone does not enable it to significantly
influence those decisions as suggested under Ind AS 28.

 

Having a
representation on the Board of Directors is an indicator of significant
influence. It is not an automatic confirmation. Additional analysis would be
required and relevant facts and circumstances will need to be considered. Ke
Ltd., in this scenario, holds far less than 20% shareholding threshold
indicated in the standard. It therefore does not have significant influence
over Internet Ltd.

 

CONCLUSION

The
determination of significant influence is a matter of considerable judgement
and needs careful evaluation of all the details, the facts and circumstances of
the case.

DEFINITION OF A BUSINESS (AMENDMENTS TO Ind AS 103)

The definition of business
has been amended (vide MCA notification dated 24th July,
2020) and continues to be intended to assist entities to determine whether a
transaction should be accounted for as ‘a business combination’ or as ‘an asset
acquisition’.

 

The accounting for the
acquisition of an asset and for the acquisition of a business are very different,
hence the classification is very critical. The amendments are applicable to
business combinations for which the acquisition date is on or after the
beginning of the first annual reporting period beginning on or after 1st
April, 2020 and to asset acquisitions that occur on or after the beginning of
that period. In a nutshell, the amendments have made the following broad
changes:


(i) the definition of a
business and the definition of outputs is made narrow.

(ii) clarify the minimum
features that the acquired set of activities and assets must have in order to
be considered a business.

(iii) the evaluation of
whether market participants are able to replace missing inputs or processes and
continue to produce outputs is removed.

(iv) an optional concentration
test that allows a simplified assessment of whether an acquired set of
activities and assets is not a business has been introduced.

 

The amendments replace the
wording in the definition of a business as follows:

Old Definition

New Definition

‘An integrated set of activities and assets
that is capable of being conducted and managed for the purpose of providing a
return in the form of dividends, lower costs or other economic benefits
directly to investors or other owners, members or participants’

‘An integrated set of activities and assets
that is capable of being conducted and managed for the purpose of providing
goods or services to customers, generating investment income (such as
dividends or interest) or generating other income from ordinary activities’

 

 

The changed definition
focuses on providing goods and services to customers, removes the emphasis from
providing a return to shareholders as well as to ‘lower costs or other
economics benefits’, because many asset acquisitions are made with the motive
of lowering costs but may not involve acquiring a substantive process.

 

Under the revised
standard, the following steps are required to determine whether the acquired
set of activities and assets is a business:

Step 1

Consider whether
to apply the concentration test

Does the entity want to apply the
concentration test?

If yes go to Step 2, if no go to Step 4

Step 2

Consider what
assets have been acquired

Has a single identifiable asset or a group
of similar identifiable assets been acquired?

If yes go to Step 3, if no go to Step 4

Step 3

Consider how the
fair value of gross assets acquired is concentrated

Is substantially all of the fair value of
the gross assets acquired concentrated in a single identifiable asset or a
group of similar identifiable assets?

If yes, the concentration test has passed,
transaction is not a business, if no go to step 4

Step 4

Consider whether
the acquired set of activities and assets has outputs

Does the acquired set of activities and
assets have outputs?

Go to step 5

Step 5

Consider if the
acquired process is substantive

  •  If there are no outputs, in what
    circumstances is the acquired process considered substantive?
  •  If there are outputs, in what circumstances
    is the acquired process considered substantive?

If acquired process is substantive,
transaction is a business; if acquired process is not substantive,
transaction is an asset acquisition

 

 

OPTIONAL CONCENTRATION TEST


The optional concentration
test allows the acquirer to carry out a simple evaluation to determine whether
the acquired set of activities and assets is not a business. The optional
concentration test is not an accounting policy choice; therefore, it may be
used for one acquisition and not for another. If the test passes, then the
acquired set of activities and assets is not a business and no further
evaluation is required. If the test fails or the entity chooses not to apply
the test, then the entity needs to assess whether or not the acquired set of
assets and activities meets the definition of a business by making a detailed
assessment.

 

The amended standard does
not prohibit an entity from carrying out the detailed assessment if the entity
has carried out the concentration test and concluded that the acquired set of
activities and assets is not a business. The standard-setter decided that such
a prohibition was unnecessary, because if an entity intended to disregard the
outcome of the concentration test, it could have elected not to apply it.

 

In theory, the
concentration test might sometimes identify a transaction as an asset
acquisition when the detailed assessment would identify it as a business
combination. That outcome would be a false positive. The standard-setter
designed the concentration test to minimise the risk that a false positive
could deprive users of financial statements of useful information. The
concentration test might not identify an asset acquisition that would be
identified by the detailed assessment. That outcome would be a false negative.
An entity is required to carry out the detailed assessment in such a case and
is expected to reach the same conclusion as if it had not applied the
concentration test. Thus, a false negative has no accounting consequences.

 

What is a
single identifiable asset?


A single identifiable
asset includes any asset or group of assets that would be recognised and
measured as a single identifiable asset in a business combination. This will
include assets that are attached or cannot be removed from other assets without
incurring significant cost or loss of value of either asset. Examples of single
identifiable asset include land and buildings, customer lists, trademarks,
outsourcing contracts, plant and machinery, intangible asset (for example, a
coal mine), etc. Land and buildings cannot be removed from each other without
incurring significant cost or loss of value to either of them, unless the
building is inconsequential or very insignificant in value.

 

What is a
group of similar identifiable assets?


Assets are grouped when
they have a similar nature and have similar risk characteristics (i.e., the
risks associated with managing and creating outputs from the assets). The
following are examples of groupings which are not considered to be similar
assets:

(a) a tangible asset and
an intangible asset.

(b) different classes of
tangible assets under Ind AS 16, for example, equipment and building (unless
the equipment is embedded in the building and cannot be removed without
incurring significant cost or loss of value to either the building or the
equipment).

(c) tangible assets that
are recognised under different Standards (e.g. Ind AS 2 ‘Inventories’ and Ind
AS 16 ‘Property, Plant and Equipment’).

(d) a financial asset and
a non-financial asset.

(e) different classes of
financial assets under Ind AS 109 ‘Financial Instruments’ (e.g receivables,
equity investments, etc.).

(f) different classes of
intangibles (e.g. brand, mineral rights, etc.)

(g) assets belonging to
the same class but have significantly different risk characteristics, for
example, different types of mines.

 

In applying the
concentration test, one test is to evaluate whether substantially all of the
fair value of the gross assets acquired is concentrated in a single
identifiable asset or a group of similar identifiable assets? How is the fair
value determined?

 

The fair value of the
gross assets acquired shall include any consideration transferred (plus the
fair value of any NCI and the fair value of any previously held interest) in
excess of the fair value of net identifiable assets acquired. The fair value of
the gross assets acquired may normally be determined as the total obtained by
adding the fair value of the consideration transferred (plus the fair value of
any NCI and the fair value of any previously held interest) to the fair value
of the liabilities assumed (other than deferred tax liabilities), and then
excluding cash and cash equivalents, deferred tax assets and goodwill resulting
from the effects of deferred tax liabilities.

 

The
standard-setter concluded that whether a set of activities and assets includes
a substantive process does not depend on how the set is financed. Consequently,
the concentration test is based on the gross assets acquired, not on net
assets. Thus, the existence of debt (for example, a mortgage loan financing a
building) or other liabilities does not alter the conclusion on whether an acquisition is a business combination. In addition, the gross assets
considered in the concentration test exclude cash and cash equivalents
acquired, deferred tax assets, and goodwill resulting from the effects of
deferred tax liabilities. These exclusions were made because cash acquired, and
the tax base of the assets and liabilities acquired, are independent of whether
the acquired set of activities and assets includes a substantive process.

 

Example – Establishing the
fair value of the gross assets acquired

 

Ze Co holds a 30% interest
in Ox Co. A few years later, Ze acquires control of Ox by acquiring an
additional 45% interest in Ox for INR 270. Ox’s assets and liabilities on the
acquisition date are the following:

 

  •  a building with a fair
    value of INR 720
  •  an identifiable
    intangible asset with a fair value of INR 420
  • cash and cash
    equivalents with a fair value of INR 180
  •  deferred tax assets of
    INR 120
  •  financial liabilities
    with a fair value of INR 900
  •  deferred tax liabilities
    of INR 240 arising from temporary differences associated with the building and
    the intangible asset.

 

Ze determines that at the
acquisition date the fair value of Ox is INR 600, that the fair value of the
NCI in Ox is INR 150 (25% x INR 600) and that the fair value of the previously
held interest is INR 180 (30% x INR 600).

 

Analysis

 

When performing the
optional concentration test, Ze needs to determine the fair value of the gross
assets acquired. Ze determines that the fair value of the gross assets acquired
is INR 1,200, calculated as follows:

 

  •  the total (INR 1,500)
    obtained by adding:

– the consideration paid
(INR 270), plus the fair value of the NCI (INR 150) plus the fair value of the
previously held interest (INR 180); to

– the fair value of the
liabilities assumed (other than deferred tax liabilities) (INR 900); less

 

  • the cash and cash
    equivalents acquired (INR 180); less

 

  • deferred tax assets
    acquired (INR 120).

 

Alternatively, the fair
value of the gross assets acquired (INR 1,200) is also determined by:

 

  •  the fair value of the
    building (INR 720); plus
  •  the fair value of the
    identifiable intangible asset (INR 420); plus
  •  the excess (INR 60) of:

 

– the sum (INR 600) of the
consideration transferred (INR 270), plus the fair value of the NCI (INR 150),
plus the fair value of the previously held interest (INR 180); over

– the fair value of the
net identifiable assets acquired (INR 540 = INR 720 + INR 420 + INR 180 + INR
120 – INR 900).

 

MINIMUM REQUIREMENTS TO QUALIFY AS BUSINESS

What are the
minimum requirements to meet the definition of a business?

 

Elements
of a business

Explanation

Examples

Inputs

An
economic resource that creates outputs or has the ability to contribute to
the creation of outputs when one or more processes are applied to it

 tangible assets

•
right-of-use assets

•
intangible assets

•
intellectual property

•
employees

•
ability to obtain necessary material or rights

Processes

A
system, standard, protocol, convention or rule that when applied to an input
or inputs, creates outputs or has the ability to contribute to the creation
of outputs. These processes typically are documented, but the intellectual
capacity of an organised workforce having the necessary skills and experience
following rules and conventions may provide the necessary processes that are
capable of being applied to inputs to create outputs. (Accounting, billing,
payroll and other administrative systems typically are not processes used to
create outputs.)

•
strategic management processes

•
operational processes

•
resource management processes

Outputs

The
result of inputs and processes applied to those inputs that provide goods or
services to customers, generate investment income (such as dividends or
interest) or generate other income from ordinary activities

•
revenue

 

 

To qualify as a business,
the acquired set of activities and assets must have inputs and substantive
processes that together enable the entity to contribute to the creation of
outputs. However, the standard clarifies that outputs are not necessary for an
integrated set of assets and activities to qualify as a business. A business
need not include all of the inputs or processes that the seller used in
operating that business. However, to be considered a business, an integrated
set of activities and assets must include, at a minimum, an input and a
substantive process that together enable the entity to contribute to the
creation of outputs.

 

According to the
standard-setters, the reference in the old definition to lower costs and other
economic benefits provided directly to investors did not help to distinguish
between an asset and a business. For example, many asset acquisitions may be
made with the motive of lowering costs but may not involve acquiring a
substantive process. Therefore, this wording was excluded from the definition
of outputs and the definition of a business.

 

Ind AS 103 adopts a market
participant’s perspective in determining whether an acquired set of activities
and assets is a business. This means that it is irrelevant whether the seller
operated the set as a business or whether the acquirer intends to operate the
set as a business. An assessment made from a market participant’s perspective
and driven by facts that indicate the current state and condition of what has
been acquired (rather than the acquirer’s intentions) helps to prevent similar
transactions being accounted for differently. Moreover, bringing more subjective
elements into the determination would most likely have increased diversity in
practice.

 

When is an acquired process considered to be substantive?


The amended Standard
requires entities to assess whether the acquired process is substantive. The evaluation
of whether an acquired process is substantive depends on whether the acquired
set of activities and assets has outputs or not. For example, an early-stage
entity may not have any outputs / revenue, and is therefore subjected to a
different analysis of whether the acquired process along with the acquisition
of the development stage entity is substantive or not. Moreover, if an acquired
set of activities and assets was generating revenue at the acquisition date, it
is considered to have outputs at that date, even if subsequently it will no
longer generate revenue from external customers, for example because it will be
integrated by the acquirer.

 

For activities and assets
that do not have outputs at the acquisition date, the acquired process is substantive
only if:

(i) it is critical to the
ability to develop or convert an acquired input or inputs into outputs; and

(ii) the inputs acquired
include both an organised workforce that has the necessary skills, knowledge,
or experience to perform that process (or group of processes) and other inputs
that the organised workforce could develop or convert into outputs. Those other
inputs could include:

(a)    intellectual
property that could be used to develop a good or service;

(b)    other
economic resources that could be developed to create outputs; or

(c)    rights to
obtain access to necessary materials or rights that enable the creation of
future outputs.

 

Examples of the inputs
include technology, in-process research and development projects, real estate
and mineral interests.

 

As can be seen from the
above discussion, for an acquired set of activities and assets to be considered
a business, if the set has no outputs, the set should include not only a
substantive process but also both an organised workforce and other inputs that
the acquired organised workforce could develop or convert into outputs.
Entities will need to evaluate the nature of those inputs to assess whether
that process is substantive.

 

For activities and assets
that have outputs at the acquisition date, the acquired process is substantive
if, when applied to an acquired input or inputs:

(1) it is critical to the
ability to continue producing outputs, and the inputs acquired include an
organised workforce with the necessary skills, knowledge, or experience to
perform that process (or group of processes); or

(2) significantly
contributes to the ability to continue producing outputs and is considered
unique or scarce; or cannot be replaced without significant cost, effort, or delay
in the ability to continue producing outputs.

 

The following additional
points support the above:

(A) an acquired contract
is an input and not a substantive process. Nevertheless, an acquired contract,
for example, a contract for outsourced property management or outsourced asset
management, may give access to an organised workforce. An entity shall assess
whether an organised workforce accessed through such a contract performs a
substantive process that the entity controls, and thus has acquired. Factors to
be considered in making that assessment include the duration of the contract
and its renewal terms.

(B) difficulties in
replacing an acquired organised workforce may indicate that the acquired
organised workforce performs a process that is critical to the ability to
create outputs.

(C) a process (or group of
processes) is not critical if, for example, it is ancillary or minor within the
context of all the processes required to create outputs.

 

As can be seen from the
above discussions, more persuasive evidence is required in determining whether
an acquired process is substantive, when there are no outputs, because the
existence of outputs already provides some evidence that the acquired set of
activities and assets is a business. The presence of an organised workforce
(although itself an input) is an indicator of a substantive process. This is
because the ‘intellectual capacity’ of an organised workforce having the
necessary skills and experience following rules and conventions may provide the
necessary processes (even if not documented) that are capable of being applied
to inputs to create outputs.

 

The standard-setter
concluded that although an organised workforce is an input to a business, it is
not in itself a business. To conclude otherwise would mean that hiring a
skilled employee without acquiring any other inputs could be considered to be
acquiring a business. The standard-setter decided that such an outcome would be
inconsistent with the definition of a business.

 

Prior to the amendments,
Ind AS 103 stated that a business need not include all of the inputs or
processes that the seller used in operating that business, ‘if market
participants are capable of acquiring the business and continuing to produce
outputs, for example, by integrating the business with their own inputs and
processes’. The standard-setter, however, decided to base the assessment on
what has been acquired in its current state and condition, rather than on
whether market participants are capable of replacing any missing elements, for
example, by integrating the acquired activities and assets. Therefore, the
reference to such integration was deleted from Ind AS 103. Instead, the
amendments focus on whether acquired inputs and acquired substantive processes
together significantly contribute to the ability to create outputs.

 

Illustrative
examples

 

Example
–Acquisition of real estate

 

Base facts

 

Ze
Co purchases a portfolio of 8 single-family homes along with in-place lease
contracts for each of them. The fair value of the consideration paid is equal
to the aggregate fair value of the 8 single-family homes acquired. Each
single-family home includes the land, building and lease-hold improvements.
Each home is of a different carpet size and interiors. The 8 single-family
homes are in the same area and the class of customers (e.g., tenants) are
similar. The risks in relation to the homes acquired and leasing them out are
largely similar. No employees, other assets, processes or other activities are
received in this transaction.

 

Scenario 1 – Application of optional concentration test

 

Analysis

 

Ze elects to apply the
optional concentration test set and concludes that:

 

  •  each single-family home
    is considered a single identifiable asset because:

 

  •  the building and
    lease-hold improvements are attached to the land and cannot be removed without
    incurring significant cost; and
  •  the building and the
    associated leases are considered a single identifiable asset, because they
    would be recognised and measured as a single identifiable asset in a business
    combination.

 

  •  the group of 8
    single-family homes is a group of similar identifiable assets because they are
    all single-family homes, are similar in nature and the risks associated with
    operations and creating outputs are not significantly different. This is
    consistent with the fact that the types of homes and classes of customers are
    not significantly different.

 

Ze concludes that the
acquired set of activities and assets is not a business because substantially
all of the fair value of the gross assets acquired is concentrated in a group
of similar identifiable assets.

 

Scenario 2 –Corporate
office park

 

Facts

 

Assume the same base case,
except that Ze also purchases a multi-tenant corporate office park with four
15-storey office buildings with in-place leases. The additional set of
activities and assets acquired includes the land, buildings, leases and
contracts for outsourced cleaning, security and maintenance. However, no
employees, other assets, other processes or other activities are transferred.
The aggregate fair value associated with the office park is similar to the
aggregate fair value associated with the 8 single-family homes. The processes
performed through the contracts for outsourced cleaning and security are minor
within the context of all the processes required to create outputs.

 

Analysis

 

Ze elects to apply the
optional concentration test and concludes that the single-family homes and the
office park are not similar identifiable assets, because the risks associated
with operating the assets, obtaining tenants and managing tenants are
significantly different. This is consistent with the fact that the two classes
of customers are significantly different. As a result, the concentration test
fails because the fair value of the corporate office park and the 8
single-family homes is similar. Thus, Ze proceeds to evaluate whether the
acquisition is a business in the normal way.

 

The set of activities and
assets has outputs because it generates revenue through the in-place leases. Ze
needs to evaluate if there is an acquired process that is substantive. For
activities and assets that have outputs at the acquisition date, the acquired
process is substantive if, when applied to an acquired input or inputs:

  •  it is critical to the
    ability to continue producing outputs, and the inputs acquired include an
    organised workforce with the necessary skills, knowledge, or experience to
    perform that process (or group of processes); or
  •  significantly
    contributes to the ability to continue producing outputs and is considered
    unique or scarce; or cannot be replaced without significant cost, effort, or
    delay in the ability to continue producing outputs.

 

Ze concludes that the
above criterion is not met because:

 

  •  the set does not include
    an organised workforce;

 

  •  the only processes
    acquired (processes performed by the outsourced cleaning, security and
    maintenance personnel) are ancillary or minor and, therefore, are not critical
    to the ability to continue producing outputs.

 

  • the processes do not
    significantly contribute to the ability to continue producing outputs.

 

  •  the processes are not
    unique or scarce and can be replaced without significant cost, effort, or delay
    in the ability to continue producing outputs.

 

Consequently, Ze concludes
that the acquired set of activities and assets is not a business. Rather, it is
an asset acquisition.

 

Scenario 3 –Corporate
office park

 

Facts

 

Consider the same facts as
in Scenario 2, except that the acquired set of activities and assets also
includes the employees responsible for leasing, tenant management, and managing
and supervising all operational processes.

 

Analysis

 

Ze elects not to apply the
optional concentration test and proceeds to evaluate whether there is a
business in the normal way. The acquired set of activities and assets has
outputs because it generates revenue through the in-place leases. Consequently,
Ze carries out the same analysis as in Scenario 2.

 

The acquired set includes
an organised workforce with the necessary skills, knowledge or experience to
perform processes (i.e. leasing, tenant management, and managing and
supervising the operational processes) that are substantive because they are
critical to the ability to continue producing outputs when applied to the
acquired inputs (i.e. the land, buildings and in-place leases). Additionally,
those substantive processes and inputs together significantly contribute to the
ability to create output. Therefore, Ze concludes that the acquired set of
activities and assets is a business.

 

In the author’s view,
these amendments may result in more acquisitions being accounted for as asset
acquisitions as the definition of business has narrowed. Further, the
accounting for disposal transactions will also be impacted as Ind AS 110 Consolidated
Financial Statements will be applicable in case of the recognition of
proceeds from the sale of a business, while Ind AS 115 Revenue from
Contracts with Customers will be applied for the recognition of proceeds
from the sale of an asset.

DISCONTINUED OPERATIONS

BACKGROUND

Ind AS 105 Non-current
assets held for sale and discontinued operations requires discontinued
operations to be presented separately in the profit and loss account, so that
the users of financial statements can separate the profits or losses from
continuing and discontinued operations. Such a segregated presentation helps
users of financial statements to determine the maintainable profits or losses
that arise from continuing operations.

 

Ind AS 105 (paragraph 32) defines
a discontinued operation as a component of an entity that either has been
disposed of, or is classified as held for sale, and

(a)   represents a separate major line of business or geographical area
of operations,

(b)  is part of a single co-ordinated plan to dispose of a separate
major line of business or geographical area of operations, or

(c)   is a subsidiary acquired exclusively with a view to resale.

 

Paragraph 33 of Ind AS 105
requires an entity to disclose:

(a)   a single amount in the statement of profit and loss comprising the
total of:

(i)    the post-tax profit or loss of discontinued operations; and

(ii)   the post-tax gain or loss recognised on the measurement to fair
value less costs to sell or on the disposal of the assets or disposal group(s)
constituting the discontinued operation.

(b)   an analysis of the single amount in (a) into:

(i)    the revenue, expenses and pre-tax profit or loss of discontinued
operations;

(ii)   the related income tax expense;

(iii) the gain or loss recognised on the measurement to fair value less
costs to sell or on the disposal of the assets or disposal group(s)
constituting the discontinued operation; and

(iv) the related income tax expense.

A common question that is
generally raised is with respect to a parent transferring an operation to a
subsidiary and whether in the parent’s separate financial statements the
disposal of the operation will be presented as a discontinuing operation. In
the consolidated financial statements, since the business remains within the
group, there is no discontinued operation which is required to be presented separately. Consider the detailed fact pattern below:

 

FACT PATTERN

A Ltd. (‘the Company’ or ‘the
parent’) enters into an arrangement whereby it will transfer an operation that
qualifies as an operation (as defined earlier) under Ind AS 105 to a
newly-set-up company (NewCo). The transfer is a slump sale and is set out in a
Business Transfer Agreement (BTA). NewCo is a wholly-owned subsidiary of the
company when it is set up.

 

The transfer is done with a
pre-requisite that an investor will concurrently invest in NewCo. to the extent
of 30%. The company has not lost control due to the said infusion, because it
still holds majority (70%) ownership. The investor will have significant
influence over NewCo.

 

There is no impairment on the
assets transferred.

 

Should the transferred operation
be classified as discontinued operations in the Separate Financial Statements
of A Ltd.?

 

ANALYSIS

There is no guidance with respect
to this specific issue either under Ind AS 105 or other Ind AS’s. In the stated
fact pattern, there are two possible views for the classification of the
transferred operation.

 

View 1: The
transferred operation is a discontinued operation in the parent’s separate
financial statements

In the fact pattern, an investor
will be investing to the extent of 30% shareholding in NewCo. There will be no
loss of control for the parent, because the parent still owns a majority stake
in NewCo. Nonetheless, running the operations by the company on its own as
against transferring it to a subsidiary, in which a potential investor has
significant influence, are two different things. Essentially, in the separate
financial statements of the parent the business is getting converted into an
investment in a subsidiary in which an independent investor will play a
significant role.

 

Earlier, the parent was running
the operations. After the transfer, the parent will have to manage the
investment in the subsidiary. The relevant decisions at the separate financial
statement level will be whether to retain the investment or dispose of the
investment, whether the investment should be further diluted, the proposal with
respect to dividends, etc. The parent and the subsidiary are two separate
entities with independent boards and subjected to a regulatory framework. This
suggests that the appropriate classification of the transferred operation
should be discontinued operation.

 

Accordingly, the transferred
operations should be classified as a discontinued operation.


View 2: The
transferred operation is not a discontinued operation in the parent’s separate
financial statements

The transfer
of operations to NewCo is simply a change in the geography of the operations,
because the operations continue to remain with the group. The transferred
operations are still controlled by A Ltd. In substance, A Ltd. continues to
control the operations though there will be significant influence exercised by
the independent investor in NewCo. There is a very thin line between managing
the investment in a subsidiary vs. running the operations represented by that
investment. Consequently, the transferred operations are not discontinued
operations in the separate financial statements of the parent.

 

The author believes that both the above views are
acceptable. However, View 1 may be preferred keeping in mind the concept
of ‘substance over form’. View 1 also represents faithfully the fact
that the profit and loss in the separate financial statements will not include
the results of the operation going forward. A segregated presentation will help
users of financial statements to determine the maintainable profits or losses
that arise from continuing operations in the separate financial statements. 

COVID AND FAIR VALUE MEASUREMENT

Fair value measurements are
required or permitted under Ind AS for many financial instruments and
non-financial assets and liabilities. They are required for quoted and unquoted
investments in shares, bonds, receivables, payables, derivatives, etc. As also
in certain situations for non-financial items, such as in determining
impairment of property, plant, equipment or goodwill. This article attempts to
discuss whether the current markets post the Covid outbreak can be considered
as not being orderly and therefore ignored for determining the fair values for
the year ending 31st March, 2020 financial statements.

 

Before we attempt to address the
moot question, whether markets as on 31st March, 2020 were orderly
or not, let us first look at the various provisions of Ind AS 113 Fair Value
Measurement.

(i)
Paragraph 2 of Ind AS 113 states that ‘Fair value is a market-based
measurement, not an entity-specific measurement. For some assets and
liabilities, observable market transactions or market information might be
available. For other assets and liabilities, observable market transactions and
market information might not be available. However, the objective of a fair
value measurement in both cases is the same – to estimate the price at which an
orderly transaction to sell the asset or to transfer the liability would take place
between market participants at the measurement date under current market
conditions (i.e., an exit price at the measurement date from the
perspective of a market participant that holds the asset or owes the
liability).’

(ii) Paragraph 3 of Ind AS 113
states that ‘When a price for an identical asset or liability is not
observable, an entity measures fair value using another valuation technique
that maximises the use of relevant observable inputs and minimises the use of
unobservable inputs. Because fair value is a market-based measurement, it is
measured using the assumptions that market participants would use when pricing
the asset or liability, including assumptions about risk. As a result, an
entity’s intention to hold an asset or to settle or otherwise fulfil a
liability is not relevant when measuring fair value.’

(iii) Paragraph 61 of Ind AS 113
states as follows ‘An entity shall use valuation techniques that are
appropriate in the circumstances and for which sufficient data are available to
measure fair value, maximising the use of relevant observable inputs and
minimising the use of unobservable inputs.’

(iv) Ind AS 113 defines orderly
transaction as ‘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; it
is not a forced transaction (e.g. a forced liquidation or distress sale.).’

 

IDENTIFYING TRANSACTIONS THAT ARE NOT
ORDERLY

Ind AS 113.B38 states that ‘If
an entity concludes that there has been a significant decrease in the volume or
level of activity for the asset or liability in relation to normal market
activity for the asset or liability (or similar assets or liabilities), further
analysis of the transactions or quoted prices is needed. A decrease in the
volume or level of activity on its own may not indicate that a transaction
price or quoted price does not represent fair value or that a transaction in
that market is not orderly.’

 

Ind AS 113.B43 provides guidance
for determination of whether a transaction is orderly (or is not orderly).
Whether there has been a significant decrease in the volume or level of
activity requires comparison to normal market activity level. B43 lists down
the following circumstances that may indicate that a transaction is not
orderly:

(a) There was not adequate
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 under current market conditions.

(b) There was a usual and
customary marketing period, but the seller marketed the asset or liability to a
single market participant.

(c) The seller is in or near
bankruptcy or receivership (i.e., the seller is distressed).

(d) The seller was required to
sell to meet regulatory or legal requirements (i.e., the seller was forced).

(e) The transaction price is an
outlier when compared with other recent transactions for the same or a similar
asset or liability.

 

OBSERVATIONS AND CONCLUSIONS

Fair value is a measurement of a
date-specific exit price estimate based on assumptions (including those about
risks) that market participants would make under current market conditions.
The fair value measurement objective is to determine an exit price at the
measurement date from the perspective of a market participant. Fair value of
the asset or liability reflects conditions as of the measurement date and not
a future date. It would not be appropriate for an entity to disregard
market prices at the measurement date, unless those prices are from
transactions that are not orderly. The concept of an orderly transaction is
intended to distinguish a fair value measurement from the price in a distressed
sale or forced liquidation. The intent is to convey the current value of
the asset or liability at the measurement date, not its potential value at a
future date.

 

The current situation may make it
challenging to estimate the price that would be obtained due to highly volatile
markets and / or a lack of an active market existing for certain instruments
(e.g. derivatives that are not traded on an exchange). However, the objective
of ‘fair value’ will continue to be to determine a price at which an orderly transaction
would take place between market participants under conditions that existed at
the measurement date. It would not be appropriate to adjust or disregard
observable transactions unless those transactions are determined to be not
orderly. There is a high bar to conclude that a transaction price is not
orderly under Ind AS 113.B43, which provides a list of factors to consider if a
transaction is not orderly. The author believes that there is an implicit
rebuttable presumption that observable transactions between unrelated parties
are orderly. In almost all instances, such transactions are considered orderly.
Therefore, the evidence necessary to conclude an observable transaction between
unrelated parties is not orderly should be incontrovertible. Accordingly,
the fair value of an investment in an active market (e.g. BSE, NSE, etc.) would
continue to be calculated as the product of the quoted price for the individual
instrument times the quantity held (commonly referred to as ‘P times Q’), even
in times of significant market volatility. Volatility may raise questions
as to whether current pricing is reflective of fair value. However, the
standard does not permit current market evidence to be dismissed on the basis
of volatility alone.

 

Some may argue that in the
current environment there is an element of forced selling and that fair value
measurement is not intended to reflect prices in a forced or distressed sale.
Nevertheless, the presence of distressed or forced sellers in a market may
influence the price that could be obtained by a non-distressed seller in an
orderly transaction.

 

Fair value measurement would
consider how the Covid outbreak and any actions taken by governments at the
reporting date would have impacted market participants’ valuation assumptions.
Current market conditions may appear to be a ‘distress sale’, however, if such
conditions exist broadly in the market, then those factors should be
incorporated into a fair value measurement. It would be incorrect to adjust a
measure for expected ‘rebounds’ in value. For financial instruments with level
1 prices (those that are quoted on an active market), even if there is a
significant decline in activity on that market, this does not mean that the
price has become unobservable or that it was 
under a distress sale or a forced liquidation.

 

Whilst determining a valuation
for other than level 1 category of instruments (i.e., those that are quoted in
an active market), preparers of financial statements may have to use valuation
techniques. This may be the case for several unquoted shares or derivatives or
bonds, etc. Preparers using valuation techniques may have to consider the
impact of Covid-19 on various assumptions including discount rates,
credit-spread / counter-party credit risk, etc. In doing so, the aim will
be to maximise observable inputs and minimise unobservable inputs. The
observable inputs will reflect current market conditions at the balance sheet
date and should not be ignored.

 

The
ICAI guidance ‘Impact of Corona Virus on Financial Reporting and the
Auditors Consideration’ states that ‘It may not be always appropriate to
conclude that all transactions in such a market are not orderly. Preparers
should be guided by the application guidance in Ind AS 113 that indicates
circumstances in which the transaction is not considered an orderly
transaction.’ Though the ICAI guidance does not provide any detailed
guidance, it makes no exception to complying with the requirements of the
Standards. For Indian GAAP, similar considerations will apply in respect of
financial assets within the scope of AS 13 Accounting for Investments.

UNCERTAINTY OVER INCOME TAX TREATMENTS

Ind
AS 12 Uncertainty over Income Tax Treatments (Appendix C) is effective
for the financial years beginning 1st April, 2019. An ‘uncertain tax
treatment’ is a tax treatment for which there is uncertainty over whether the
relevant taxation authority will accept the tax treatment under tax law. For
example, an entity’s decision not to submit any income tax filing in a tax
jurisdiction, or not to include particular income in taxable profit, is an
uncertain tax treatment if its acceptability is uncertain under tax law.

 

Uncertain
tax treatments generally occur where there is uncertainty as to the meaning of
the law, or to the applicability of the law to a particular transaction, or
both. For example, the tax legislation may allow the deduction of research and
development expenditure, but there may be disagreement as to whether a specific
item of expenditure falls within the definition of eligible research and
development costs in the legislation. In some cases, it may not be clear how
tax law applies to a particular transaction, if at all.

 

One
of the questions that was not clear in Appendix C was with respect to the presentation
of uncertain tax liabilities / assets. Whether, in its statement of financial
position, an entity is required to present uncertain tax liabilities as current
(or deferred) tax liabilities or, instead, within another line item such as
provisions? A similar question could arise regarding uncertain tax assets.

 

The
presentation of uncertainty over income tax treatments is very sensitive as it
may lead the Income-tax authorities to draw conclusions on the entities’
conclusion over the outcome of the uncertainty, or may provide information that
may lead to an investigation. Therefore, given a choice, entities would like to
combine uncertain tax provisions with another line item such as provisions.

 

AUTHOR’S RESPONSE


The
following points are relevant to respond to the question:


(i)
uncertain tax liabilities or assets
recognised applying Appendix C are liabilities (or assets) for current tax as
defined in Ind AS 12 Income Taxes, or deferred tax liabilities, or
assets as defined in Ind AS 12; and


(ii)
       neither Ind AS 12 nor Appendix C
contain requirements on the presentation of uncertain tax liabilities or
assets. Therefore, the presentation requirements in Ind AS 1 Presentation of
Financial Statements apply. Paragraph 54 of Ind AS 1 states that ‘the
statement of financial position shall include line items that present:… (n)
liabilities and assets for current tax, as defined in Ind AS 12; (o) deferred
tax liabilities and deferred tax assets, as defined in Ind AS 12…’

 

Therefore,
applying Ind AS 1, an entity is required to present uncertain tax liabilities
as current tax liabilities (paragraph 54[n]) or deferred tax liabilities
(paragraph 54[o]); and uncertain tax assets as current tax assets (paragraph
54[n]), or deferred tax assets (paragraph 54[o]).

 

Similarly,
Ind AS Schedule III to the Companies Act 2013 requires separate
presentation of current tax asset, current tax liability, deferred tax asset
and deferred tax liability. Additionally, General Instruction No. 2 for
preparation of financial statements of a company required to comply with Ind AS
clarifies that the requirements of Ind AS will prevail over Schedule III, if
there are any inconsistencies.

 

In
particular, one should note that:


(a)
       when there is uncertainty over
income tax treatments, Appendix C specifies how an entity reflects any effects
of that uncertainty in calculating current or deferred tax in accordance with
Ind AS 12. Paragraph 4 of Appendix C states (emphasis added):


‘This
Appendix clarifies how to apply the recognition and measurement requirements in
Ind AS 12 when there is uncertainty over
income tax treatments. In such a circumstance, an entity shall recognise and
measure its current or deferred tax asset or liability applying the
requirements in Ind AS 12 based on taxable profit (tax loss), tax bases,
unused tax losses, unused tax credits and tax rates determined applying this
Appendix.’


(b)
       An entity therefore applies
Appendix C in determining taxable profit (tax loss), tax bases, unused tax
losses, unused tax credits and tax rates when there is uncertainty over income
tax treatments. These amounts are in turn used to determine current / deferred
tax applying Ind AS 12, which in turn flow through to be current / deferred tax
liabilities if the amounts relate to the current or prior periods but are
unpaid / unreversed.

 

(c)
       Appendix C requires an entity to
reflect the effect of uncertainty in determining taxable profit, tax rates,
etc. when it concludes that it is not probable that the taxation authority will
accept an uncertain tax treatment (paragraph 11 of Appendix C). Consequently,
the taxable profit on which current tax, as defined in Ind AS 12, is calculated
is the taxable profit that reflects any uncertainty applying Appendix C. The
definition of current tax in paragraph 5 of Ind AS 12 does not limit the
taxable profit (tax loss) used in determining current tax to the amount
reported in an entity’s income tax filings. Instead, the definition refers to
(emphasis added) ‘the amount of income taxes payable (recoverable) in respect
of the taxable profit (tax loss) for the period’.

 

(d)
       Paragraph 54 of Ind AS 1 states:


‘The
statement of financial position shall include line items that present the
following amounts:…


(l)
provisions;…

 

(n)
liabilities and assets for current tax, as defined in Ind AS 12 Income Taxes;

(o)
deferred tax liabilities and deferred tax assets, as defined in Ind AS 12;…’

 

Particularly,
requirements in paragraphs 54(n) and 54(o) of Ind AS 1 will preclude an entity
from presenting some elements of income tax within another line in the
statement of financial position, such as provisions. In particular, paragraph
29 of Ind AS 1 states ‘…an entity shall present separately items of a
dissimilar nature or function unless they are immaterial’. Paragraph 57 of
Ind AS 1 states that ‘…paragraph 54 simply lists items that are sufficiently
different in nature or function to warrant separate presentation in the
statement of financial position.’ Consequently, liabilities for current
(or deferred) tax as defined in Ind AS 12 are sufficiently different in nature
or function from other line items listed in paragraph 54 to warrant presenting
such liabilities separately in their own line item (if material).

 

CONCLUSION

When
there is uncertainty over income tax treatments, paragraph 4 of Appendix C
requires an entity to ‘recognise and measure its current or deferred tax asset
or liability applying the requirements in Ind AS 12 based on taxable profit
(tax loss), tax bases, unused tax losses, unused tax credits and tax rates determined
applying Appendix C’. Paragraph 5 of Ind AS 12 Income Taxes defines:


(1)
       current tax as the amount of income
taxes payable (recoverable) in respect of the taxable profit (tax loss) for a
period; and


(2)
       deferred tax liabilities (or
assets) as the amounts of income taxes payable (recoverable) in future periods
in respect of taxable (deductible) temporary differences and, in the case of
deferred tax assets, the carry forward of unused tax losses and credits.

 

Consequently,
uncertain tax liabilities or assets recognised applying Appendix C are
liabilities (or assets) for current tax as defined in Ind AS 12, or deferred
tax liabilities or assets as defined in Ind AS 12.

 

Neither
Ind AS 12 nor Appendix C contains requirements on the presentation of uncertain
tax liabilities or assets. Therefore, the presentation requirements in Ind AS 1
apply. Paragraph 54 of Ind AS 1 states that ‘the statement of financial
position shall include line items that present:… (n) liabilities and assets for
current tax, as defined in Ind AS 12; (o) deferred tax liabilities and deferred
tax assets, as defined in Ind AS 12…’.

 

Paragraph
57 of Ind AS 1 states that paragraph 54 ‘lists items that are sufficiently
different in nature or function to warrant separate presentation in the
statement of financial position’. Paragraph 29 requires an entity to ‘present
separately items of a dissimilar nature or function unless they are
immaterial’.

 

Similarly,
Ind AS Schedule III to the Companies Act 2013 requires separate
presentation of current tax asset, current tax liability, deferred tax asset
and deferred tax liability. Additionally, General Instruction No. 2 for
preparation of financial statements of a company required to comply with Ind AS
clarifies that the requirements of Ind AS will prevail over Schedule III if
there are any inconsistencies.

 

Accordingly, applying
Ind AS 1, an entity is required to present uncertain tax liabilities as current
tax liabilities (paragraph 54[n]) or deferred tax liabilities (paragraph
54[o]); and uncertain tax assets as current tax assets (paragraph 54[n]) or
deferred tax assets (paragraph 54[o]).  

 

REVERSE FACTORING OR SUPPLIER FINANCING

BACKGROUND

Banks may
offer services to buyers of goods or services in order to facilitate payment of
their trade payables arising from purchases from suppliers. In a reverse
factoring arrangement, a bank agrees to pay amounts an entity owes to its
suppliers and the entity agrees to pay the bank at a date later than when the
suppliers are paid. Reverse factoring arrangements can vary significantly in
both form and substance. When the original liability to a supplier has been
extinguished or there is a change in terms, the following issues arise:

(a)  Whether the resulting new liability to the
bank should be presented as bank borrowing or ‘trade payables.’ A point to note
is that bank borrowing is required to be separately presented from trade
payables under Ind AS Schedule III requirements. Needless to say that
presentation as bank borrowing may have a significant impact on the gearing
ratios and debt covenants.

(b)
Additionally, the entity is also required to consider various disclosure
requirements. Consequently, this issue is very important.

 

Whether the
resulting new liability to the bank should be presented as bank borrowing or
‘trade payables’?

 

REQUIREMENTS OF Ind AS
STANDARDS

Before we
embark on answering these questions, let us consider the various requirements
under Ind AS standards:

1. Paragraph
54 of Ind AS 1 – Presentation of Financial Statements: ‘The
balance sheet shall include line items that present the following amounts:
(a)………….. (k) trade and other payables; (l) provisions; (m) financial
liabilities excluding amounts shown under (k) and (l)……….’

 

2. Paragraph
57 of Ind AS 1: ‘This Standard does not prescribe the order or format in which
an entity presents items. Paragraph 54 simply lists items that are sufficiently
different in nature or function to warrant separate presentation in the balance
sheet. In addition:

(a) line
items are included when the size, nature or function of an item or aggregation
of similar items is such that separate presentation is relevant to an
understanding of the entity’s financial position; and (b)…’

 

3. Paragraph
70 of Ind AS 1 explains that ‘some current liabilities, such as trade payables…
are part of the working capital used in the entity’s normal operating cycle’.

 

4. Paragraph
29 of Ind AS 1 states that ‘…An entity shall present separately items of a
dissimilar nature or function unless they are immaterial …’

 

5. Paragraph
11(a) of Ind AS 37 – Provisions, Contingent Liabilities and
Contingent Assets states that ‘trade payables are liabilities to pay for
goods or services that have been received or supplied and have been invoiced or
formally agreed with the supplier’.

 

6. Paragraph
3.3.1 of Ind AS 109 – Financial Instruments states: ‘An entity
shall remove a financial liability (or part of a financial liability) from its
balance sheet when, and only when, it is extinguished – i.e., when the
obligation specified in the contract is discharged or cancelled or expires.’

 

ANALYSIS

Based on the
various requirements of Ind AS standards presented above, an entity presents a
financial liability as a trade payable only when it:

(i)
represents a liability to pay for goods or services;

(ii) is
invoiced or formally agreed with the supplier; and

(iii) is
part of the working capital used in the entity’s normal operating cycle.

 

Other
payables are included within trade payables only when those other payables have
a similar nature and function to trade payables; for example, when other
payables are part of the working capital used in the entity’s normal operating
cycle.

 

A point to
note is that bank borrowing is required to be separately presented from trade
payables under Ind AS Schedule III requirements. In assessing whether to
present reverse factoring arrangements as trade payables (whether included with
other payables or not) or bank borrowing, requires further analysis. An entity
will have to assess whether to derecognise a trade payable to a supplier and
recognise a new financial liability to a bank as bank borrowings. Such an
assessment is made in accordance with Ind AS 109 – Financial Instruments.

 

Under Ind AS
109 if the arrangement results in derecognition of the original liability (e.g.
if the purchaser is legally released from its original obligation to the
supplier), an entity in such a case will have to pay the bank rather than the
supplier. Consequently, in such a case, presentation as a bank borrowing may be
more appropriate. Derecognition can also occur and presentation as bank
borrowing will also be appropriate if the purchaser is not legally released
from the original obligation but the terms of the obligation are amended in a
way that is considered a substantial modification. For example, the payment of
trade payable may not entail transfer of any collateral. However, if collateral
is provided in a supplier financing arrangement, this would mean that the
original agreement to pay to the creditor has been substantially modified. In
such cases, too, presentation of the reverse factoring as a bank borrowing
rather than trade payable may be more appropriate. Even if the original
liability is not derecognised, other factors may indicate that the substance
and nature of the arrangements indicate that the liability should no longer be
presented as a trade payable and a bank borrowing presentation may be more
appropriate.

 

Analysis of
supply-chain finance is a complex and judgemental exercise. Obtaining an
understanding of the following factors would help in making the decision on the
presentation:

• What are
the roles, responsibilities and relationships of each party (i.e. the entity,
the bank and the supplier) involved in the reverse factoring?

• What are
the discounts or other incentives received by the entity that would not have
otherwise been received without the bank’s involvement?

• Whether
there is any extension of the date by the bank by which payment is due from the
entity beyond the invoice’s original due date?

• Is the
supplier’s participation in the reverse factoring arrangement optional?

• Do the
terms of the reverse factoring arrangement preclude the company from
negotiating returns of damaged goods to the supplier?

• Is the
buyer released from its original obligation to the supplier?

• Is the
buyer obligated to maintain cash balances or are there credit facilities with
the bank outside of the reverse factoring arrangement that the bank can draw
upon in the event of non-collection of the invoice from the buyer?

• Does the
buyer have a separate credit line for these arrangements?

• Whether
additional security is provided as part of the arrangement that would not be
provided without the arrangement?

• Whether
the terms of liabilities that are part of the arrangement are substantially
different from the terms of the entity’s trade payables that are not part of
the arrangement?

 

Some reverse
factoring arrangements require that a buyer will pay the invoice regardless of
any disputes that might arise over the goods (for example, the goods are found
to be damaged or defective). In the event of a dispute, a buyer who agrees to
such a condition would use other means, such as adjustments on future purchases
from the supplier, to recover the losses. These provisions provide greater
certainty of payment to the bank and may reflect that the arrangement in
substance is a financing to the buyer. However, for a buyer who buys regularly
from a supplier to routinely apply credits for returns against payments on
future invoices, this condition might not be viewed as a significant change to
existing practice. Additionally, this provision may not constitute a
significant change to the terms of the original trade payable if failure by the
buyer to pay on the invoice due date does not entitle the bank to any recourse
or remuneration beyond what is stipulated in the terms of the invoice.

 

In some
reverse factoring arrangements, the buyer may be required to maintain
collateral or other credit facilities with the bank. These requirements may
indicate a financing arrangement in substance, particularly if a buyer’s
failure to maintain an appropriate cash balance would trigger
cross-collateralisation events on the buyer’s other debt instruments held by
the bank. For the liability to be considered a trade payable, the bank
generally can collect the amount owed by the buyer only through its rights as
owner of the receivable it purchased from the supplier. Some examples are
provided below which help in understanding the above requirements.

 

Example 1 –
Financing of advances to suppliers made by the buyer

A buyer
makes an advance payment to a supplier for goods to be delivered to the buyer
six months later. For this purpose, the buyer obtains a credit from the bank
based on its own credit rating and credit facility. The supplier is not
involved in the buyer obtaining the credit facility from the bankers. Here, as
far as the buyer is concerned, the buyer obtains credit from a bank and makes
an advance payment to the supplier. The buyer may directly make the advance to
the supplier, or the bank may do so on behalf of the buyer. In this example, it
is not appropriate for the buyer to present the borrowing from the bank and the
advance to the supplier on a net basis. It is also not appropriate for the
buyer to present the borrowing from the bank as trade payable, because no goods
have been received at the date of borrowing.

 

Example 2:
Bank negotiates with supplier directly on buyer’s behalf

A supplier
approaches a bank for discounting an invoice representing supply of goods to a
buyer. The bank agrees to pay the supplier before the legal due date to obtain
an early payment discount. However, the buyer is not legally relieved from the
obligation under its trade payable. The way the mechanism works is that the
supplier agrees to receive the amount from the buyer net of the early payment
discount at the contractual due date and to pay the bank this same amount only
if it receives the payment from the buyer. If the supplier fails to pay the
bank, the buyer agrees to pay the bank. The bank charges a fee to the buyer,
which is lower than the early payment discount. This effectively results in the
bank and the supplier sharing the benefit of the early payment discount. In
this example, since the buyer is not legally relieved of his obligation to pay
the supplier (or to the bank on behalf of the supplier), the buyer continues to
recognise the trade payable to the supplier. Furthermore, the buyer does not
provide any collateral to the bank, nor is the arrangement substantially
different from the terms of the entity’s trade payable. The buyer will
recognise the liability as trade payable. Additionally, the buyer also
recognises a guarantee obligation, initially measured at fair value, for its
promise to pay the bank if the bank does not receive a payment from the
supplier.

 

Example 3:
Receivables purchase agreement

In a reverse
factoring arrangement, a bank acquires the rights under the trade receivable
from the supplier. However, the buyer is not legally released from the payable.
The buyer may be involved to some extent in such an arrangement. For example,
the buyer agrees that he is no longer eligible to offset the payable against
credit notes received from the supplier, or the buyer may be restricted from
making direct payments to the supplier. In this fact pattern, the buyer would
need to consider whether the change to the terms of the trade payable is
significant or not.

 

If there is
a substantial change, the transfer is accounted for as an extinguishment –
which means, the previous liability should be derecognised and replaced with a
new liability to the bank. The impact of any additional restrictions imposed by
the reverse factoring agreement on the buyer’s rights will need to be properly
evaluated. One possibility is that because the buyer selects each payable at
its sole discretion, it will only select those payables where the effect of any
such restriction is not significant. On the other hand, it may be the case that
the buyer, bank and supplier have agreed initially on a minimum amount of
payables / receivables being refinanced by the bank. In such a case, the buyer
has no further discretion to avoid the change in his rights, even when the
change is significant.

 

Example 4:
Trade structure / supply chain finance / reverse factoring

• Steel
Limited (SL) purchases raw material and other supplies from various suppliers.

• SL has
negotiated 180 days’ extended credit term with all suppliers, which fact will
be stated in the invoice.

• To address
the working capital issues of suppliers, SL’s bankers have agreed to buy bills
endorsed by SL.

• The
suppliers decide whether they need to transfer bills to SL’s bankers as well as
timing and other terms of transfer. The suppliers can also get their bill
discounted from other bankers. However, it may not be cost effective.

• If a
supplier decides to get bill discounted from SL’s banker, the banker will
consider SL’s credit risk to decide the amount payable on transfer.

• Transfer
does not release SL from its liability toward the supplier. Rather, SL
continues to be liable to pay the amount to the supplier.

• If SL
defaults in payment of dues, the banker can use the court process against SL
for payment but only through the involvement of the supplier.

• SL does
not receive any additional benefit except extended credit period as originally
agreed with the supplier.

• SL does
not have a separate credit line with the bank for these arrangements, nor
provides any collateral.

 

Response

From the
facts it is clear that:

• SL is not released from its obligation towards the supplier.

• Nor is
there a change in the terms of payable.

• Nor has SL
received any discounts or rebates that would not have otherwise been received.

• There is no
extension of the payment date beyond the invoice’s original due date.

• The
supplier’s participation in the reverse factoring arrangement is completely
optional.

• SL does
not have a separate credit line with the bank for these arrangements, nor does
it provide any collateral.

• These
factors indicate that SL should continue to classify its liability as trade
payable.

 

Example 5:
Trade structure / supply chain finance / reverse factoring

• SL
purchases raw material and other supplies from various suppliers.

• SL has
negotiated 180 days’ extended credit term with all suppliers.

• Within one
month of purchase, SL can select suppliers who need to get their bill
discounted from SL’s bank. The selected suppliers will transfer their bills to
the bank for immediate cash.

• Assume
that the bill amount is Rs. 100; the bank will deduct Rs. 10 as discounting
charge and pay the remaining amount (Rs. 90) to the supplier.

• Through an
agreement signed between SL and the bank, SL:

• Commits itself to pay to the bank the specified
invoice on its due date.

• Pays a service fee for ‘services’ to the
bank.

• Pays finance cost to the bank (as per a
credit line with the bank).

• In
summary, SL will pay to the bank:

• Nominal amount of the invoice (Rs. 100).

• Less discount for immediate payment
included in the payment conditions between the buyer and SL (Rs.
10).

• Plus, the service and finance
commission payable to the Bank (Rs. 5).

 

Response

• The
supplier appears to have relinquished its obligation to pay to the bank. It
appears that SL has now the obligation for payment to the bank.

• The
substance of the transaction is that SL is paying in advance to the supplier
for getting the benefit of cash discount.

• For this
purpose, it is drawing a credit line from the bank and paying the related
interest expense.

• The
supplier’s participation in the arrangement is decided by SL.

• These
facts indicate that the supplier payable should be reclassified from trade
payable to a bank borrowing.

 

What are the
various disclosure requirements applicable in a reverse factoring arrangement?

 

REQUIREMENTS OF Ind AS
STANDARDS

1. Paragraph
6 of Ind AS 7 – Statement of Cash Flows defines: (a) operating activities as
the principal revenue-producing activities of the entity and other activities
that are not investing or financing activities; and (b) financing activities as
activities that result in changes in the size and composition of the
contributed equity and borrowings of the entity.

 

2. Paragraph 43 of Ind AS 7 states: ‘Investing and financing transactions
that do not require the use of cash or cash equivalents shall be excluded from
a statement of cash flows. Such transactions shall be disclosed elsewhere in
the financial statements in a way that provides all the relevant information
about those investing and financing activities.’

 

3. Paragraph
44 of Ind AS 7 states: ‘Many investing and financing activities do not have a
direct impact on current cash flows although they do affect the capital and
asset structure of an entity. The exclusion of non-cash transactions from the
statement of cash flows is consistent with the objective of a statement of cash
flows as these items do not involve cash flows in the current period.’

 

4. Paragraph
44A of Ind AS 7 states: ‘An entity shall provide disclosures that enable users
of financial statements to evaluate changes in liabilities arising from
financing activities, including both changes arising from cash flows and
non-cash changes.’

 

5. Paragraph 122 of Ind AS 1 – Presentation of Financial Statements states: ‘An entity shall disclose,
along with its significant accounting policies or other notes, the judgements,
apart from those involving estimations, that management has made in the process
of applying the entity’s accounting policies and that have the most significant
effect on the amounts recognised in the financial statements.’

 

6. Paragraph
112 of Ind AS 1 states: ‘The notes shall: …. (c) provide information that is
not presented elsewhere in the financial statements, but is relevant to an
understanding of any of them.’

 

ANALYSIS

The analysis
below is consistent with the IFRIC tentative agenda decision in June, 2020, ‘Supply
Chain Financing Arrangements – Reverse Factoring – Agenda Paper 2.’

 

Cash flow
statement

An entity
that has entered into a reverse factoring arrangement determines whether to
classify cash flows under the arrangement as cash flows from operating
activities or cash flows from financing activities. If the entity considers the
related liability to be a trade or other payable that is part of the working
capital used in the entity’s principal revenue-producing activities, then the
entity presents cash outflows to settle the liability as arising from operating
activities in its statement of cash flows. In contrast, if the entity considers
the related liability as borrowings of the entity, then the entity presents
cash outflows to settle the liability as arising from financing activities in
its statement of cash flows.

 

Investing
and financing transactions that do not require the use of cash or cash
equivalents are excluded from an entity’s statement of cash flows (paragraph 43
of Ind AS 7). Consequently, if cash inflow and cash outflow occur for an entity
when an invoice is factored as part of a reverse factoring arrangement, then
the entity presents those cash flows in its statement of cash flows. If no cash
flows are involved in a financing transaction of an entity, then the entity
discloses the transaction elsewhere in the financial statements in a way that
provides all the relevant information about the financing activity (paragraph
43 of Ind AS 7).

 

NOTES TO FINANCIAL
STATEMENTS

Paragraph 44A of Ind AS 7 requires an entity to provide ‘disclosures that
enable users of financial statements to evaluate changes in liabilities arising
from financing activities, including both changes arising from cash flows and
non-cash changes’. Such a disclosure is required for liabilities that are part
of a reverse factoring arrangement if the cash flows for those liabilities
were, or future cash flows will be, classified as cash flows from financing
activities.

 

Ind AS 107 –
Financial Instruments: Disclosures defines liquidity risk as ‘the risk
that an entity will encounter difficulty in meeting obligations associated with
financial liabilities that are settled by delivering cash or another financial
asset’. Reverse factoring arrangements often give rise to liquidity risk
because:

(a) the
entity has concentrated a portion of its liabilities with one financial
institution rather than a diverse
group of suppliers. The entity may also obtain other sources of funding from
the financial institution providing the reverse factoring arrangement. If the
entity were to encounter any difficulty in meeting its obligations, such a
concentration would increase the risk that the entity may have to pay a
significant amount, at one time, to one counter party.

(b) some
suppliers may have become accustomed to, or reliant on, earlier payment of
their trade receivables under the reverse factoring arrangement. If the
financial institution were to withdraw the reverse factoring arrangement, those
suppliers could demand shorter credit terms. Shorter credit terms could affect
the entity’s ability to settle liabilities, particularly if the entity were
already in financial distress.

 

Paragraphs 33-35 of Ind AS 107 require an entity to disclose how exposures
to risk arising from
financial instruments including liquidity risk arise, the entity’s objectives,
policies and processes for managing the risk, summary quantitative data about
the entity’s exposure to liquidity risk at the end of the reporting period
(including further information if this data is unrepresentative of the entity’s
exposure to liquidity risk during the period), and concentrations of risk.
Paragraphs 39 and B11F of Ind AS 107 specify further requirements and factors
an entity might consider in providing liquidity risk disclosures.

 

An entity
applies judgement in determining whether to provide additional disclosures in
the notes about the effect of reverse factoring arrangements on its financial
position, financial performance and cash flows. An entity needs to consider the
following:

(i)
assessing how to present liabilities and cash flows related to reverse
factoring arrangements may involve judgement. An entity discloses judgements
that management has made in this respect if they are among the judgements made
that have the most significant effect on the amounts recognised in the
financial statements (paragraph 122 of Ind AS 1).

(ii) reverse
factoring arrangements may have a material effect on an entity’s financial
statements. An entity provides information about reverse factoring arrangements
in its financial statements to the extent that such information is relevant to
an understanding of any of those financial statements (paragraph 112 of Ind AS
1).

ACCOUNTING RELIEF FOR RENT CONCESSIONS ON LEASES

On 28th May, 2020,
the International Accounting Standards Board (the IASB) finalised an amendment
to IFRS 16 Leases titled ‘Covid-19-Related Rent Concessions –
Amendment to IFRS 16’. The Institute of Chartered Accountants of India
(ICAI) has already issued an Exposure Draft mirroring the IFRS 16 amendment.
This will become a standard in India when it is notified by the Ministry of
Corporate Affairs (MCA).

 

The modified standard
provides lessees with an exemption from assessing whether a Covid-19-related
rent concession is a lease modification. The amendments require lessees that
have elected to apply the exemption to account for Covid-19-related rent
concessions as if they were not lease modifications. It may be noted that
accounting for lease modification can be very cumbersome and time consuming for
many lessees that have significant leases on their balance sheet. If the
modification accounting applies, a lessee does not recognise the benefits of
the rent concession in profit or loss straight away. Instead, the lessee will
recalculate its lease liability using a revised discount rate and adjust its
right-of-use assets. If the modification accounting does not apply, the profit
or loss impact of the rent concession would generally be more immediate.

 

The practical expedient in
many cases will be accounted for as a variable lease payment. If accounted for
as a variable lease payment, the concession is accounted for in profit or loss
in the period in which the event or condition that triggers those payments
occurs.

 

It may be noted that the
practical expedient is a choice and it is not mandatory to apply. The practical
expedient is not available to lessors. The practical expedient applies only to
rent concessions that meet all the following conditions (paragraphs 46A and
46B):

 

Condition 1
– The rent concession occurs as a direct consequence of the Covid-19 pandemic.

 

Condition 2
– The change in lease payments results in revised consideration for the lease
that is substantially the same as, or less than, the consideration for the
lease immediately preceding the change.

 

Condition 3
– Any reduction in lease payments affects only payments originally due on or
before 30th June, 2021.

 

Condition 4
– There is no substantive change to other terms and conditions of the lease.

 

Let’s take a few scenarios to
assess the applicability of the practical expedient.

 

ISSUE

Base fact
pattern

  •  Lessor leases commercial space to lessee,
  • Lease term is four years and rental is fixed at Rs. 4,000 p.m.

 

Whether practical expedient
is available in the following scenarios?

Scenario

Facts

Can practical
expedient be applied?

1

  •  Year 2020: Rent is reduced
    to Rs. 3,000 p.m. for May-July, 2020 due to business disruption as a result
    of Covid-19

 

  •  No change in subsequent years and no other change in


lease contract

Yes, as rent concession is as a direct
consequence of the Covid-19 pandemic and all the other three conditions are
also met

2

  •  Year
    2020: Rent is reduced to Rs. 3,000 p.m. for


May-July, 2020

 

  •   Year 2021: Rent for
    Aug.-Oct., 2021 is increased by Rs. 1,000 p.m. from the original rent. B will
    pay Rs. 5,000 p.m. for


Aug.-Oct., 2021

Yes, because reduction in lease payments affects
only payments originally due on or before 30th June, 2021.
Additionally, the increase in lease rental is beyond 30th June,
2021 and is in proportion to the concession provided. For Condition 3,
amendment acknowledges that a rent concession would meet this condition if it
results in reduced lease payments on or before 30th June, 2021 and
increased lease payments that extend beyond 30th June, 2021

3

  •  Lessor agreed for a six-month rent holiday from May – Oct., 2020, i.e.,
    concession of Rs. 24,000

 

  • However, in the month of March, 2021, the lessee pays this amount along with interest of Rs. 3,000, which totals to Rs. 27,000

 

Here, though there is a rent holiday, but those
rents are paid subsequently, along with interest. IASB has noted in their
basis of conclusion that if the cash flows have increased to compensate the
time value of money, it would appear to be appropriate for entities to assess
that Condition 2 is met. Other increases in consideration, such as penalties
that are included in the deferral, would cause this criterion to be not
satisfied

4

  • Year 2020 & 2021: Rent is reduced to Rs. 3,000 p.m. for May, 2020 – Dec.,
    2021

 

  • Year
    2022 & 2023: Rent for Jan. 2022 – Aug. 2023 is increased by Rs. 1,000
    p.m. from original rent. B will pay     Rs. 5,000 p.m. for Jan., 2022 – Aug., 2023

 

No. In this scenario, the rent reduction is as a
direct consequence of Covid. However, the reduction of Rs. 1,000 affects the
payments originally due for the period even beyond 30th June,
2021. The timeline prescribed in the amendment is purely rule-based. It would
not be appropriate to interpret it in such a way that rental concession can
be applied to the rent covering the period up to 30th June, 2021
and for rent changes beyond 30th June, 2021 the normal accounting
of lease modification can be applied. One should consider the changes in the
lease rentals in their entirety. It is not acceptable that rent concessions
are accounted such that one portion satisfies the criterion (i.e. May, 2020 –
June, 2021, i.e., 30th June is the date beyond which rent
concessions completely disqualify the entity from applying the accounting
relief) and the remaining portion, i.e., July, 2021 to August, 2023 does not
satisfy the criterion

5

  • Year 2020: Rent is reduced to Rs. 3,000 p.m. for


May-July, 2020

 

  • Year 2021: Rent for Aug.-Oct., 2021 is increased by Rs. 4,000 p.m. from original rent. B will pay Rs. 8,000 p.m. for
    Aug.-Oct., 2021

No, because the reduction is of Rs. 1,000 in 2020
but in 2021 the rent increased by Rs. 4,000 from original rent which is not
in proportion to the concession provided

6

  • Lessor offers to reduce the monthly rent on the condition that its space is
    reduced from 8,000 sq. ft. to 5,000 sq. ft.

No, it would be a substantive change to other
terms and conditions, and therefore the practical expedient would be unavailable
for that rent concession

7

  • Rent holiday for May-July, 2020

 

  • At the end of the lease term, it gets extended for three months on the terms
    and conditions contained in the original lease agreement

 

Yes, because the lease extension is not considered
as a substantive change to other terms and conditions of the lease. This
point has been clarified in basis for conclusion of the standard

 

 

 

Comparison
between applying the practical expedient and lease modification

Example –
rent abatement

Entity A leases retail space
from Entity B. As at 31st May, 2020, Entity B grants Entity A a
one-month rent abatement, where rent of Rs. 1 million that would otherwise be
due on 1st June, 2020 is unconditionally waived. The rent concession
satisfies the criteria to apply the practical expedient. The rent concession is
a lease modification because it is a change in consideration for a lease that
is not part of the original terms and conditions of the lease. The rent
concession meets the definition of a lease modification and it would be
accounted for as such if the practical expedient is not elected by Entity A.

           

 

Practical expedient not applied – lease
modification accounting (Ind AS 16.39 – 43)

Practical expedient is applied – variable lease
payment accounting [Ind AS 16.38(b)]

Effect on
lease liability

Reduced to
reflect the revised consideration

Reduced to
reflect the revised consideration

Effect on
discount rate

The total
revised, remaining consideration is re-measured using an updated discount rate
as at the effective date of the lease modification

No change
in discount rate

Effect on
right-of-use asset

The
offsetting adjustment is recorded against the carrying value of the
right-of-use asset

No effect

Effect on
profit or loss

None as at
the time of modification; but will result in modified finance expense and
depreciation in subsequent periods

The
offsetting adjustment is recorded in profit or loss

 

As is
visible from the above example, the practical expedient provides relief to the
lessee in the following ways:

(a) The lessee does not have to assess each rent
concession to determine whether it meets the definition of a lease
modification;

(b) It also simplifies the
calculations that are prepared by the lessee, since it does not require a revised
discount rate;

(c) The rent concession is accounted in profit or
loss in the period in which the event or condition that triggers the revised
consideration occurs, rather than being reflected in future periods as revised
finance expense and depreciation of the right-of-use asset.

 

CONCLUSION

The author believes that the
practical expedient is a welcome relief for lessees that have a large number of
leases, for example, airline, telecom, retail and other entities. However,
applying practical expedient may not be as simple as it appears and there could
be numerous complexities in determining what scenarios can be subjected to a
practical expedient, as well as the accounting of the practical expedient.

 

If the lessee applies the
practical expedient, it shall disclose if it has applied the expedient to all
lease contracts or the nature of the contracts to which it has applied the
expedient. The lessee should also disclose the P&L impact of applying the
practical expedient.

 

ACCOUNTING FOR OWN EMPLOYEE TRAINING COSTS INCURRED ON CUSTOMER CONTRACTS

This article seeks to provide guidance on
the most appropriate accounting under Ind AS 115 Revenue from Contracts with
Customers to account for own employee training costs incurred on customer
contracts.

 

FACT PATTERN

Consider the following fact pattern:

 

1. Ez Co enters
into a contract with a customer, Ti Co, that is within the scope of Ind AS 115.
The contract is for the supply of outsourced services. Ez’s employees take
calls from Ti’s customers and provide them with online assistance for
electronic products purchased from Ti.

2. To be able to
provide the services to Ti, Ez incurs training costs for its employees so that
they understand Ti’s equipments and processes. Applying Ind AS 115, Ez does not
identify the training as a performance obligation.

3. The contract
permits Ez to recharge to Ti the costs of training (i) Ez’s employees at the
beginning of the contract, and (ii) new employees that Ez hires as a result of
any expansion of Ti’s operations. Ez is unable to recharge costs associated
with training replacement employees (i.e., new employees of Ez recruited to
replace those that leave Ez’s employment).

 

Whether Ez should
recognise an asset for the training costs incurred to fulfil a contract with
the customer (Ti)?

 

RESPONSE

Training costs
should not be capitalised as a cost to fulfil a contract, regardless of whether
they are explicitly rechargeable in Ez’s contract with its customer.

 

ANALYSIS

Paragraphs 95-96 of
Ind AS 115 state:

 

95  If the costs incurred in fulfilling a contract
with a customer are not within the scope of another Standard (for example, Ind
AS 2 Inventories, Ind AS 16 Property, Plant
and Equipment or Ind AS 38 Intangible Assets), an entity shall
recognise an asset from the costs incurred to fulfil a contract only if those
costs meet all of the following criteria:

(a)  The costs relate directly to a contract or to an
anticipated contract that the entity can specifically identify (for example,
costs relating to services to be provided under renewal of an existing contract
or costs of designing an asset to be transferred under a specific contract that
has not yet been approved);

(b)  the costs generate or enhance resources of the
entity that will be used in satisfying (or in continuing to satisfy)
performance obligations in the future; and

(c)  the costs are expected to be recovered.

 

96  For costs incurred in fulfilling a contract
with a customer that are within the scope of another Standard, an entity shall
account for those costs in accordance with those other Standards.

 

In this context,
training costs are specifically addressed in Ind AS 38. Ind AS 38.69 requires
that (extract):

‘In some cases,
expenditure is incurred to provide future economic benefits to an entity, but
no intangible asset or other asset is acquired or created that can be
recognised. … Other examples of expenditure that are recognised as an expense
when it is incurred include:

a)   …

b)   Expenditure on training activities

c)   …

d)   …’

 

Paragraph 3 of Ind AS 38 states (extract) – ‘If another Standard
prescribes the accounting for a specific type of intangible asset, an entity applies
that Standard instead of this Standard. For example, this Standard does not
apply to:

(a)….

…….

(i)   assets arising from contracts with customers
that are recognised in accordance with Ind AS 115, Revenue
from Contracts with Customers’.

 

It may be noted
that Ind AS 115 does not apply specifically to training costs. Consequently,
Ind AS 38 will apply. As a result, training costs that are incurred in respect
of a contract with a customer cannot be recognised as an asset and must be
expensed as incurred. A prohibition on capitalising employee training costs is
consistent with the requirement that an asset must be controlled. Since an
employer does not control its employees, it follows that training costs that
enhance the knowledge and performance of employees cannot be capitalised (see
paragraph 15 of Ind AS 38). This is also consistent with the requirements of
paragraph B 37 of Ind AS 103 Business Combinations, which prohibits the
recognition of an asset for an acquired assembled workforce because it is not
an identifiable asset.

 

The training costs
meet the following requirements of paragraph 95 Ind AS 115:

  •     relate specifically to a
    contract that Ez can identify (Ind AS 115.95[a]);
  •     enhance the resources of Ez
    that will be used in satisfying performance obligations in the future (Ind AS
    115.95[b]); and
  •     are expected to be
    recovered (Ind AS 115.95[c]).

 

A key difference
between Ind AS 115.95 and the criteria in Ind AS 38 is that, under Ind AS
115.95, the entity does not need to control the resource. It is not necessary to demonstrate that the employees are controlled
by Ez; instead, it is sufficient that Ez’s resources (the employees) have been
enhanced by the training.

 

Paragraph 95 of Ind
AS 115 requires an entity to recognise an asset from the costs incurred to
fulfil a contract with a customer not within the scope of another Ind AS
Standard only if those costs meet all the three criteria specified in paragraph
95. Consequently, before assessing the criteria in paragraph 95, an entity
first considers whether training costs incurred to fulfil a contract are within
the scope of another Standard.

 

Paragraph 5 of Ind
AS 38 states that ‘this Standard applies to, among other things, expenditure
on advertising, training, start-up, research and development activities’.

 

Accordingly, in the
fact pattern described, the entity applies Ind AS 38 in accounting for the
training costs incurred to fulfil the contract with the customer. Since an
employer does not control its employees, it follows that training costs that
enhance the knowledge and performance of employees cannot be capitalised.  

 

COVID-19 AND PRESENTATION OF ‘EXCEPTIONAL ITEMS’

This article
provides guidance on the presentation and disclosure of exceptional items in
the financial statements arising due to Covid-19. Firstly, it is important to
look at the requirements of various authoritative guidances which are given
below:

 

(1)  Schedule III to the Companies Act, 2013
specifically requires a line item for ‘exceptional items’ on the face of the
statement of Profit and Loss (P&L).

(2)  The Securities and Exchange Board of India
Circular dated 5th July, 2016 requires that listed entities shall
follow the Schedule III to the Companies Act, 2013 format for purposes of
presenting the financial results.

(3)  The term ‘exceptional items’ is neither
defined in Schedule III nor in any Ind AS.

(4) Paragraphs 9, 85, 86, 97 and 98 of Ind AS 1 Presentation
of Financial Statements are set out below:

 

9    ‘The objective of financial statements is to
provide information about the financial position, financial performance and
cash flows of an entity that is useful to a wide range of users in making economic
decisions… This information, along with other information in the notes,
assists users of financial statements in predicting the entity’s future
cash flows and, in particular, their timing and certainty.’

85   An entity shall present additional line items
(including by disaggregating the line items listed in paragraph 82), headings
and subtotals in the statement of profit and loss, when such presentation is
relevant to an understanding of the entity’s financial performance.

86   Because the effects of an entity’s various
activities, transactions and other events differ in frequency, potential for
gain or loss and predictability, disclosing the components of financial
performance assists users in understanding the financial performance achieved
and in making projections of future financial performance. An entity includes
additional line items in the statement of profit and loss, and it amends the
descriptions used and the ordering of items when this is necessary to explain
the elements of financial performance. An entity considers factors including
materiality and the nature and function of the items of income and expense. For
example, a financial institution may amend the descriptions to provide
information that is relevant to the operations of a financial institution. An
entity does not offset income and expense items unless the criteria in
paragraph 32 are met.

97   When items of income or expense are material,
an entity shall disclose their nature and amount separately.

     

98   Circumstances that would give rise to the
separate disclosure of items of income and expense include:

(a) write-downs of inventories to net realisable
value or of property, plant and equipment to recoverable amount, as well as
reversals of such write-downs;

(b) restructurings of the activities of an entity
and reversals of any provisions for the costs of restructuring;

(c)   disposals of items of property, plant and
equipment;

(d) disposals of investments;

(e) discontinued operations;

(f)   litigation settlements; and

(g) other reversals of provisions.

 

(5) In December, 2019 IASB issued
an Exposure Draft General Presentation and Disclosures (ED) that, once
finalised, would replace IAS 1 and eventually Ind AS 1. The deadline for
submitting comments is 30th September, 2020. The ED proposes
introducing a definition of ‘unusual income and expenses’ and requiring all
entities to disclose unusual income and expenses in a single note.

 

(6) As per the ED: ‘Unusual income and expenses
are income and expenses with limited predictive value. Income and
expenses have limited predictive value when it is reasonable to expect that
income or expenses that are similar in type and amount will not arise for
several future annual reporting periods.’

 

(7) Paragraph B67-B75 of the application guidance
to the ED provides further explanation of the nature of ‘unusual’ items. In
particular, the following extracts may be noted:

 

‘In
determining whether income or expenses are unusual, an entity shall consider
both the type of the income or expense and its amount. For example, an
impairment loss resulting from a fire at an entity’s factory is normally an
unusual type of expense and hence would be classified as an unusual expense
because in the absence of other indicators of impairment, another similar
expense would not reasonably be expected to recur for several future annual
reporting periods.

 

Income and expenses that are not unusual by type may be unusual in
amount. Whether an item of income or expense is unusual in amount is determined
by the range of outcomes reasonably expected to arise for that income or
expense in several future annual reporting periods. For example, an entity that
incurs regular litigation costs that are all of a similar amount would not
generally classify those litigation expenses as unusual. However, if in one
reporting period that entity incurred higher litigation costs than reasonably
expected because of a particular action, it would classify the costs from that
action as unusual if litigation costs in several future annual reporting
periods were not expected to be of a similar amount. The higher litigation
costs are outside the range of reasonably expected outcomes and not predictive
of future litigation costs.’

 

(8) The ED also supports the conceptual concerns
raised by certain stakeholders about the presentation of exceptional items as a
separate line item in the P&L statement rather than in the notes. The
following may be particularly noted:

 

The Board
proposes that information about unusual income and expenses should be disclosed
in the notes rather than presented in the statement(s) of financial
performance. The Board concluded that disclosure in the notes would enable
entities to provide a more complete description and analysis of such income and
expenses. Disclosure in the notes also provides users of financial statements
with a single location to find information about such income and expenses and
addresses some stakeholders’ concerns that unusual income and expenses may be
given more prominence than other information in the statement(s) of financial
performance.

 

Some
stakeholders suggested that, given the importance some users of financial
statements attach to the disclosure of unusual income and expenses, operating
profit before unusual income and expenses should be added to the list of
subtotals specified by IFRS Standards and the requirements relating to analysis
of operating expenses by function or by nature adjusted accordingly. In their
view, no longer being able to present an operating profit subtotal before
unusual items would be a significant step back from current practice. The Board
has not proposed adding this subtotal because, in some cases, presentation of
an operating profit before unusual income and expenses subtotal could result in
a presentation that mixes natural and functional line items. Users have told
the Board that they do not find mixed presentation useful and want to see all
operating expenses analysed by one characteristic (nature or function).

 

AUTHOR’S ANALYSIS AND CONCLUSIONS

The two
fundamental questions that need to be answered are as follows:

(i)   What items are included as exceptional items?

(ii)   Whether an exceptional item is presented as a
separate line item in the P&L or only described in the notes?

 

Before we start
addressing the above questions, the following points may be kept in mind:

(a) Exceptional items may arise from Covid or
non-Covid factors or a combination of both. For example, the fall in oil prices
may be due to Covid as well as trade wars between oil-producing countries.

(b) The separate presentation of exceptional item
in the P&L is required by both SEBI and Schedule III.

(c)   The two factors / tests that dominate whether
an item is exceptional are the size of the item (‘materiality test’) and the
predictive value (‘predictability test’). For example, by presenting a non-recurring
item as exceptional, investors can exclude those exceptional items in making
future projections of the performance. This aspect is also clear in the IASB’s
ED. At this point in time, the pandemic should be considered to be unusual and
non-recurring and will meet the test in the ED.

 

(d) Whilst Schedule III and SEBI require separate
presentation of exceptional items, there are a few anomalies which are listed
below:

(i)   The presentation of exceptional item as a
separate line item results in a mixed presentation. For example, presentation
of losses on inventory due to marking them down to net realisable value as
exceptional item results in cost of sales division into two separate line
items.

(ii)   An item of expense or loss may be caused by
both exceptional and non-exceptional factors. Segregating between what is
exceptional and what is not exceptional may be challenging. For example,
consider that the value of investment in an equity mutual fund at December-end
was Rs. 100. Prior to the outbreak / lockdown the value had gone up to Rs. 110.
On 31st  March, 2020 the value
had fallen to Rs. 85. Consequently, a net loss of Rs. 15 is included in the
P&L for the last quarter. This theoretically may be represented in two
ways, (a) Rs. 15 is an exceptional item, or (b) Rs. 25 is an exceptional item
and Rs. 10 is income from normal gains. Putting it simply, determining what is
exceptional can be very arbitrary in this case, because it involves determining
an arbitrary cut-off date. It also results in a mixed presentation when one
item is segregated into two different components. In this given case, the
author believes that Rs. 15 should be considered as an exceptional item and the
segregation was done to merely illustrate the point.

 

(e)   Given the specific
requirement of SEBI and Schedule III, it may not be incorrect to disclose a
material and non-recurring item as exceptional on the face of the P&L.
However, a better option would be not to present an exceptional item in the
P&L because it results in a mixed presentation and arbitrariness in
segregating an item as exceptional and not exceptional. Rather, exceptional
items may be more elaborately described in the notes to accounts.

 

Table
1

 

Expenditure

Author’s evaluation of exceptional and
non-exceptional

Impairment

For many enterprises, impairment is
non-recurring. Therefore, the same may be presented as exceptional items if
those are material, irrespective of whether they are caused due to Covid or
non-Covid factors

Incremental costs
due to Covid

If the costs are incremental to costs incurred
prior to the Covid outbreak and not expected to recur once the crisis has
subsided and operations return to normal, and clearly separable from normal
operations, they may be presented as an exceptional item. Temporary premium
payments to compensate employees for performing their normal duties at
increased personal risk, charges for cleaning and disinfecting facilities
more thoroughly and / or more frequently, termination fees or penalties for
terminated contracts or compliance with contractual provisions invoked
directly due to the events of the pandemic, may be both incrementally
incurred as a result of the coronavirus outbreak and separable from normal
operations. On the other hand, payments to employees for idle time, rent and
other recurring expense (e.g., security, utilities insurance and maintenance)
related to temporarily idle facilities, excess capacity costs expensed in the
period due to lower production, paying employees for increased hours required
to perform their normal duties and paying more for routine inventory costs
(e.g., shipping costs) will generally not be incremental and separable and
should not be presented as exceptional items

Provision for
doubtful debts

Provisions for doubtful debts are determined using
the expected credit loss method (ECL). The forward-looking projections in the
ECL model may be adjusted to reflect the post-Covid economic situation.
Generally, it will be difficult to segregate the overall ECL between those
that are Covid-caused and others. Besides, a higher ECL may be expected, on a
go forward basis, because Ind AS 109 specifically requires the ECL model to
be adjusted for forward-looking information. Consequently, it is difficult to
argue that a higher ECL provision will be a non-recurring feature. Therefore,
the provisions should not be identified as an exceptional item

Suspension of capitalisation of borrowing cost
due to Covid lockdown

There can be two views on this matter. Due to
suspension, the borrowing costs incurred during construction of an asset may
be expensed rather than capitalised. Consequently, the expense will impact
the P&L all at once. Had the interest expenditure been capitalised, had
there been no Covid, the expense would have been reflected by way of future
depreciation charge. As a result, since the expenditure is in any case
incurred, there is no exceptional item. The alternative view is that because
of the lockdown the interest expenditure is impacting the P&L all at
once. Since such expenditure is non-recurring the same may be presented as an
exceptional item

Litigation costs

Is the litigation caused due to Covid? For
example, there is clear evidence that the contract delay was due to Covid and
the customer is litigating on the same? Legal costs incurred to defend the
entity’s position may be presented as an exceptional item. Similarly, advice
from counsel on force majeure clauses in contracts may be considered
to be exceptional. These items may be presented as an exceptional item

Write-off / write-down
of inventories

If this meets the materiality test and the
predictability test, it may be presented as an exceptional item

Losses due to fall in NAV of investments made in
mutual
funds (MF)

If this meets the materiality test and the
predictability test, it may be presented as an exceptional item

Restructuring costs

Costs incurred on downscaling of operations if
caused due to Covid may be presented as an exceptional item

Onerous contracts

If this meets the materiality test and the
predictability test, it may be presented as an exceptional item

Severance pay for premature termination of
employment

Normal salary cost paid for lockdown period will
generally not pass the tests because salary is a recurring cost. However,
severance pay may be non-recurring in nature, whether caused due to Covid or
otherwise, and hence may be presented as an exceptional item

 

 

For the
purposes of providing additional guidance, the following indicative list of
expenditures is evaluated from the perspective of whether those are
exceptional, from the prism of the principles described above. The assumption
is that the items discussed in Table 1 (on the previous page) are
material to the specific entity.

 

The fundamental challenge in
identifying an exceptional item is that it results in arbitrariness due to
segregating an item into two separate components and a mixed presentation. Therefore,
it is suggested that the items discussed above which are identified as
exceptional items may be presented as such with an elaborate description in the
notes to the accounts.

 

It is not uncommon for
entities to supplement the EPS figures required by Ind AS 33 by voluntarily
presenting additional amounts per share, for example, profits before and after
exceptional items. For additional earnings per share amounts, the standard
requires:

(I)    that the denominator used should be that
required by Ind AS 33;

(II)   that basic and diluted amounts be disclosed
with equal prominence and presented in the notes;

(III) an indication of the basis on which the
numerator is determined, including whether amounts per share are before or
after tax; and

(IV) if the numerator is not reported as a line item
in the statement of comprehensive income or separate statement of P&L, a
reconciliation to be provided between it and a line item that is reported in
the statement of comprehensive income [Ind AS 33.74].

 

Alternative EPS figures may
be presented on the face of the P&L as well as in the notes.  

 

PRACTICAL GUIDANCE – DETERMINATION OF LEASE TERM FOR LESSEE

Determining the lease term under Ind AS 116 Leases can be a very
complex and judgemental exercise. For purposes of evaluating the lease term,
one needs to understand the interaction between the non-cancellable period in a
lease, the enforceable period of the lease and the lease term. Lease term is
determined at the inception of the contract. An entity shall revise the lease
term if there is a change in the non-cancellable period of a lease.

 

Note: The determination of lease term under Ind AS 116 is very crucial
because it impacts the determination of (1) whether a lease is a short-term
lease – if it is a short-term lease, practical expediency is available not to
apply the detailed recognition requirements of the standard applicable to a
non-short-term lease, (2) the lease term also determines the amount of the
right of use asset (ROU) and the lease liability on the balance sheet.
Subsequent depreciation and finance charges are also impacted by the amount
capitalised on account of the ROU asset and the lease liability.

 

The concepts are described in detail below under three broad steps.

 

STEP
1 – DETERMINE THE ENFORCEABLE PERIOD

A contract is defined as ‘An agreement between two or more parties that
creates enforceable rights and obligations.’

 

(Para B34) In determining the lease term and assessing the length of the
non-cancellable period of a lease, an entity shall apply the definition of a
contract and determine the period for which the contract is enforceable. A
lease is no longer enforceable when both the lessee and the lessor have the right to terminate the lease without permission from the other
party with no more than an insignificant penalty.

IFRIC observed (see IFRIC update June, 2019, Agenda Paper 3, Lease
term and useful life of leasehold improvements IFRS 16 Leases and IAS 16
Property, Plant and Equipment) that, in applying paragraph B34 (above) of
IFRS 16 and determining the enforceable period of the lease, an entity
considers:

(a) the economics of the contract. For example, if either party has an
economic incentive not to terminate the lease and thus would incur a
penalty on termination that is more than insignificant, the contract is
enforceable beyond the date on which the contract can be terminated; and

(b) whether each of the parties has the right to terminate the
lease without permission from the other party with no more than an
insignificant penalty. If only one party has such a right, the contract is
enforceable beyond the date on which the contract can be terminated by that
party.

 

Therefore, when either party has the right to terminate the contract
with no more than insignificant penalty, there is no longer an enforceable
contract. However, when one or both parties would incur a more than
insignificant penalty by exercising its right to terminate, the contract
continues to be enforceable. The penalties should be interpreted broadly to
include more than simply cash payments in the contract. The wider
interpretation considers economic disincentives. If an entity concludes that
the contract is enforceable beyond the notice period of a cancellable lease (or
the initial period of a renewable lease), it then applies paragraphs 19 and
B37-B40 of IFRS 16 to assess whether the lessee is reasonably certain not to
exercise the option to terminate the lease.

 

Author’s note: These
clarifications should equally apply to Ind AS, as IFRIC deliberations and
conclusions are global and robust.

 

Example – Enforceable
period

A lease contract of a retail outlet in a shopping mall allows for the
lease to continue until either party gives notice to terminate the contract.
The contract will continue indefinitely (but not beyond ten years) until the
lessee or the lessor elects to terminate it and includes stated consideration
required during any renewed periods (referred to as ‘cancellable leases’).  Neither the lessor nor the lessee will incur
any contractual cash payment or penalty upon exercising the termination right.
The lessee constructs leasehold improvements, which cannot be moved to another
premise. Upon termination of the lease, these leasehold improvements will need
to be abandoned, or dismantled. Can the lease term go beyond the date at which
both parties can terminate the lease (inclusive of any notice period)?

 

In the fact pattern above, while the lease can be terminated early by
either party after serving the notice period, the enforceable rights in the
contract (including the pricing and terms and conditions) contemplate the
contract can continue beyond the stated termination date (but not beyond ten
years), inclusive of the notice period. There is an agreement which meets the
definition of a contract (i.e., an agreement between two or more parties that
creates enforceable rights and obligations). However, the mere existence of
mutual termination options does not mean that the contract is automatically
unenforceable at a point in time when a potential termination could take
effect. Ind AS 116.B34 provides explicit guidance on when a contract is no
longer enforceable – ‘a lease is no longer enforceable when the lessee and
the lessor each has the right to terminate the lease without permission from
the other party with no more than an insignificant penalty.’ The penalties
should be interpreted broadly to include more than simply cash payments in the
contract. The wider interpretation considers economic disincentives.

 

In the above example, the enforceable period is ten years, i.e., if
either party has an economic incentive not to terminate the lease and
thus would incur a penalty on termination that is more than insignificant, the
contract is enforceable beyond the date on which the contract can be
terminated.

 

The fact pattern includes an automatic renewal up to a period of ten
years. The agreement could have been drafted as a one-year contract with a
fixed nine-year renewal period (setting out detailed terms and conditions of
renewal), which either party could have terminated. In either of these fact
patterns, if there is more than an insignificant penalty for either of the
parties for the period of ten years, the enforceable period will be ten years.
This assessment should be carried out at the inception of the contract.

 

STEP
2 – DETERMINE THE LEASE TERM

Extract of Ind AS 116:

18 An entity shall determine
the lease term as the non-cancellable period of a lease, together with both:

(a) periods covered by an option to extend the lease if the lessee is
reasonably certain to exercise that option; and

(b) periods covered by an option to terminate the lease if the lessee is
reasonably certain not to
exercise that option.

19 In assessing whether a
lessee is reasonably certain to exercise an option to extend a lease, or not to
exercise an option to terminate a lease, an entity shall consider all relevant
facts and circumstances that create an economic incentive for the lessee to
exercise the option to extend the lease, or not to exercise the option to
terminate the lease, as described in paragraphs B37–B40.

B34 In determining
the lease term and assessing the length of the non-cancellable period of a
lease, an entity shall apply the definition of a contract and determine the
period for which the contract is enforceable. A lease is no longer enforceable
when the lessee and the lessor each has the right to terminate the lease
without permission from the other party with no more than an insignificant
penalty.

B35 If only a
lessee has the right to terminate a lease, that right is considered to be an
option to terminate the lease available to the lessee that an entity considers
when determining the lease term. If only a lessor has the right to terminate a
lease, the non-cancellable period of the lease includes the period covered by
the option to terminate the lease.

B37… entity
considers all relevant facts and circumstances that create an economic
incentive for the lessee to exercise, or not to exercise, the option (Ind AS
116.19, Ind AS 116.B37-B40):

* contractual terms and conditions for the optional periods compared
with market rates

* significant leasehold improvements

* costs relating to the termination of the lease

* the importance of that underlying asset to the lessee’s operations

* conditionality associated with exercising the option

 

To determine the lease term, the parties would apply Ind AS 116.18-19
and B37-40 (i.e., the reasonably certain threshold). ‘Reasonably certain’ is a
high threshold and the assessment requires judgement. It also acknowledges the
guidance in Ind AS 116.B35 which indicates that the lessor termination options
are generally disregarded. If only a lessor has the right to terminate a lease,
that is disregarded to determine the lease term, because the lessee does not
have an unconditional right to avoid its obligation to continue with the lease.

 

Example – Lease term

Incremental facts to the previous example are that the mandatory
non-cancellable period is one year and notice period is two months. In this
example, it is possible that the lease term may exceed the one year and two
months period. The lease term is one year and two months plus the period
covered by the termination option that it is reasonably certain the lessee will
not exercise such termination option. However, the lease term cannot be no
longer than the period the contract is enforceable, i.e. ten years. The lease
term therefore, will fall between one year two months and ten years.

 

STEP
3 – CONSIDER INTERACTION BETWEEN ENFORCEABLE PERIOD AND LEASE TERM

Consider the following lease contract:

# Lock-in period is one year

# Contract is for ten years and will be auto renewed for a year for next
nine years after lock-in period of one year

# The terms and conditions of the auto renewal are clearly spelt out in
the contract

# Either party can cancel the contract by giving two months’ notice
after lock-in period without paying any monetary penalty.

 

In the above example, the non-cancellable period is
one year. The enforceable period is dependent upon whether either party is
incurring more than an insignificant penalty. If neither party is incurring
more than an insignificant penalty, the enforceable period is one year
(non-cancellable period) and two months (notice period). However, if either
party is incurring more than an insignificant penalty, the enforceable period
is ten years (total contract period). The enforceable period could have been
greater than ten years if the contract had a further renewal clause and the
terms and conditions of the auto renewal are clearly spelt out in the contract.
The lease term will fall between the non-cancellable period and the enforceable
period. It cannot be greater than the enforceable period. For example, if the
lessee has made significant investment by way of leasehold improvement, and the
life of the improvement is eight years, the lease term may be eight years,
subject to other facts. If, however, the life of leasehold improvements is ten
years, then there may be significant disincentive for the lessee to walk away
from the lease earlier than ten years, and the lease term may be ten years,
subject to evaluation of other facts.

 

The above thought process is captured in the table below.

 

ILLUSTRATIVE
EXAMPLES

Query

3Z Co (lessee) enters into arrangements for lease of warehouses for a
period of one year. The lease agreement does not provide any purchase option in
respect of the leased asset, but 3Z has a right to renew for one additional
year. Consider two scenarios: (a) right of renewal does not require permission
of the lessor; (b) right of renewal requires permission of the lessor. Whether
the recognition exemption for short-term leases is available to 3Z?

 

Response

Whether the short-term lease exemption applies depends on what the lease
term is and if that term is one year or less. First, one should determine the
enforceable period. If either party has an economic incentive not to terminate
the lease and thus would incur a penalty on termination that is more than
insignificant, the contract is enforceable beyond the date on which the
contract can be terminated. Assuming that there is economic disincentive for
one of the parties (either lessee or lessor), the enforceable period is two
years in both the scenarios.

 

The next step is to determine the lease term. In assessing whether a
lessee is reasonably certain to exercise an option to extend a lease, or not to
exercise an option to terminate a lease, an entity shall consider all relevant
facts and circumstances that create an economic incentive for the lessee to exercise
the option to extend the lease, or not to exercise the option to terminate the
lease. If only the lessor has the right to terminate a lease, that is
disregarded to determine the lease term, because the lessee does not have an
unconditional right to avoid its obligation to continue with the lease.
Consequently, in both the scenarios the lease term could range between one and
two years. If the lease term is greater than one year, the lease would not
qualify for short-term exemption.

 

Query

Scenario 1

Lessee entered into a lease arrangement with lessor for an overhead line
facility with Indian Railways across their railway track for a period of ten
years. Lessee paid in advance the rentals for the entire period of ten years.
The arrangement does not grant lessee with tenancy or right or interest in the
land. Based on past experience, the lessor will renew the contract for another
ten years at the end of the contract period. The following are some of the
principal terms of agreement:

 

(i)    Either
party can terminate the contract by giving one month’s notice and no monetary
penalty will apply.

(ii)   Lessor
reserves full rights on the land below the overhead line facility.

(iii) If
lessor gives termination notice, lessee at its own cost shall remove the overhead
line and shall restore the railway land to its original condition. Lessor has
given notice to lessees to shift transmission lines from railway land only in a
few rare and unusual cases.

(iv) Lessee
is reasonably certain to continue the lease till the validity of transmission
licence, i.e. 30 years since shifting of transmission lines will affect its
business adversely.

(v)   There
are no renewal options beyond ten years and a new agreement will need to be
entered into between the lessor and the lessee, and the terms and conditions
with respect to the new agreement will have to be agreed upon by both parties
at that point in time.

 

Will the lease qualify as a short-term lease?

 

Scenario 2

Consider the same fact pattern as above, with some
changes. Beyond the ten-year period, the contract includes an automatic renewal
option whereby the contract will automatically continue for an additional term
of 20 years, unless either party terminates the contract. What will be the
lease term in this fact pattern?

 

Response

Scenario 1

If one or both parties would incur a more than
insignificant penalty by exercising its right to terminate – the contract
continues to be enforceable over the ten-year period. The penalties should be
interpreted broadly to include more than simply cash payments in the contract.
The wider interpretation considers economic disincentives. The following
factors prima facie suggest that at the commencement date, the lessee is
not likely to have an economic incentive to exercise the termination option:

(a)   Lessee
expects to operate the transmission line beyond ten years.

(b)   It is
unlikely that the lessee will be able to locate an alternative location that
fulfils its requirements. Such open spaces will generally be available only
with Indian Railways. If at all an alternative location is available, it may
involve a considerable increase in the length of the transmission line and may
therefore involve considerable additional cost.

(c)   If at
all relocation is possible, the relocation may entail significant additional
costs and the benefit of obtaining alternative location at lower lease rentals
may not be worth it.

(d) In case
premature termination by the lessee results in the lessor forfeiting a significant
part of the advance lease rental payment, this would be an additional factor
providing economic incentive to the lessee to not terminate the lease
prematurely.

 

The enforceable period will therefore be ten years,
irrespective of whether the lessor will incur more than an insignificant
penalty or not by terminating the contract. The next step is to determine the
lease term. An entity shall determine the lease term as the non-cancellable
period of a lease, together with the periods covered by an option to extend the
lease if the lessee is reasonably certain to exercise that option.
Interestingly, under Ind AS 116, the legal enforceability of the option from
the perspective of the lessor is not relevant. In other words, the lessor may
refuse to extend the lease and may cancel the lease during the ten-year period,
or at least has the ability to cancel the lease at any time during the ten-year
period. However, in determining the lease term, the lessor’s rights are not
relevant. Consequently, based on the facts in the given case, the lease term
will be ten years and will not qualify for short-term exemption.

 

Scenario 2

In the second scenario, the same assessment as in
Scenario 1 is relevant. However, in this scenario the contract will be
automatically renewed for another 20 years unless either of the party walks
away from the contract. As mentioned above, in determining the lease term, the
lessor’s rights are not relevant. An entity will consider the factors described
in B37. From the available information it appears that the lessee will continue
for 30 years, beyond which there are no additional renewal or automatic renewal
clauses. The lease term could therefore be 30 years, subject to further
analysis of detailed facts.

 

Query

A part of the transmission line of El Co passes through private land
(not owned by Indian Railways). El enters into a lease agreement with the
private land owner for a period of 12 months for overhead facility. The
following are some of the principal terms of agreement:

(i)    There
are no renewal or automatic renewal clauses and the lease can be renewed or
cancelled with the mutual consent of both the parties.

(ii)   Either
party shall be at liberty to put an end to the arrangement by giving one-month
previous notice in writing to that effect and in the event of such a notice
neither of the party shall have any claim for any compensation whatsoever.

 

It is likely that the contract will be renewed for another one year at
the expiry of its current term. The lease agreement does not provide any
purchase option in respect of the leased asset to the lessee. The lessee is
reasonably certain to continue the lease till the validity of transmission
licence, i.e. 30 years, since shifting of transmission lines will affect its
business adversely. Whether the short-term lease exemption will apply?

 

Response

The lease agreement to allow overhead transmission lines is for a period
of 12 months. The agreement does not grant a renewal, auto-renewal or extension
or purchase option to the lessee. Accordingly, the lease qualifies as a
‘short-term lease’, notwithstanding the fact that upon expiry of each 12-month
period there is high degree of certainty that the lease will be renewed for a
further period of 12 months by mutual consent between the lessor and the lessee
at that point in time. The lessee can, therefore, avail the exemption of not
applying the lessee accounting model of the standard to the lease and instead
account for the lease as per paragraph 6 of Ind AS 116. As per paragraph 6, the
lessee recognises the lease payments as an expense on a straight-line basis
over the lease term or another systematic basis.  

 

           

 

 

ACCOUNTING FOR CRYPTOCURRENCY

In June, 2019 the IFRIC decided on
the interesting issue of accounting for cryptocurrency. The IFRIC applies to
cryptocurrency that has the following characteristics:

 

i.   a
digital or virtual currency recorded on a distributed ledger that uses
cryptography for security;

ii.   not
issued by a jurisdictional authority or other party; and

iii.  does not give rise to a contract between the holder and another
party.

 

Ind AS 38 Intangible Assets
applies in accounting for all intangible assets except:

 

a. those that are within the scope
of another Standard;

b. financial assets, as defined in
Ind AS 32 Financial Instruments: Presentation;

c. the recognition and measurement
of exploration and evaluation assets; and

d. expenditure on the development and extraction of minerals, oil, natural
gas and similar non-regenerative resources.

 

A financial asset is any asset that
is: (a) cash; (b) an equity instrument of another entity; (c) a contractual
right to receive cash or another financial asset from another entity; (d) a
contractual right to exchange financial assets or financial liabilities with
another entity under particular conditions; or (e) a particular contract that
will or may be settled in the entity’s own equity instruments.

 

Cash is a financial asset because
it represents the medium of exchange and is therefore the basis on which all
transactions are measured and recognised in financial statements. A deposit of
cash with a bank or similar financial institution is a financial asset because
it represents the contractual right of the depositor to obtain cash from the
institution or to draw a cheque or similar instrument against the balance in
favour of a creditor in payment of a financial liability. Consequently, cash is
expected to be used as a medium of exchange (i.e. used in exchange for goods or
services) and as the monetary unit in pricing goods or services to such an
extent that it would be the basis on which all transactions are measured and
recognised in financial statements.

 

Though some cryptocurrencies can be
used in exchange for goods or services, they are not used to such an extent
that it would be the basis on which all transactions are measured and
recognised in financial statements. Consequently, in the present times
cryptocurrency is not cash. Neither is a cryptocurrency an equity
instrument of another entity. It does not give rise to a contractual right for
the holder and it is not a contract that will or may be settled in the holder’s
own equity instruments.

 

Ind AS 2 Inventories applies
to inventories of intangible assets. Paragraph 6 of that Standard defines
inventories as assets:

 

1.  held
for sale in the ordinary course of business;

2.  in
the process of production for such sale; or

3.  in
the form of materials or supplies to be consumed in the production process or
in the rendering of services.

 

If an entity holds cryptocurrencies
for sale in the ordinary course of business, the general requirements of Ind AS
2 apply to that holding. However, a broker-trader of cryptocurrencies, who buys
or sells commodities for others or on their own account, will measure their
inventories at fair value less cost to sell [Ind AS 2.3(b)].

 

IFRIC CONCLUSION

Paragraph 8 of Ind AS 38 defines an
intangible asset as ‘an identifiable non-monetary asset without physical substance’.
Paragraph 12 of Ind AS 38 states that an asset is identifiable if it is
separable or arises from contractual or other legal rights. An asset is
separable if it ‘is capable of being separated or divided from the entity and
sold, transferred, licensed, rented or exchanged, either individually or
together with a related contract, identifiable asset or liability’. Paragraph
16 of Ind AS 21 The Effects of Changes in Foreign Exchange Rates states
that ‘the essential feature of a non-monetary item is the absence of a right to
receive (or an obligation to deliver) a fixed or determinable number of units
of currency’. IFRIC concluded that a holding of cryptocurrency meets the
definition of an intangible asset in Ind AS 38 because (a) it is capable of being
separated from the holder and sold or transferred individually; and (b) it does
not give the holder a right to receive a fixed or determinable number of units
of currency. IFRIC also concluded that Ind AS 2 applies to cryptocurrencies
when they are held for sale in the ordinary course of business. If Ind AS 2 is
not applicable, an entity applies Ind AS 38 to holdings of cryptocurrencies.

 

In addition to other disclosures
required by Ind AS Standards, an entity is required to disclose any additional
information that is relevant to an understanding of its financial statements
(paragraph 112 of Ind AS 1 Presentation of Financial Statements). An
entity provides the disclosures required by (i) paragraphs 36–39 of Ind AS 2
for cryptocurrencies held for sale in the ordinary course of business; and
(ii) paragraphs 118–128 of Ind AS 38 for holdings of cryptocurrencies to which
it applies Ind AS 38. If an entity measures holdings of cryptocurrencies at
fair value, paragraphs 91–99 of Ind AS 113 Fair Value Measurement
specify applicable disclosure requirements.

 

Applying paragraph 122 of Ind AS 1,
an entity discloses judgements that its management has made regarding its
accounting for holdings of cryptocurrencies if those are part of the judgements
that had the most significant effect on the amounts recognised in the financial
statements. Paragraph 21 of Ind AS 10 Events after the Reporting Period
requires an entity to disclose details of any material non-adjusting events,
including information about the nature of the event and an estimate of its
financial effect (or a statement that such an estimate cannot be made). For
example, an entity holding cryptocurrencies would consider whether changes in
the fair value of those holdings after the reporting period are of such significance
that non-disclosure could influence the economic decisions that users of
financial statements make on the basis of the financial statements.  

 

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ACCOUNTING OF E-WASTE OBLIGATION

The E-waste (Management) Rules, 2016 (“Rules”), as amended,
impose e-waste obligations on manufacturers of electrical and electronic goods
who have placed any goods in the market in the current financial year. The
collection, storage, transportation, segregation, refurbishment, dismantling,
recycling and disposal of e-waste shall be in accordance with the guidelines
published by the Central Pollution Control Board.

 

The purpose of this article is not to dive deep into the
legislation, but to explain the accounting consequences with a simplified
example.

 

Consider a refrigerator manufacturer that has been in
manufacturing for many years; it has the following e-waste obligations under
the Rules:

Obligation for financial year

(the measurement period)

Quantum of
e-waste obligation

Expected cost (Rs. million)

2018-19

10% of
refrigerators sold in 2008-09

50

2019-20

20% of
refrigerators sold in 2009-10

110

2020-21

30% of
refrigerators sold in 2010-11

200

2021-22

40% of
refrigerators sold in 2011-12

310

2022-23

50% of
refrigerators sold in 2012-13

415

2023-24

60% of
refrigerators sold in 2013-14

550

2024-25

70% of
refrigerators sold in 2014-15

690

2025-26

70% of
refrigerators sold in 2015-16

750

2026-27

70% of
refrigerators sold in 2016-17

850

2027-28

70% of
refrigerators sold in 2017-18

990

 

 

4,915

 

If the manufacturer participated in the market in the current
financial year (2018-19), its obligation is determined with reference to 10% of
the refrigerators sold in the preceding 10th year (2008-09) and the
cost is estimated at Rs. 50 million. As can be seen from the above table, the
liability increases substantially over the years due to volume increases (i.e.,
the number of refrigerators sold each year keeps increasing) and the percentage
applied under the Rules also increases steeply. The question that arises is, is
a provision of Rs. 4,915 million required for the year end 2018-19?

 

The main argument for supporting a provision of Rs. 50
million is that the obligating event is the participation in the market for the
financial year 2018-19 (the measurement period), and the cost of fulfilling the
obligation is determined by reference to the year 2008-09 under the Rules. On
this basis, the cost of obligation is Rs. 50 million, and should be provided
for, unless it has already been expended and charged to P&L.

 

The main argument for supporting a provision of Rs. 4,915
million is that the obligating event is all the sales made in the past, rather
than participation in the market for the current financial year. A provision of
Rs. 4,915 million will ensure that cost related to all previous years’ sales
are provided for. Accordingly, any costs including future costs for sales
already made are recognised. Consequently, the sales and the accompanying cost
of those sales are matched and recognised in the same period, thereby ensuring
that matching principles are followed.

 

Appendix B, Liabilities arising from Participating in a
Specific Market – Waste Electrical and Electronic Equipment of Ind AS 37 Provisions,
Contingent Liabilities and Contingent Assets deals with the accounting and
is discussed below. At a global level this issue was discussed and led to
issuance of IFRIC 6 Liabilities arising from Participating in a Specific
Market – Waste Electrical and Electronic Equipment, on the basis of which
Appendix B was developed.

 

What constitutes the obligating event in accordance with
paragraph 14(a) of Ind AS 37 for the recognition of a provision for waste
management costs:

  • the manufacture or sale of the
    historical household equipment?
  • participation in the market
    during the measurement period?
  • the incurrence of costs in the
    performance of waste management activities?

 

Paragraph 17 of Ind AS 37 specifies that an obligating
event is a past event that leads to a present obligation that an entity has no
realistic alternative to settling. Paragraph 19 of Ind AS 37 states that
provisions are recognised only for “obligations arising from past events
existing independently of an entity’s future actions”.

 

Participation in the market during the measurement period is
the obligating event in accordance with paragraph 14(a) of Ind AS 37. As a consequence, a liability for waste
management costs for historical household equipment does not arise as the
products are manufactured or sold. Since the obligation for historical
household equipment is linked to participation in the market during the
measurement period, rather than to production or sale of the items to be
disposed of, there is no obligation unless and until a market share exists
during the measurement period.

 

The International Financial Reporting Interpretations
Committee (IFRIC) considered an argument that manufacturing or selling products
constitutes a past event that gives rise to a constructive obligation.
Supporters of this argument emphasise the definition of a constructive
obligation in paragraph 10 of IAS 37 and point out that in determining whether
past actions of an entity give rise to an obligation, it is necessary to
consider whether a change in practice is a realistic alternative. These
respondents believed that when it would be necessary for an entity to take some
unrealistic action in order to avoid the obligation then a constructive
obligation exists and should be accounted for.

 

The IFRIC rejected this
argument, concluding that a stated intention to participate in a market during
a future measurement period does not create a constructive obligation for
future waste management costs. IFRIC felt that in accordance with paragraph 19
of Ind AS 37, a provision can be recognised only in respect of an obligation
that arises independently of the entity’s future actions. If an entity has no
market share in a measurement period, it has no obligation for the waste
management costs relating to the products of that type which it had previously
manufactured or sold and which otherwise would have created an obligation in
that measurement period. This differentiates waste management costs, for
example, from warranties, which represent a legal obligation even if the entity
exits the market. Consequently, no obligation exists for the future waste
management costs until the entity participates in the market during the
measurement period.

 

Some constituents asked
the IFRIC to consider the effect of the following possible national
legislation: the waste management costs for which a producer is responsible
because of its participation in the market during a specified period (for
example, 20X6) are not based on the market share of the producer during that period but on the producer’s
participation in the market during a previous period (for example, 20X5). The
IFRIC noted that this affects only the measurement of the liability and that
the obligating event is still participation in the market during 20X6.

 

The IFRIC considered whether its conclusion is undermined by
the principle that the entity will continue to operate as a going concern. If
the entity will continue to operate in the future, it treats the costs of doing
so as future costs. For these future costs, paragraph 18 of Ind AS 37
emphasises that financial statements deal with the financial position of an
entity at the end of its reporting period and not its possible position in the
future. Therefore, no provision is recognised for costs that need to be
incurred to operate in the future.

 

On the basis of the above discussions, under Appendix B of
Ind AS 37, a provision of only Rs. 50 million is required in 2018-19 (unless
the amount is already expended), which should be charged to the P&L.

DETERMINING INCREMENTAL BORROWING RATE UNDER Ind AS 116

BACKGROUND

Ind AS 116 requires a
lessee to discount the lease liability using the interest rate implicit in the
lease if that rate can be readily determined. If the interest rate implicit in
the lease cannot be readily determined, then the lessee should use its incremental
borrowing rate. The interest rate implicit in the lease is likely to be similar
to the lessee’s incremental borrowing rate (IBR) in many cases. This is because
both rates, as they have been defined in Ind AS 116, take into account the
credit standing of the lessee, the length of the lease, the nature and quality
of the collateral provided and the economic environment in which the
transaction occurs. However, the interest rate implicit in the lease is
generally also affected by a lessor’s estimate of the residual value of the
underlying asset at the end of the lease and may be affected by taxes and other
factors known only to the lessor, such as any initial direct costs of the
lessor. It is likely to be difficult for lessees to determine the interest rate
implicit in the lease for many leases, particularly those for which the
underlying asset has a significant residual value at the end of the lease.
Consequently, the standard requires use of the IBR in these situations.

 

The lessee’s IBR is the rate that the lessee
would have incurred on debt obtained over a similar term for the specific
purpose of acquiring the leased asset. The lessee’s IBR may be equivalent to a
secured borrowing rate if that rate is determinable, reasonable and consistent
with the financing that would have been used in the particular circumstances.
The lessee’s IBR should reflect the effect of any compensating balances or
other requirements present in the lease that would affect the lessee’s
borrowing cost for similar debt. The IBR should also reflect the effect of any
third party guarantees of minimum lease payments obtained by the lessee, to the
extent that similar guarantees of debt payments would have affected the
borrowing costs. However, the lessee’s IBR should not include any component
related to the lessee’s cost of capital (i.e., the IBR should not reflect the
effect of lessee’s use of a combination of debt and equity to finance the
acquisition of the leased asset).

 

If the lessee’s financial condition is such
that third parties generally would be unwilling to provide debt financing, the
IBR of the lessee might not be readily determinable. In these rare cases, the
lessee should use the interest rate for the lowest grade of debt currently
available in the market place as its IBR.

 

Three steps are critical in determining the
IBR, namely: (a) the reference rate, (b) the financing spread adjustment, and
(c) lease-specific adjustment. These aspects are discussed below.

 

REFERENCE RATE

This will generally be the relevant
government bonds or currency swap rates (e.g., LIBOR) reflecting a risk-free
rate. The borrowings should be matched with the currency of the cash outflows
on the lease so that foreign exchange risk is removed. For example, lease cash
flows denominated in USD or GBP (or any other currency) should be matched with
the appropriate risk-free rates, such as those determined from US Treasury
Bills or UK Gilts.

 

The repayment profile should be considered
when aligning the term of the lease with the term for the source of the reference
rate. Risk-free rates exist for different durations. Therefore, the chosen rate
should be matched with the lease term, as defined by Ind AS 116. The relevant
duration of government bonds to consider is not the total lease term but a
weighted average lease term. While a risk-free rate determined from government
bonds or interest rate yield curves assumes repayment of the capital at
maturity, for an operating lease the repayments are typically spread over the
lease period.

 

Example: Foreign currency leases

Ez Co, an Indian airline company with INR
functional currency, leases aircrafts; the lease payments are specified in USD
and the interest rate implicit in the lease is not readily determinable. For
making the lease payments, Ez has borrowed in USD and taken a forward contract
to hedge against INR / USD exchange fluctuation risks. The USD loan interest
rate is 4% per annum and the hedge cost is 2% per annum. The currency in which
the lease is determined forms part of the economic environment for which the borrowing
rate is assessed. It is the US dollar incremental borrowing rate that has to be
determined. In this case, the IBR is 4% (subject to any further adjustments
required by the Standard) and not 6%.

 

FINANCING SPREAD ADJUSTMENT

For determining the spread, lessees should
use credit spreads from debt with the appropriate term. If the same is not
available, it will have to be estimated. The data available to entities to
determine their financing spread adjustment will depend on the type of company
and their financing structures.

 

Nature of debt financing

Type of entity

Data points available

Multiple debt financing arrangements

Large listed entities

Multiple data points

A bank loan

Small companies

Single data point

No significant debt financing arrangements

Cash surplus company

None

 

For entities with zero debt and / or net
cash balances, consideration should be given to both historical as well as
future debt facilities. The historical position may not be representative of
the current position of the company. It is incorrect to assume that companies
in this situation will have a zero spread, as Ind AS 116 requires the discount
rate to reflect the rate of interest the lessee would have to pay to borrow.
Companies with few data points on their credit spread should seek indicative
pricing from several banks or look to comparable data points available, such as
similar sized companies in a similar industry.

 

Ind AS 116 is very clear that the IBR is
lessee-specific. Therefore, it is important to evaluate what rate the lessee
would achieve on his own even if theoretically all funding would ultimately be
achieved through a group debt structure. Depending on who is the issuer, and
whether there are written guarantees from the group for the lease payments in
place, it may mean that in some cases a group credit spread that is applicable
to all lessees in a group may be more relevant. In determining an IBR, the
overall level of indebtedness of the entity (i.e., leverage) and whether the
value of the lease results in a change to the leverage ratio such that it
warrants a higher IBR, should be considered.

 

LEASE SPECIFIC ADJUSTMENT

The key requirement of Ind AS 116 is that the
IBR is directly linked to the asset itself, rather than being a general IBR. To
an extent, the lease is a secured lending arrangement as the lessor can reclaim
the underlying property. The security of the underlying asset should
potentially reduce the credit spread charged by a lender. If there are no data
points with respect to secured borrowing rates the lessee may consider asking
banks or lenders, or use valuation specialists. While all leases will reflect a
secured borrowing position, in practice certain assets may be more valuable to
a lessor and easier to redeploy. For example, the costs of repossessing an
asset of low value (e.g., a Xerox machine) or low duration relative to its cash
flow would be high. Consequently, the security would be largely irrelevant. On
the other hand, in larger value assets with a longer duration (e.g., office
space), the benefit of having security is more valuable because the lessor will
not be at a significant loss in the event of default by the lessee.

 

PROPERTY YIELDS

In the basis for conclusions of IFRS 16,
property yields are specifically identified as a potential data point for
companies to consider: ‘The IASB noted that, depending on the nature of the
underlying asset and the terms and conditions of the lease, a lessee may be
able to refer to a rate that is readily observable as a starting point when
determining its incremental borrowing rate for a lease (for example, the rate
that a lessee has paid, or would pay, to borrow money to purchase the type of
asset being leased, or the property yield when determining the discount rate to
apply to property leases). Nonetheless, a lessee should adjust such observable
rates as is needed to determine its incremental borrowing rate as defined in
IFRS 16.’

 

The valuation typically is determined by a
multiplier being applied to the rental income to be received, with the
multiplier representing 1/Yield. Using property yield is more suitable to
valuing commercial property where all likely buyers in the market view the
asset as an investment, for example, valuing
commercial properties. Using property yield is less suitable for owner-occupied
property (e.g., residential properties). Property yields are determined by
assessing the yield profile from recent, comparable sales of similar assets
with similar characteristics. The ‘equivalent yield’ reflected by comparable
sales represents the weighted average of current and future rental income,
smoothing out the effect of rent-free periods or vacancy. In determining the
property yield, the risk to be considered includes location, quality of
property, specification, future rental and capital growth prospects, the
tenants’ credit profile and local supply / demand dynamics. For companies
wanting to use property yields to help them determine lease specific
adjustments, the following assumptions are relevant:

 

(i)   The currency of property
lease cash flows is aligned with the currency in which the property is valued;

(ii)   The duration of the property
yield data points available are aligned to the weighted average term of the
lease; and

(iii)  The property yields are
aligned to the characteristics of the property lease being assessed (quality,
sector and location of the property).

 

Practical questions and answers

Query

Ind AS 116 defines the lessee’s incremental
borrowing rate as ‘The rate of interest that a lessee would have to pay to
borrow over a similar term, and with a similar security, the funds necessary to
obtain an asset of a similar value to the right-of-use asset in a similar
economic environment.’ What does ‘similar term’ mean in the context of a lease
with a non-cancellable period followed by one or more optional periods? Does
similar term imply:

 

(a)  A debt for a period equal to the
non-cancellable term?

(b) A debt for a period equal to the maximum term
(including the periods covered by the options to renew)?

(c)  A debt for a period equal to the
non-cancellable term with extension options?

(d) A debt for a period equal to the lease term as
determined in accordance with Ind AS 116 (i.e., taking into account whether or
not it is reasonably certain to exercise the option/s to renew).

 

Response

The discount rate should be consistent with
the cash flows that are to be discounted and since those cash flows take into
account only the rentals over the lease term as determined according to Ind AS
116, (d) is the right answer.

Query

Ind AS 116
defines the lessee’s incremental borrowing rate as ‘The rate of interest that a
lessee would have to pay to borrow over a similar term, and with a similar
security, the funds necessary to obtain an asset of a similar value to the
right-of-use asset in a similar economic environment.’ What does ‘similar
security’ mean in the context of a lease that grants to the lessee the
right-of-use (ROU) for the underlying asset for a period of time? Sometimes,
there could be some guarantees by the parent company or another company in the
group. Can the parent company’s IBR be used?

 

Response

If parent
provides guarantee on the subsidiary’s debt the pricing of the lease would be
more influenced by the credit risk associated with the parent. The rate used by
the subsidiary should reflect the IBR of the parent, unless the subsidiary is
able to obtain financing on a stand-alone basis without the parent or other
related entities guaranteeing the debt. If that is not the case, the parent’s
IBR would be a more appropriate rate to estimate.

 

However,
allowing a subsidiary to look up at the parent’s borrowing rate without looking
at anything else, such as the currency exchange rates, may not be appropriate.
Even with a guarantee from the parent company, there are other factors that
could influence the pricing (and the implicit rate) offered by the lessor (such
as tax and other local regulations for example). The lessee should always look
at its own borrowing rate and take into account the impact of any guarantees
provided by the parent company to the lessor. This could be done by soliciting
quotes from local lenders for similar conditions and guarantees. Corporate
borrowing rates may be used as a starting point. However, appropriate
adjustments are usually necessary to take into account specific facts and
circumstances of the lease. The inter-company rate on loans from the parent to
the subsidiary generally should not be used as the lessee’s incremental
borrowing rate.

 

Query

Ind AS 116
defines the lessee’s incremental borrowing rate as ‘The rate of interest that a
lessee would have to pay to borrow over a similar term, and with a similar
security, the funds necessary to obtain an asset of a similar value to the
right-of-use asset in a similar economic environment.’ What does ‘similar
value’ mean?

 

Response

The
right-of-use (ROU) asset rather than the underlying asset shall be considered
as a security with similar value. The value of the ROU
asset does not include payments that are not lease payments (e.g., variable
payments not based on an index or rate). Similarly, the lease payments relating
to optional periods that are not included in the lease term should also be
excluded.

 

Query

A company is able to estimate the IBR at
which it would borrow to buy a truck (10 years’ useful life) or property.
Whether the same IBR can be applied if the asset is not the truck but rather a
5-year right of use (ROU) or the asset is not property but an ROU of the
property, or say only two floors of a building are leased?

 

Response

Whilst there is a practical difficulty in
determining the IBR in the case of an ROU, it is necessary to do so and it will
not be the same as the IBR of the truck or the property.

 

A lessee should start with the rate it would
incur to purchase the underlying asset, but that rate would require adjustment
to reflect ‘an asset of similar value to the ROU asset’. Adjustments may be
both negative and positive depending on the type of asset and risks associated
with the residual value of the asset.  

 

DEMERGER TRANSACTION UNDER Ind AS

QUERY

  •      A has control over its100%
    subsidiary B.
  •      There are 5 investors
    (shareholders – X, X1, X2, X3 and X4) in A. No investor controls or jointly
    controls or has significant influence on A.
  •      A, B and all the investors in
    A follow Ind AS. All the investors measure their investment in A at FVTPL. A’s
    accounting policy is to measure investments in subsidiary and associates at
    cost in separate financial statements.
  •      Due to certain regulatory
    issues, A should not be controlling B.
  •      Consequently, B issues its
    shares to the investors in A without any consideration, which will reduce A’s
    shareholding in B to 40%. Accordingly, B becomes A’s associate.
  •      The number of shares which A
    held in B, pre and post the transaction has not changed, as shares have been
    distributed by B directly to the shareholders of A. However, A’s holding in B
    is reduced to 40%.
  •      Investor X, one of the 5
    investors, is holding 100 shares in A at fair value of INR 200. Investor X
    continues to hold 100 shares and has received shares of B for no consideration.
  •      All investors are treated
    equal in proportion to their shareholding.
  •      The decision to undertake the
    above transaction had the unanimous approval of the board of directors of B.

 

Pre- and post-restructuring shareholding pattern is depicted in the
diagram below:

How shall A, B and investor X account for this transaction in their Ind
AS separate financial statement (SFS)?

RESPONSE

Accounting
in SFS of investor X

View 1 – There is no change in X’s situation except that now X is directly
holding in B instead of through A. Consequently, X will simply split the fair
value of its holding in A into A’s share and B’s share on relative fair value
basis. Under this view, there is no P&L impact.

 

To support
this view, one may draw an analogy from ITFG 20 issue 4. In that fact pattern,
there is transfer of a business division from an associate to fellow associate.
ITFG concluded that there is no ‘exchange’ of investments. Investor continues
to hold the same number and proportion of equity shares in A Limited
(Transferor associate) after the demerger as it did before the demerger.
Therefore, applying this principle, the ‘cost’ of the new shares received in B
is represented by the amount derecognised by X Limited in respect of its
investment in A Limited. The accounting is presented below, with assumed
figures. However, one should be mindful that in ITFG’s case, investment is
carried at cost, whereas in the given case these investments are carried at
fair value. Consequently, if the fair value of shares in A pre-transaction is
less than the aggregate fair value of shares in A and B post-transaction, this
accounting may result in subsequent gains to investor X, which needs to be
recognised in the P&L.

 

In X’s SFS

Particulars

Dr. (INR)

Cr. (INR)

Investment in A (relative fair value)

Investment in B (relative fair value)

To investment in A (pre-receipt of B’s share)

80

120

 

 

200

 

 

View 2 – X is having investment in financial instrument, which are carried at
FVTPL. Post the transaction, X shall fair value its investment in A and B; if
there is any gain due to unlocking of value or other factors, gain should be
recognised in P&L immediately.

In X’s SFS

Particulars

Dr. (INR)

Cr. (INR)

Investment in B(@ fair value)      Dr

To Investment in A (change in fair value)

To gain on exchange – P&L (if any)

140

 

110

30

 

 

Note: Fair value of
investment in B and change in fair value of investment in A are hypothetical
and for illustrative purposes only. The gain of INR 30 reflects unlocking of
value in the hands of investors.

 

Accounting
in the SFS of A

View 1 – The number of shares which A held in B pre and post the transaction
has not changed. As the cost of investment for holding the same number of
shares has not changed and A has not received or distributed any shares, the
investments will continue to be recorded at the same cost, even though the
investment is now an associate. However, A will test the investment for
impairment as per Ind AS 36 and record the impairment charge to P&L, if
any. Analogy can be drawn from transactions wherein subsidiary issues shares to
outside unrelated shareholders and thereby the parent loses control and that investment
becomes as associate. In such a case, the common practice in SFS of parent is
that the investment continues to be recorded at cost (subject to impairment).

 

  •    Additionally, at the ultimate
    shareholders level per se nothing has changed. Therefore, it cannot be
    inferred that any dividend has been distributed to the shareholders by A. The
    decision is taken by the ultimate shareholders, and A does nothing substantial.
    At best, A is merely a pass through; that, too, indirectly rather than
    directly. Consequently, A is neither receiving any dividends nor distributing
    any dividends. However, due to the dilution, its investment in B will be tested
    for impairment.

 

  •    To support View 1, there can be
    multiple ways of looking at this transaction:

•   A is giving up the value of its
underlying investment in subsidiary B to its shareholders. A has not declared
and is not obliged to distribute any dividends (hence Ind AS 10 Appendix A Distribution
of Non-cash Assets to Owners does not apply). Neither is there a demerger
from A’s perspective. Consequently, A’s Investment in B will be credited at
fair value, book value, or brought to its post impaired value, with the
corresponding impact taken to equity.

•   This is merely a restructuring
arrangement where the subsidiary is now split between A and the ultimate
shareholders. There are no dividends received or paid. The decision of
splitting the shares is taken by ultimate shareholders, rather than A. A does
nothing. Consequently, A’s investment in B will be only tested for impairment.

 

In View 1, there is no credit to the P&L in the SFS of A.

 

View 2 – A
has not declared and is not obliged to distribute any dividends, but there is
an indirect distribution by A to its shareholders. In the absence of any
specific guidance to this unique fact pattern, and based on Ind AS 8
Paragraph10, A may draw analogy from Appendix A to Ind AS 10. Accordingly,
applying the guidance on distribution of non-cash assets to the owners, A shall
create a dividend payable liability out of its reserves, and then record the
distribution of non-cash asset (indirect receipt of shares of B) in its books
at fair value of the assets distributed, and the difference between dividend
payable (at fair value) and the investment in B (at proportionate cost of
deemed dilution) would be recorded as a gain in the P&L.

In SFS of A

Particulars

Dr. (INR)

Cr. (INR)

On creation of dividend
payable
liability at fair value

Equity Dr

To Dividend Payable

 

 

1000

 

 

 

1000

On distribution of dividend

Dividend payable (@ fair
value)

To Investment in B

(@Proportionate Cost)

To P&L (Gain) [Balancing
figure]

 

1000

 

 

900

 

100

 

Note: Fair value of dividend
payable and proportionate value of investment in B are hypothetical and for
illustrative purposes only.

 

Accounting
in the SFS of B

From B’s perspective, additional shares are being issued to ultimate
shareholders for which no consideration is received. Consequently, B will
credit share capital and debit equity. Essentially, the debit and credit is
reflected within the equity caption and there is no P&L impact.

 

CONCLUSION

Had A
directly distributed its investment in B to its shareholders, so that its
shareholding in B is reduced to 40%, the application of Ind AS 10 Appendix A
would result in View 2 only, from the perspective of SFS of A. However, in the
absence of any specific guidance under Ind AS with respect to SFS, the author
believes that different views have emerged. Moreover, it is unfair that a
restructuring transaction to comply with regulations should result in a P&L
gain. The ITFG may provide necessary clarifications.  

 

UNINSTALLED MATERIALS AND IMPACT ON REVENUE RECOGNITION

BACKGROUND


Contract Co (CoCo) enters
into a contract with a customer to refurbish a 40-storey building and install
new lifts for a total consideration of INR 1,62,000. The promised refurbishment
service, including the installation of the lifts, is a single performance
obligation satisfied over time. The refurbishment will be performed over a three-year
period. The total revenue is expected to be as follows:

 

TOTAL EXPECTED REVENUE

 

 

INR

Transaction
price

1,62,000

Expected
costs

 

Lifts

81,000

Other
costs

54,000

Total
expected costs

1,35,000

Expected
gross margin

27,000

 

 

The contract costs incurred
over the three-year period are as follows:

 

CONTRACT COSTS OVER  THREE YEARS

           

 

Year 1

Year 2

Year 3

Total

 

INR

INR

INR

INR

Other
costs incurred

18,000

18,000

18,000

54,000

Cost
of lifts delivered to site but not yet installed at year-end

81,000

–

–

81,000

Total
costs incurred

99,000

18,000

18,000

1,35,000

 

At the end of Year 1,
included in the total costs of INR 99,000 are the costs incurred to purchase
the lifts worth INR 81,000. These lifts had been delivered at the site at the
end of Year 1 but had not yet been installed. The lifts were procured from a third-party
supplier and CoCo was not involved in either the designing or the manufacture
of the lifts. These lifts were installed at the end of Year 2. CoCo recognises
revenue over time, applying an input method based on costs incurred. Assume
that in arriving at the agreed transaction price, CoCo had applied the
following mark-up to its costs:

 

COST MARK-UP BY THE COMPANY

 

 

Cost

Mark-up

Transaction

Price

Gross Margin

 

INR

INR

INR

%

Cost
of lifts

81,000

7,200

88,200

8.2

Other
costs

54,000

19,800

73,800

26.8

Total

1,35,000

27,000

1,62,000

16.7

 

 

CoCo has determined that it
acts as a principal in accordance with Ind AS 115.B34-B38, because it obtains
control of the lifts before they are transferred to the customer.

 

QUERY 1

CoCo uses an input method
based on costs incurred. How should it determine the amount of revenue, profit
and gross margin to be recognised in its financial statements for Year 1, Year
2 and Year 3?

 

YEAR 1

The general principle of
over time revenue recognition in Ind AS 115 is that the pattern of revenue
recognition should reflect the entity’s performance in transferring control of
goods and services to the customer (see Ind AS 115.39). Paragraph B19 of Ind AS
115 notes that when an input method is used, an entity should exclude the
effects of any inputs that do not reflect the entity’s performance to date. It
specifically requires that revenue is only recognised to the extent of costs
incurred if:

 

(a) the goods are not
distinct; (b) the customer is expected to obtain control of the goods
significantly before receiving services relating to the goods; (c) the cost of
the transferred goods is significant relative to the total expected costs to
completely satisfy the performance obligation; and (d) the entity procures the
goods from a third party and is not significantly involved in designing and
manufacturing the same (but the entity is acting as a principal in accordance
with paragraphs B34-B38).

 

Therefore, CoCo excludes
the cost of the lifts from the cost-to-cost calculation in Year 1 because the
cost of the lifts is not proportionate to CoCo’s measure of progress towards
performing the refurbishment. Paragraph B19 is met because:

 

(i) The
lifts are not distinct. The refurbishment and installation of the lifts represents
one single performance obligation;

(ii) The
customer obtains control of the lifts when they arrive on its premises at the
end of Year 1, but installation of the lifts is only performed at the end of
Year 2;

(iii) The
costs of the lifts are significant relative to the total expected costs of the
refurbishment; and

(iv) The
lifts were procured from a third party and CoCo is not involved in designing or
manufacturing the lifts.

 

CoCo
therefore adjusts the measure of its progress towards completion and excludes
the uninstalled lifts from the costs incurred when determining the entity’s
performance to date:

 

 

DETERMINING THE ENTITY’S PERFORMANCE

       

 

INR

Total costs incurred to date:

99,000

Less: uninstalled lifts

(81,000)

 

18,000

 

CoCo then
calculates the percentage of performance completed to date:

 

INR 18,000
other costs (excluding lifts) / INR 54,000 total other costs (excluding lifts)
= 33.33% complete. CoCo recognises revenue to the extent of the adjusted costs
incurred and does not recognise a profit margin for the uninstalled lifts:

PROFIT MARGIN RECOGNISED

 

 

Year 1

 

INR

Total transaction price

1,62,000

Less: Cost of lifts

(81,000)

Adjusted revenue (excluding lifts)

81,000

% of performance completed to date

33%

Revenue for the period (excluding lifts)

27,000

Revenue recognised for cost of lifts

81,000

Total revenue for the period

1,08,000

Less: Costs for the period

(99,000)

Profit for the period

9,000

Profit margin (profit / total revenue)

8.33%

 

The above
accounting is clearly in accordance with Ind AS 115 and there are no
interpretation issues. However, the accounting in the following years is not
clear under Ind AS 115, which is the subject of this discussion.

 

YEARS 2 & 3

At the end
of Year 2 the lifts have been installed and an additional INR 18,000 of costs
has been incurred. Ind AS 115 does not contain specific guidance on the
accounting for the previously uninstalled materials that have now been
installed. Possible approaches for the accounting in the remaining years are:

 

View 1
– Continue to exclude the cost of the lifts from the cost-to-cost calculation
in the remaining periods of the contract;

View 2 –
Include the cost of the lifts in the cost-to-cost calculation once the lifts
have been installed and use a contract-wide profit margin;

View 3
– The cost-to-cost calculation would continue to exclude the cost of the lifts;
however, once the lifts have been installed, an applicable profit margin on the
lifts would be recognised as revenue;

View 4 – Since Ind  AS 115 is not specific in its requirements,
Views 1, 2 or 3 might be acceptable depending on the facts and circumstances.
It is necessary to consider whether the approach selected meets the overall
principle in Ind AS 115.39 that the amount of revenue should ‘depict an
entity’s performance in transferring control of goods or services promised to a
customer’. This principle once selected should be applied consistently.

 

View 1
– Continue to exclude the cost of the lifts from the cost-to-cost calculation
in the remaining periods of the contract;

Under this
approach, no profit margin would be recognised for the installed lift. The
profit margin derived from the lifts is instead shifted to the other services
in the contract as costs for those services are incurred.

 

COSTS INCURRED TO DATE

 

 

Year 1

Year 2

Year 3

 

INR

INR

INR

Total costs incurred to date

99,000

1,17,000

1,35,000

Less: Cost of lifts delivered but not installed at end of Year 1

(81,000)

(81,000)

(81,000)

Adjusted costs incurred to date (excl. lifts)

18,000

36,000

54,000

% of performance completed to date

33%

67%

100%

Revenue recognised to date (excl. lifts)

27,000

54,000

81,000

Revenue recognised for cost of lifts

81,000

81,000

81,000

Cumulative revenue recognised to date

1,08,000

1,35,000

1,62,000

 

 

REVENUE FOR THREE YEARS

 

 

Year 1

Year 2

Year 3

Total

 

INR

INR

INR

INR

Revenue for the period (excluding lifts)

27,000

27,000

27,000

81,000

Add: Revenue for cost of lifts

81,000

 

 

81,000

Revenue for the period

1,08,000

27,000

27,000

1,62,000

Less: Costs for the period

(99,000)

(18,000)

(18,000)

(1,35,000)

Profit for the period

9,000

9,000

9,000

27,000

Profit margin

8%

33%

33%

17%

 

Arguments for View 1:

 

Under B19(b)
only one accounting treatment applies to goods that meet the conditions set out
in B19(b). B19(b) does not distinguish goods that have been installed from
those that have not yet been installed. As per para B19(b), a faithful
depiction of an entity’s performance might be to recognise revenue at an amount
equal to the cost of goods used to satisfy a performance obligation if the
entity expects at contract inception that certain conditions are met.

The Basis
for Conclusions to IFRS 15 notes that the aim of the adjustment is to reflect
the same profit or loss and margin as if the customer had supplied those goods
themselves for the entity to install or use in the construction activity.
Paragraph BC172 of IFRS 15 notes: For goods that meet the conditions in paragraph
B19(b) of IFRS 15, recognising revenue to the extent of the costs of those
goods ensures that the depiction of the entity’s profit (or margin) in the
contract is similar to the profit (or margin) that the entity would recognise
if the customer had supplied those goods themselves for the entity to install
or use in the construction activity [IFRS 15.BC172]. If the customer had
supplied the lifts itself, then CoCo would not have recognised any profit or
margin on the lifts.

 

Per
paragraph IE98 from Illustrative Example 19, the adjustment to cost-to-cost can
be read to be applied throughout the entire life of the contract, in
accordance with paragraph B19 of Ind AS 115, the entity adjusts its measure of
progress to exclude the costs to procure the elevators from the measure of
costs incurred and from the transaction price. The entity recognises
revenue for the transfer of the elevators in an amount equal to the costs to
procure the elevators (i.e., at a zero margin).

 

Arguments against View 1:

 

View 1 does not reflect the
reality of the transaction as an entity would typically charge a margin for
procurement (the extent of the margin would likely depend on whether the item
is generic or of a specialised nature – a higher margin is likely to be applied
for items that are specialised in nature or that are harder to source), and
would not recognise a profit margin on the item when it is installed. Rather,
the margin is being shifted to the other services in the contract as costs for those
services are incurred. However, such margins may not be material when the
entity is procuring a generic item and is not involved in its design.

 

View 1 would
result in a different cumulative amount of revenue being recognised using the
same input method at the end of Year 2 when there has been a significant delay
between delivery and installation compared to when there is no delay – even
though the same amount of work has been performed at the end of Year 2. This is
because B19(b)(ii) would not be met because the customer does not obtain
control of the goods significantly before receiving the services.

 

View 2
– Include the cost of the lifts in the cost-to-cost calculation once the lifts
have been installed.

Under this approach, once the lifts have been installed, the cost of the
lifts would be included in cost-to-cost calculations.

 

COST-TO COST CALCULATIONS

 

 

Year 1

Year 2

Year 3

 

INR

INR

INR

Total costs incurred to date

99,000

1,17,000

1,35,000

Less: cost of lifts delivered but not yet installed

(81,000)

N/A

N/A

Costs incurred to date

18,000

1,17,000

1,35,000

% of POCM to date (rounded off)

33%

87%

100%

Revenue recognised to date

27,000

1,40,400

1,62,000

Revenue recognised for cost of lifts

81,000

N/A

N/A

Cumulative revenue recognised to date

1,08,000

1,40,400

1,62,000

                       

 

Year 1

Year 2

Year 3

Total

 

INR

INR

INR

INR

Revenue for the period

27,000

32,400

21,600

81,000

Add: Revenue for costs of lifts

81,000

N/A

N/A

81,000

Revenue for the period

1,08,000

32,400

21,600

1,62,000

Less: Costs for the period

(99,000)

(18,000)

(18,000)

(1,35,000)

Profit for the period

9,000

14,400

3,600

27,000

Profit margin

8%

44%

17%

17%

 

Arguments for View 2:

The
guidance in Illustrative Example 19 and the Basis for Conclusions to IFRS 15
focuses on the situation before the goods are installed, so the adjustment to
the cost-to-cost calculation only applies on goods that have been delivered but
not yet installed.

 

The
relevant extracts from the section for ‘Uninstalled materials’ in the Basis for
Conclusions are as follows:

 

BC171 of IFRS 15 states: The boards observed that if a customer
obtains control of the goods before they are installed by an entity… The boards
noted that recognising a contract-wide profit margin before the goods are
installed could overstate the measure of the entity’s performance and,
therefore, revenue would be overstated… [emphasis added].

BC172: The
boards noted that the adjustment to the cost-to-cost measure of progress for
uninstalled materials… (emphasis added).

 

BC174: …Although
the outcome of applying paragraph B19(b) of 1FRS 15 is that some goods or
services that are part of a single performance obligation attract a margin, while any uninstalled materials attract only a zero margin…

 

Arguments against View 2

When the
profit margin applicable to the procured item(s) is significantly different
from the profit margin attributable to other goods and services to be provided
in accordance with the contract, the application of a contract-wide profit
margin will overstate the amount of revenue and profit that is attributed to
the procured item(s). This is not consistent with the underlying principle in
Ind AS 115.39, which is that the amount of revenue recognised should ‘depict an
entity’s performance in transferring control of goods or services promised to a
customer’ (i.e., the satisfaction of an entity’s performance obligation).

 

As noted
in the analysis for Year 1 above, Ind AS 115.B19(b) includes guidance for
uninstalled material at the point at which control has passed to the customer.
This guidance is noted as being an example of ‘faithful depiction’ of an
entity’s performance. Consequently, when there are significantly different
profit margins attributable to procured item(s), it is necessary to adjust the
amount of revenue that is attributable to those procured item(s).

 

View 3
– Once the lifts have been installed, an applicable profit margin is recognised
for the lifts separately from the rest of the project:

 

APPLICABLE PROFIT MARGIN

       

 

Year 1

Year 2

Year 3

 

INR

INR

INR

Total costs incurred to date

99,000

1,17,000

1,35,000

Less: cost of lifts delivered but not yet installed

(81,000)

(81,000)

(81,000)

Adjusted costs incurred to date (excl. lifts)

18,000

36,000

54,000

% of performance completed to date

33%

67%

100%

Revenue recognised to date (excl. lifts)

24,600

49,200

73,800

Revenue recognised for lifts (mark-up included in Years 2 &
3)

81,000

88,200

88,200

Cumulative revenue recognised to date

1,05,600

1,37,400

1,62,000

 

       

 

Year 1

Year 2

Year 3

Total

 

INR

INR

INR

INR

Revenue for the period (excl. lifts)

24,600

24,600

24,600

73,800

Add: Revenue for lifts

81,000

7,200

0

88,200

Revenue for the period

1,05,600

31,800

24,600

1,62,000

Less: Costs for the period

(99,000)

(18,000)

(18,000)

(1,35,000)

Profit for the period

6,600

13,800

6,600

27,000

Profit margin

6%

43%

27%

17%

 

Arguments for View 3:

Same
arguments as for View 2, but it also addresses the downside of View 2 of
overstating profit margin once the materials are installed. Proponents of View
3 argue that this would most faithfully depict the economics of the transaction.

 

Arguments against View 3:

Mark-ups /
profit margins could be subject to management manipulation.

 

The
approach seems to have been considered but rejected by the boards as noted in
paragraph BC171 of IFRS 15. Alternatively, requiring an entity to estimate a
profit margin that is different from the contract-wide profit margin could be
complex and could effectively create a performance obligation for goods that
are not distinct (thus bypassing the requirements for identifying performance
obligations) [IFRS 15.BC171].

 

QUERY 2 –
assuming either View 2 or View 3 is followed for Question 1:

 

Where the
profit margins attributable to different components of a contract that is
accounted for as a single performance obligation are significantly different,
is it appropriate to use an input method as a measure of progress?

 

View 1

Yes. Although
different profit margins might arise from different parts of a contract, the
fact that the seller has a single performance obligation means that Ind AS 115
does not require those different components to be separately identified.
Proponents of this view note that IFRS 15.BC171 would appear to support this
approach: ‘Alternatively, requiring an entity to estimate a profit margin that
is different from the contract-wide profit margin could be complex and could
effectively create a performance obligation for goods that are not distinct
(thus bypassing the requirements for identifying performance obligations).’ It
is also noted that Example 19, which has different components that would
typically be expected to have different profit margins, is based on the vendor
using an input method to measure progress towards contract completion.

 

View 2

No. Ind AS
115.39 includes the objective that is required to be followed when measuring
progress where a performance obligation is satisfied over time, which is: ‘…The
objective when measuring progress is to depict an entity’s performance in
transferring control of goods or services promised to a customer (i.e., the
satisfaction of an entity’s performance obligation.’ Proponents of View 2
consider that, in the fact pattern set out above, the use of an input method,
with a single overall profit margin being allocated to costs incurred, would
result in an overstatement of performance for the transfer of the lifts and an
understatement of performance for the transfer of other services.

 

Supporters of View 2 also question whether the lifts are in fact part of
a single performance obligation. If the seller can procure the lifts
separately, then the customer could also procure the lifts, meaning that the
procurement of the lifts could be viewed as being a separate performance
obligation.

 

This
conclusion would also appear to be supported by IFRS 15.BC172, in that: ‘…For
goods that meet the conditions in paragraph B19(b) of IFRS15, recognising
revenue to the extent of the costs of those goods ensures that the depiction of
the entity’s profit (or margin) in the contract is similar to the profit (or
margin) that the entity would recognise if the customer had supplied those
goods themselves for the entity to install or use in the construction
activity.’

 

View 3

Ind AS115 is not specific in its requirements. Consequently, either View
1 or View 2 are acceptable as an accounting policy choice, to be applied
consistently to similar transactions.

 

AUTHOR’S VIEW AND
CONCLUSION

On Question
1,View 1 and View 2 are the two acceptable views, though on balance View 1 is
more preferred. View 3 and View 4 are not acceptable. View 1 practically makes
sense because it sticks with one approach throughout the period. This approach
is also consistent with Ind AS 115.B19 and meets the spirit of the requirement
in the Standard. View 2 may be accepted because Ind AS 115.B19 only applies to
uninstalled materials and once they are installed, then an entity goes back to
the general model for measuring progress.

 

On the
second question, View 1 is more appropriate. There is generally a better
alignment in margin using the input method, but not a guarantee of having a
consistent margin throughout in all cases.

 

The key
question is whether the use of the input method would be a faithful depiction
of the entity’s performance – and the response is in the affirmative. In any case, the standard
does not provide an option of applying input method, using different margins
for different components.  

 

DETERMINING THE LEASE TERM FOR CANCELLABLE LEASES

FACT PATTERN


A lease contract of a
retail outlet in a shopping mall allows for the lease to continue until either
party gives notice to terminate the contract. The contract will continue
indefinitely until the lessee or the lessor elects to terminate it and includes
stated consideration required during any renewed periods (referred to as
“cancellable leases” in the rest of the document). Neither the lessor nor the
lessee will incur any contractual cash payment or penalty upon exercising the
termination right. The lessee constructs leasehold improvements, which cannot
be moved to another premise. Upon termination of the lease, these leasehold
improvements will need to be abandoned, or dismantled if the lessor so
requests.

 

QUESTION


Can the lease term go
beyond the date at which both parties can terminate the lease (inclusive of any notice period)?

 

TECHNICAL DISCUSSION


View 1:
No. The lease term cannot go beyond the date where the lessee can enforce a
right to use the underlying asset, i.e. the end of the notice period. The
existence of economic penalties (eg; cost of shifting) does not create
enforceable rights and obligations.

The definition of “lease
term” in Ind AS 116 refers to lessee’s rights and reads as follows:

 

The
non-cancellable period for which a lessee has the right to use an underlying
asset, together with both:

 

a)  Periods covered by an option to extend the
lease if the lessee is reasonably certain to exercise that option; and

b)  Periods covered by an option to
terminate the lease if the lessee is reasonably certain not to exercise that
option.

 

B34 of Ind AS 116 contains
further guidance and states:

 

In
determining the lease term and assessing the length of the non-cancellable
period of a lease, an entity shall apply the definition of a contract and
determine the period for which the contract is enforceable. A lease is no
longer enforceable when the lessee and the lessor each has the right to
terminate the lease without permission from the other party with no more than
an insignificant penalty.

 

Appendix A of Ind AS 116
clarifies that the word “contract” is defined in other standards and
used in Ind AS 116 with the same meaning, i.e. “an agreement between two or
more parties that creates enforceable rights and obligations”.

 

For example, paragraphs 10
and 11 of Ind AS 115 include the following more detailed guidance about “contracts”:

 

10. A contract is an
agreement between two or more parties that creates enforceable rights and
obligations. Enforceability of the rights and obligations in a contract is a
matter of law. Contracts can be written, oral or implied by an entity’s
customary business practices. The practices and processes for establishing
contracts with customers vary across legal jurisdictions, industries and
entities. In addition, they may vary within an entity (for example, they may
depend on the class of customer or the nature of the promised goods or
services). An entity shall consider those practices and processes in
determining whether and when an agreement with a customer creates enforceable
rights and obligations.

 

11. Some
contracts with customers may have no fixed duration and can be terminated or
modified by either party at any time. Other contracts may automatically renew
on a periodic basis that is specified in the contract. An entity shall apply
this Standard to the duration of the contract (ie the contractual period) in
which the parties to the contract have present enforceable rights and
obligations.

 

Both B34 and the definition
of a contract in Appendix A of Ind AS 116 is cross-referenced to BC127 in the
Basis of Conclusions of IFRS 16, specifically deals with “cancellable leases”
as follows:

 

Cancellable
leases

For the
purposes of defining the scope of IFRS 16, the IASB decided that a contract
would be considered to exist only when it creates rights and obligations that
are enforceable. Any non-cancellable period or
notice period in a lease would meet the definition of a contract and, thus,
would be included as part of the lease term. To be part of a contract, any
options to extend or terminate the lease that are included in the lease term
must also be enforceable; for example the lessee must be able to enforce its
right to extend the lease beyond the non-cancellable period. If optional
periods are not enforceable, for example, if the lessee cannot enforce the
extension of the lease without the agreement of the lessor, the lessee does not
have the right to use the asset beyond the non-cancellable period.
Consequently, by definition, there is no contract beyond the non-cancellable
period (plus any notice period) if there are no enforceable rights and
obligations existing between the lessee and lessor beyond that term. In
assessing the enforceability of a contract, an entity should consider whether
the lessor can refuse to agree to a request from the lessee to extend the
lease.

 

This conclusion is entirely
consistent with a “right-of-use model” based on recognising and measuring the
rights that the lessee controls and has had transferred to it by the lessor.
Including a renewal which the lessee cannot enforce without the agreement of
the lessor would unduly recognise in the right of use optional periods that do
not meet the definition of an asset. Even if the lessee has a significant economic
incentive to continue the lease, this does not turn a period subject to the
lessor’s approval into an asset because the lessee does not control the
lessor’s decision, unless the lessor’s termination right lacks substance. This
is a very high hurdle, which would be expected to be extremely rare and require
objective evidence.

 

View 2:
Yes, the lease term go beyond the date at which both parties can terminate the
lease.

 

Supporters of view 2
believe that an entity should evaluate the relevant guidance in the standard.
In considering the guidance in the standard, View 1 believes Ind AS 116 is
clear the lease term cannot be longer than the period in which the contract is
enforceable. However, Ind AS 116 is equally clear that a contract is
enforceable until both parties could terminate the contract with no more than
an insignificant penalty – which may be a period beyond the termination notice
period.

 

In the fact pattern above,
while the lease can be terminated early by either party after serving the
notice period, the enforceable rights in the contract (including the pricing
and terms and conditions) contemplate the contract can continue beyond the
stated termination date, inclusive of the notice period. In the fact pattern
above, there is an agreement which meets the definition of a contract (i.e., an
agreement between two or more parties that create enforceable rights and
obligations). However, the mere existence of mutual termination options does
not mean that the contract is automatically unenforceable at a point in time
when a potential termination could take effect.

 

Ind AS 116.B34 provides
explicit guidance on when a contract is no longer enforceable:

 

“A lease
is no longer enforceable when the lessee and the lessor each has the right to
terminate the lease without permission from the other party with no more than
an insignificant penalty.”

 

Therefore, when either
party has the right to terminate the contract with no more than insignificant
penalty there is no longer an enforceable contract. However, when one or both
parties would incur a more than insignificant penalty by exercising its right
to terminate – the contract continues to be enforceable. The penalties should
be interpreted broadly to include more than simply cash payments in the
contract. The wider interpretation considers economic disincentives.

 

While the IFRS16.BC127 does
not discuss the notion of “no more than insignificant penalty”, supporters of
View 2 believe that Ind AS116.B34 should be evaluated based on the wording in
the standard (i.e., taking into account the economic disincentives for the
parties). To the extent that the lessee has a more than insignificant economic
disincentives (e.g., significant leasehold investments) to early terminate the
lease, the 2nd sentence in B34 will not be applicable. However, on
the other hand, if one or both parties have only insignificant economic
disincentives to terminate, say, after five years, the lease is not considered
enforceable after five years and hence the lease term cannot exceed five years.
Ind AS116.B34 does not directly provide guidance as to how long the lease term
should be. Rather, it provides guidance as to when a contract is no longer
enforceable and thus no longer exists.

 

While Ind AS 116.B34 and
B35 provide guidance on evaluating the period in which a contract continues to
be enforceable and how to evaluate lessee and lessor termination options, they
do not address how to evaluate the lease term once the enforceable period of
the contract has been determined (i.e., at least until both parties no longer
have a more than insignificant penalty if they were to terminate the contract).
To determine the lease term, the parties would apply Ind AS 116.18-19 and
B37-40 (i.e., the reasonably certain threshold). “Reasonably certain” is a high
threshold and the assessment requires judgement. It also acknowledges the
guidance in Ind AS 116.B35 which indicates lessor termination options are
generally disregarded (“If only a lessor has the right to terminate a lease,
the non-cancellable period of the lease includes the period covered by the
option to terminate the lease.”)

Thus, in this fact pattern
above, it is possible that the lease term may exceed the notice period. The
lease term is the non-cancellable (notice) period together with the period
covered by the termination option that it is reasonably certain the lessee will
not exercise such termination option.

 

However, the lease term
cannot be no longer than the period the contract is enforceable (i.e., the
point in time in which either party may terminate the lease without permission
from the other with no more than an insignificant economic disincentive,
inclusive of any notice period). 

 

If the facts were different
and the contract had an end date but contemplates the lease might be extended
if both the lessee and lessor agree to new terms and conditions (including new
pricing) there may be no enforceable contract but rather an invitation to enter
into new negotiations.

 

In light of the compelling
arguments in both views, the author recommends that the Ind AS Transition
Facilitation Group (ITFG) should address this issue in consultation with the
IASB staff or IFRIC.

 

 

 

IMPACT OF ORDINANCE DATED 20th SEPTEMBER, 2019

The tax ordinance of
September, 2019 has made significant changes in the income-tax provisions and
the income-tax rates.

 

Prior to
this, existing domestic companies were liable to tax at the basic rate of
either 25% or 30%. The effective tax rate ranged from 26% to 34.94% after
considering surcharge of 7% / 12% and health and education cess of 4%.

 

The tax rate of 25% was
applicable to two types of domestic companies, viz., (a) those having turnover
or gross receipts not exceeding Rs. 400 crores in tax year 2017-18; and (b) new
domestic manufacturing companies set up and registered on or after 1st
March, 2016 fulfilling specified conditions.

 

With
effect from the tax year 2019-20, domestic companies shall have an option to
pay income tax at the rate of 22% plus 10% surcharge and 4% cess, taking the
effective tax rate (ETR) to 25.17%, subject to the condition that they will not
avail specified tax exemptions or incentives under the ITA. Such an option,
once exercised, cannot be subsequently withdrawn. Companies exercising such option will not be required to pay Minimum Alternate Tax (MAT).

 

Domestic companies claiming
any tax exemptions or incentives shall also be eligible to exercise such an
option after the expiry of the tax incentive period.

 

Subsequently, the CBDT has
clarified that domestic companies opting for the 22% concessional tax rate
(CTR) will not be allowed to set off the following while computing the total
income and their tax liability:

 

(i) Brought forward ‘losses’
on account of additional depreciation arising in any tax year prior to opting
for the 22% CTR;

(ii) Brought forward credit of
taxes paid under MAT provisions of the Indian Tax Law (ITL) in any tax years
prior to opting for the 22% CTR in view of inapplicability of MAT provisions to
a domestic company which opts for the 22% CTR.

 

Further, the CBDT clarified
that in the absence of any time-line for exercising of option to claim 22% CTR,
the domestic company, if it so desires may opt for the 22% CTR after it has
exhausted the accumulated MAT credit and unabsorbed additional depreciation by
being governed by the regular taxation regime existing under the ITL prior to
the ordinance.

 

The comparative effective tax
rates before and after exercise of the option are as follows:

 

Sr

Nature of domestic
company

Current ETR (%)

ETR on Exercise of
Option (%)

Reduction in tax
liability

1

Total
turnover or gross receipts = INR4b during FY 2017-18 or new manufacturing
companies incorporated between 1st March, 2016 and 30th
September, 2019

 

• Income < INR
10m

• Income > INR
10m, but < INR 100m

• Income > INR
100m

26%

27.82%

29.12%

25.17%

25.17%

25.17%

0.83%

2.65%

3.95%

2

Optional
tax rate for new manufacturing companies incorporated on or after
1st October, 2019

 

• Income < INR
10m

• Income > INR
10m, but < INR 100m

• Income > INR
100m

26%

27.82%

29.12%

17.16%

17.16%

17.16%

8.84%

10.66%

11.96%

3

Other
domestic companies

 

 

• Income < INR
10m

• Income > INR
10m, but < INR 100m

• Income > INR
100m

31.2%

33.38%

34.94%

25.17%

25.17%

25.17%

6.03%

8.21%

9.77%

 

There are numerous tax issues
relating to the recent ordinance. From an accounting perspective, it converges
to a few important questions. These are discussed below and are equally
applicable to AS (Indian GAAP) as well as Ind AS.

 

Question

Does the ordinance have any
effect on the 31st March, 2019 financial statements (which were yet
to be issued at the time the ordinance was announced)?

 

Response

The ordinance was not an
enactment / substantive enactment at the balance sheet date, i.e. 31st
March, 2019. Consequently, the tax charge and deferred taxes are based on the
pre-ordinance rates / income tax provisions. However, it is a subsequent event
which needs the disclosure below in the notes to accounts. This disclosure may
need suitable modification to the fact pattern. For example, the impact
quantification may not be appropriate / required where the impact cannot be
estimated with reasonable certainty or is not material.

 

Pursuant to the Taxation Laws
(Amendment) Ordinance, 2019 (Ordinance) issued subsequent to the balance sheet
date, the tax rates have changed with effect from 1st April, 2019
and the company plans to pay tax at the revised rates. If those changes were
announced on or before reporting date, deferred tax asset (or / and deferred
tax liability) would have been reduced by xxxx. The tax charge or (credit) for
the year would have been increased / (decreased) by xxxx.

 

Question

The company currently has MAT
credit and unabsorbed depreciation. It is currently evaluating the tax position
and has not decided whether it should adopt new rates now or later. How should
the matter be dealt with in the quarter ended September, 2019 interim results?

 

Response

The ordinance is an abiding
law that came into force in September, 2019. Accordingly, the impact on tax
expenses based on the option elected by the company needs to be considered in
the September quarter financial results. Merely stating that the company is in
the process of evaluating the impact will not comply with Ind AS / AS
requirements. It is also possible that a decision made in the September, 2019
quarter may change at the year-end. The impact of change on the tax expense
will constitute a change in the accounting estimate which will have to be
properly explained both under Ind AS and AS.

 

Question

On transition to Ind AS 115 /
Ind AS 116, the transition adjustment along with deferred tax impact was
recognised in equity. Where should the subsequent changes in deferred taxes due
to the ordinance be recognised?

 

Response

The subsequent changes to
deferred tax impact is taken to P&L and not to equity even if the earlier
deferred tax was charged or credited to equity; for example, deferred tax
impact taken to equity on transitioning to Ind AS 115 / 116 or transitioning to
Ind AS under Ind AS 101. In the author’s view, the fact that deferred tax was
charged / credited to opening equity does not mean that subsequent changes in
the deferred tax asset or liability (for example, as a result of change in tax
rates) will also be recognised in equity. Rather, management needs to determine
(using the entity’s new accounting policy) where the items on which the
deferred tax arose would have been recognised if the new policy had applied in
the earlier periods (backward tracing). Therefore, if Ind AS 115 / 116 was
always applicable, the adjustment made to equity on transition would have ended
up in the P&L. Consequently, the subsequent changes in deferred tax due to
change in tax rates should also be taken to the P&L account.

 

Question

With
respect to 31st March, 2020 accounts, whether the full tax impact is
considered in the September, 2019 quarter or spread over the three remaining
quarters, namely, September, 2019; December, 2019; and March, 2020?

 

Response

Due to the change in tax rates
/ provisions, there may be a substantial adjustment to the DTA / DTL balance.
For example, a company may be availing tax incentives due to which huge amounts
of DTA / DTL may have got accumulated. If the company decides to fall in the
new regime of taxation, a significant amount of DTA / DTL will need to be
adjusted. The impact of the adjustment has to be taken to the P&L and
cannot be deferred beyond the financial year in which the change occurs. There
are two acceptable approaches, viz., considering the full impact in the
September quarter, and the alternative approach of spreading it over the three
quarters. The reason for two acceptable approaches is as follows:

 

In determining the effective
average annual tax rate as required by Ind AS 34, it is necessary to estimate closing
deferred-tax balances at the end of the year because deferred tax is a
component of the estimated total tax charge for the year. This conflicts with
Ind AS 12 which requires deferred tax to be measured at enacted or
substantially enacted tax rates. It is therefore not clear as to when in the
annual period the impact of remeasuring closing deferred tax balances for a
change in tax rate is recognised. Consequently, two practices have emerged to
determine the tax charge for the interim period:

(a)   The estimated tax rate does not include the impact of remeasuring
closing deferred tax balances at the end of the year. It is not included in the
estimated ‘effective’ average annual tax rate. Consistent with the treatment of
tax credit granted in a one-off event, an entity may recognise the effect of
the change immediately in the interim period in which the change occurs
(Approach 1).

(b)   The estimated rate includes the impact of
remeasuring closing deferred tax balances at the end of the year. In this
approach the effect of a change in the tax rate is spread over the remaining
interim periods via an adjustment to the estimated annual effective income tax
rate (Approach 2).

 

It’s an accounting policy
choice to be followed consistently. The example below explains the two
approaches:

 

Example: Impact of change
in tax rate on tax charge / (credit) in the interim period

 

Company X’s applicable tax
rate in first quarter (June, 2019) was 40%. In the second quarter (September,
2019) the tax rate was changed retrospectively from 1st April, 2019
to 25%. Opening temporary difference on which deferred tax asset was created is
Rs. 40,000, which is expected to reverse after three years.

 

Approach
1 – Adjust the impact of change in tax rate in the quarter in which change occurs

Quarter profit

Profit for the
quarter as per statutory

books (A)

 

Incremental
depreciation in tax books (B)

Tax (loss) / profit
for the quarter as per tax return

C = A-B

 

Tax rate (D)

Tax charge in books
(excluding effect of change in tax rate)
E = A*D

Impact of change in
tax rate (F)1

Total tax charge in
books (including deferred tax) G = E + F

ETR (G/A)

June

50,000

50,000

–

40%

20,000

 

20,000

40%

Sep

40,000

35,000

5,000

25%

10,000

(1,500)

8,500

21%

Dec

40,000

25,000

15,000

25%

10,000

 

10,000

25%

March

30,000

(10,000)

40,000

25%

7,500

 

7,500

25%

 

1,60,000

1,00,000

60,000

 

 

 

46,000

 

 

Approach
2 – Adjust the impact of change in tax rate over the period of remaining
quarters (the impact cannot be carried forward beyond the end of the financial year)

 

Quarter profit

Profit for the quarter as per

statutory books (A)

 

Incremental depreciation in tax books
(B)

Tax (loss) / profit for the quarter as
per tax return

C = A-B

 

Tax rate (D)

Tax charge in books (excluding effect of
change in tax rate)

E = A*D

Impact of change in tax rate (F)2

Total tax charge in books (including
deferred tax)

G = E+F

ETR (G/A)

June

50,000

50,000

–

40%

20,000

–

20,000

40%

Sep

40,000

35,000

5,000

25%

10,000

(545)

9,455

24%

Dec

40,000

25,000

15,000

25%

10,000

(545)

9,455

24%

March

30,000

(10,000)

40,000

25%

7,500

(410)

7,090

24%

 

1,60,000

1,00,000

60,000

 

 

 

46,000

 

 

2Reversal of excess provision made in 1st
quarter, i.e., 50,000*15% = 7,500 and reversal of opening deferred tax asset
created at higher rate, i.e., 40,000*15% = 6,000, i.e., 1,500 over the next
three quarters in the ratio of book profits (40000:40000:30000) minus
non-deductible temporary difference (zero in this fact pattern).

 

CONCLUSION

The author believes that both
views discussed above are based on sound arguments and are equally acceptable.

 

 

Ind AS ACCOUNTING IMPLICATIONS FROM SUPREME COURT RULING ON PROVIDENT FUND

For many small entities,
the Supreme Court (SC) order will have a crippling effect at a time when they
are already suffering the blow of demonetisation. The ruling may also trigger a
whole litigious environment not only on Provident Fund (PF), but also around
other labour legislation such as bonus, gratuity, pension, etc. This article
deals only with the limited issue of accounting and disclosure under Ind AS
arising from the SC ruling on PF. Entities are required to do their own legal
evaluation or seek legal advice and consider an appropriate course of action.

 

BACKGROUND

Under the PF Act, the PF
contributions are required to be calculated on the following:

 

  •    Basic wages;
  •    Dearness allowance;
  •    Retaining allowance; and
  •    Cash value of any food
    concession.

 

An allowance like city
compensatory allowance, which is paid to compensate/neutralise the cost of
living, will be in the nature of dearness allowance on which PF contributions
are to be paid u/s. 6 of the EPF Act.

 

The term ‘basic wages’ is
defined to mean all emoluments which are earned by an employee in accordance
with the terms of contract of employment and which are paid or payable in cash,
but does not include the following:



  •    Cash value of any food
    concession;
  •    Dearness allowance, house
    rent allowance, overtime allowance, bonus, commission or any other similar
    allowance payable in respect of employment;
  •    Present made by the
    employer.

 

Multiple appeals were
pending before the SC on the interpretation of definition of ‘basic wages’ and
whether or not various allowances are covered under its definition for
calculation of PF contributions. The Court pronounced its ruling on 28th
February, 2019 on whether various allowances such as conveyance allowance,
special allowance, education allowance, medical allowance, etc. paid by an
employer to its employees fall under the definition of ‘basic wages’ for
calculation of PF contributions. It ruled that allowances of the following
nature are excluded from ‘basic wages’ and are not subject to PF contributions:



  •    Allowances which are
    variable in nature; or
  •    Allowances which are
    linked to any incentive for production resulting in greater output by an
    employee; or
  •    Allowances which are not
    paid across the board to all employees in a particular category; or
  •    Allowances which are paid
    especially to those who avail the opportunity, viz., extra work, additional
    time, etc.

 

The SC placed reliance on
the following rulings:

 

  •    Bridge and Roof Co.
    (India) Ltd. vs. Union of India     – The crucial test for coverage of allowances
    under the definition of ‘basic wages’ is one of universality. If an allowance
    is paid universally in a particular category, then it must form part of ‘basic
    wages’. It also held that the production bonus which is paid based on
    individual performance does not constitute ‘basic wages’.

 

  •    Muir Mills Co. Ltd. vs.
    Its Workmen     – Any variable earning which may vary from individual to
    individual according to their efficiency and diligence will be excluded from
    the definition of ‘basic wages’.

 

  •    Manipal Academy of
    Higher Education vs. PF Commissioner     – A component which is universally,
    necessarily and ordinarily paid to all across the board is included. The
    question was whether the amount received on encashment of earned leave has to
    be reckoned as ‘basic wages’. The Court answered the query in the negative and
    held that ‘basic wages’ never intended to include the amount received for leave
    encashment. It held that the test to be applied is one of universality. In the
    case of encashment of leave, the option may be available to all the employees,
    but some may avail of it and some may not. That does not satisfy the test of
    universality.

 

  •  Kichha Sugar Company Limited through General Manager vs. Tarai
    Chini Mill Majdoor Union, Uttarakhand     – The dictionary meaning of ‘basic
    wages’ is a rate of pay for a standard work period exclusive of such additional
    payments as bonuses and overtime.

 

Employers paid various
allowances such as travel allowance, canteen allowance, special allowance,
management allowance, conveyance allowance, education allowance, medical
allowance, special holidays, night shift incentives and city compensatory
allowance to their employees. Most employers have not considered these cash
allowances as part of ‘basic wages’ for calculation of PF contributions.
Consequently, many employers will suffer huge financial and administrative
burden to comply with the SC order.

 

INTERIM ACCOUNTING GUIDANCE
ON PF MATTER


For the
year ended 31st March, 2019 in Ind AS financial statements (and
Indian GAAP), should a provision on the incremental PF contribution be made
prospectively or retrospectively?

 

The SC ruling has clarified
the term ‘basic wages’, but has created huge uncertainties around the following
issues:



  •    From which date will the
    order apply?
  •    Whether HRA that is paid
    across the board to all employees should be included or excluded from ‘basic
    wages’?
  •    For past periods, whether
    employer’s liability is restricted to its own contribution or will also include
    the employees’ contribution, in accordance with the PF Act?
  •    A review petition has been
    filed in the SC by Surya Roshni Ltd., raising several issues. What will
    be the outcome of this petition?
  •    What is the impact of the
    SC order on employees drawing ‘basic wages’ greater than Rs. 15,000?
  •    How will the order be
    complied with for employers using contract labour?

 

A very vital aspect will
arise for the consideration of the employers and the PF authorities as to the
date from which the judgement should be made effective. It will all depend upon
the position to be taken by the PF authorities and the position taken by the
employers. The SC only interprets the law and does not amend the law. The
interpretation laid down by the Hon’ble SC to any particular statutory
provisions shall always apply from the date the provision was introduced in the
statute book, unless it is a case of prospective overruling, i.e., the Court,
while interpreting the law, declares it to be operative only prospectively so
as to avoid reopening a settled issue. In the instant case, there is nothing on
record to even remotely suggest that the order pronounced by the Hon’ble SC is
prospective in its operation.

 

The PF law does not lay down
any limitation period and/or look back period for determination of dues u/s. 7A
of the EPF & MP Act, 1952. This may cause grave and undue hardship to the
employee as well as the employer if the demands for the prior period without
imputing a reasonable time limitation is sought to be recovered from the
employer. Therefore, in the event any differential contribution is sought to be
recovered from employers by the PF authorities, the employers may press the
plea of undue hardship to salvage and/or limit their liability for the prior
period by referring to the decision of the Hon’ble SC rendered in the case of Shri
Mahila Griha Udyog Lijjat Papad vs. Union of India & Ors. reported in 2000.

 

Alternatively, it can also
be argued that the employers in any event cannot be saddled with the liability
to pay the employees’ contribution for the retrospective period given that the
employer has no right to deduct the same from the future wages payable to the
employees as held by the Hon’ble SC in the case of District Exhibitors
Association, Muzaffarnagar & Ors. vs. Union of India reported in AIR (1991)
SC. There is no settled jurisprudence on what would constitute a reasonable
period.

 

Given the uncertainty at
this juncture, it would be advisable for the employers to comply with the said
Judgement dated 28th February, 2019 prospectively, i.e., effectively
from 1st March, 2019 and thereafter, if any claims are made by the
PF authorities for the retrospective period, the same can be dealt with
appropriately having regard to the facts and circumstances of each case.

 

There is uncertainty on the
determination of the liability retrospectively, because theoretically there is
no limit on how much retrospective it can get, and can begin from the very
existence of the company or the beginning of the law. Additionally, the review
petition and the fact that the PF department will need to consider hardship
before finalising a circular to give effect to the SC order, is exacerbating
the uncertainty. Furthermore, companies are not required to retain accounts for
periods beyond certain years. In rare cases, when a liability cannot be
reliably estimated, Ind AS 37, paragraph 26 states as follows, “In the
extremely rare case, where no reliable estimate can be made, a liability exists
that cannot be recognised. That liability is disclosed as a contingent
liability.” This approach can be considered for the purposes of Ind AS (and
Indian GAAP) financial statements for the year ended 31st March,
2019.

 

It should also be noted
that there is little uncertainty that the order will at the least apply from 28th
February, 2019. Consequently, a provision for both employers’ and employees’
contribution for the month of March, 2019 along with likely interest should be
included in the provision. However, any provision for penalty at this stage may
be ignored. For the purposes of an accounting provision, HRA should be excluded
from ‘basic wages’ even if these are paid across the board to all employees,
because under the PF Act ‘basic wages’ excludes HRA. However, the SC order has
created uncertainty even on this issue and employers may take different
positions on this matter.

 

The above position will
remain dynamic and may change with further developments. The following note
should be included in the financial statements as a contingent liability:

 

“There are numerous
interpretative issues relating to the SC judgement on PF dated 28th
February, 2019. As a matter of caution, the company has made a provision on a
prospective basis from the date of the SC order. The company will update its
provision, on receiving further clarity on the subject.”

 

The above
note is a contingent liability and not a pending litigation. Therefore, this
matter should not be cross-referenced as a pending litigation in the main audit
report.

 

SHOULD
A PROVISION BE MADE FOR EMPLOYEES DRAWING SALARY ABOVE Rs. 15,000 PER MONTH,
SINCE PF DEDUCTION FOR THESE EMPLOYEES IS IN ANY CASE VOLUNTARY?


Domestic
workers with basic salary exceeding Rs. 15,000 per month may not get impacted
due to this ruling – where PF contributions are made by the employer on full
basic salary or on minimum Rs. 15,000 per month. Such domestic workers may be
covered under proviso to Para 26A of the PF Scheme. The SC has not dealt with
this aspect in its ruling. At the outset, it may be noted that the provisions
of the EPF Scheme do not, inter alia, apply to an employee whose pay
exceeds Rs. 15,000 per month. Such an employee is construed as an excluded
employee within the meaning of Para 2(f)(ii) of the EPF Scheme and an excluded
employee is not statutorily entitled to become a member of the statutory PF
under Para 26(1) of the EPF Scheme. Even if the membership of the PF is
extended to such an employee in terms of Para 26(6) of the EPF Scheme, the PF
contribution statutorily required to be made by the employer in respect of such
an employee is restricted to Rs. 15,000 per month in terms of the proviso to
Para 26-A(2) of the EPF Scheme.

 

Even otherwise, it is well
settled by the decision of the Hon’ble SC rendered in the case of Marathwada
Gramin Bank Karamchari Sanghatana & Ors. vs. Management of Marathwada
Gramin Bank & Ors. that the employer cannot be compelled to pay the
amount in excess of its statutory liability for all times to come just because
the employer from its own trust has started paying PF in excess of its
statutory liability for some time. Therefore, no obligation can be cast upon the
employer to remit PF contributions in excess of its statutory liability under
the EPF Scheme. Having said that, the service regulation and/or contract of
employment entered into by the employer with the employees should not be
inconsistent and/or should not provide otherwise.

 

Another view is that the
employees in the workman category may demand the PF contributions on the
increased basic wages. If the demand is not met, they can raise an industrial
dispute under the Industrial Disputes Act, 1947 for grant of such increase. In
the case of management staff, though they cannot take up the matter under the
Industrial Disputes Act, in law, they can enforce their right through a Civil
Court. Whether or not the bargaining staff or the management staff will demand
the enhanced basic wages is altogether a different matter, but in law they have
a right to raise a demand.

 

For the purposes of an
accounting provision, most employers will assess that Ind AS 37 does not
require a provision with respect to PF contributions for employees drawing
salary greater than Rs. 15,000 at this juncture, because the liability is
remote.  

 

LESSEE’S LEASE OBLIGATION – BORROWINGS VS. FINANCIAL LIABILITY

ISSUE

Ind AS 17 Leases required lessees to
classify leases as either finance leases or operating leases, based on certain
principles, and to account for these two types of leases differently. The asset
and liability arising from finance leases was required to be recognised in the
balance sheet, but operating leases could remain off-balance sheet.

 

Information reported about operating leases
lacked transparency and did not meet the needs of users of financial
statements. Many users adjusted a lessee’s financial statements to capitalise
operating leases because, in their view, the financing and assets provided by
leases should be reflected on the balance sheet. Some tried to estimate the
present value of future lease payments. However, because of the limited
information that was available, many used techniques such as multiplying the
annual lease expense by eight to estimate, for example, total leverage and the
capital employed in operations. Other users were unable to adjust and so they
relied on data sources such as data aggregators when screening potential
investments or making investment decisions. These different approaches created
information asymmetry in the market.

 

The existence of two different accounting
models for leases, in which assets and liabilities associated with leases were
not recognised for operating leases but were recognised for finance leases,
meant that transactions that were economically similar could be accounted for
very differently. The differences reduced comparability for users of financial
statements and provided opportunities to structure transactions to achieve an
accounting outcome.

 

To bridge the problems discussed above, IFRS
16 Leases was issued. Correspondingly, in India the Ministry of
Corporate Affairs issued Ind AS 116 – ‘Leases’, which is notified and
effective from 1st April, 2019 and replaces Ind AS 17. Ind AS 116 requires
lessees to recognise a liability to make lease payments and a corresponding
asset representing the right to use the underlying asset during the lease term
for all leases, except for short-term leases and leases of low-value assets, if
the lessee chooses to apply such exemptions. For lessees, this means that more
liabilities and assets are recognised if they have leases, compared to the
earlier standard, Ind AS 17.

 

Ind AS 116 requires lease liabilities to be
disclosed separately from other liabilities either in the balance sheet or in
the notes to accounts. However, Indian companies are also required to comply
with the presentation and disclosure requirements of division II – Ind AS
Schedule III to the Companies Act, 2013 (Ind AS-compliant Schedule III). As per
the Schedule III format, under financial liabilities – borrowings are required
to be presented separately. Borrowings need to be further bifurcated and
presented in the notes to accounts as follows:

 

Borrowings shall be classified as: (a) Bonds
or debentures; (b) Term loans (i) from banks or (ii) from other parties; (c)
Deferred payment liabilities; (d) Deposits; (e) Loans from related parties; (f)
Long-term maturities of finance lease obligations; (g) Liability
component of compound financial instruments; (h) Other loans (specify nature).

 

Neither Schedule III nor the guidance note
on Schedule III issued by the Institute of Chartered Accountants of India has
been revised to take cognisance of the change in the lease accounting (due to
introduction of Ind AS 116), under which there is no classification as finance
leases or operating leases for lessees. On implementation of Ind AS 116 w.e.f.
1st April, 2019 lessees will not bifurcate leases into finance leases and
operating leases and all leases will be capitalised (subject to a few
exemptions). To comply with the disclosure requirement mentioned in the
preceding paragraph, there is confusion whether (a) all lease liabilities
should be classified as borrowings; or (b) all lease liabilities should be
shown as financial liabilities because the requirement to disclose finance
lease obligation as borrowings by lessees no longer applies (the lessee does
not distinguish between operating and finance lease); or (c) for purposes of
disclosure only, the lessee distinguishes the lease as finance and operating
and discloses the finance lease obligations as borrowings and operating leases
as financial liabilities.

 

If lease obligations are presented as
borrowings in the financial statements, it will negatively impact debt
covenants, the debt-equity ratio, and will have other significant adverse
consequences for lessees. It may be noted that globally, under IFRS, companies
will not be subjected to such adverse consequences because they do not have to
comply with Schedule III or an equivalent requirement.

 

In summary, the following questions emerge:

 

1. On application of Ind AS 116, whether
lessee would disclose the entire lease obligation in its financial statements
under financial liabilities or borrowings?

2. Though not required under Ind AS 116,
whether lessees need to bifurcate all leases into finance lease and operating
lease only for the limited purpose of complying with the disclosure requirements
of Ind AS-compliant Schedule III?

 

RESPONSE

The following three views are theoretically
possible:

 

OPTIONS AND RATIONALES

 

Options

Rationale

Option 1 –

Present entire lease
obligation under financial liabilities as separate line item either on the
face of balance sheet or in the notes to accounts

Ind AS 1 deals with the presentation of financial
statements and it does not require borrowings to be presented as a minimum
line item on the face of the balance sheet. As per para 54(m) – Financial
liabilities [excluding amounts shown under 54 (k) – Trade and other payable
and 54 (l) – provisions] need to be presented as minimum line item on the
face of the balance sheet.

 

Accordingly, in the absence of
Schedule III, borrowings would have been presented as financial liabilities
in the financial statements. Under IFRS, this is indeed the case and there is
no requirement to show borrowings separately from financial liabilities;

 

Ind AS 116 requires lease liabilities to be disclosed
separately from other liabilities either in the balance sheet or in the notes
to accounts. It does not require such financial liabilities to be termed as
borrowings;

 

Schedule III requires finance lease obligation to be
disclosed under borrowings. However, under Ind AS 116, there is no finance
lease classification for lessees and all leases are capitalised, subject to
some exemptions. Since there is no finance lease obligation under Ind AS 116,
nothing is required to be presented as borrowings;

 

Further, Schedule III states the following which may
be used as the basis to present it separately from borrowings:

 

“Line items, sub-line items and sub-totals shall be
presented as an addition or substitution on the face of the Financial
Statements when such presentation is relevant to an understanding of the
company’s financial position or performance, or to cater to industry or
sector-specific disclosure requirements, or when required for compliance with
the amendments to the Companies Act, 2013, or under the Indian Accounting
Standards.”

 

It may be noted that Option 1 is completely in
compliance with the accounting standards.

Option 2 –

Present entire lease obligation as borrowings

As Ind AS 116 does not require bifurcation of leases
into finance and operating and requires all leases (other than short-term and
low-value leases) to be capitalised, the entire lease liabilities need to be
disclosed in borrowings to comply with the spirit of Ind AS-compliant
Schedule III requirements;

 

Further, this will also eliminate the difference
between the two categories of companies, i.e., Borrow to buy vs. Leasing the
assets.

Option 3 –

Bifurcate leases into finance and operating and
disclose only finance lease obligations as borrowings. Operating leases will
be presented as financial liabilities

Though Ind AS does not require bifurcation but to
comply with the Schedule III one may need to do such bifurcation;

 

Accordingly, disclose finance lease obligations as
borrowings and operating lease obligations as financial liabilities.

 

 

 

CONCLUSION AND THE WAY FORWARD

The author does not believe that Option 3
is appropriate, because it is not so intended under the Standard or Schedule
III. Additionally, this issue has arisen because Schedule III is not amended
post -Ind AS 116, to either eliminate the requirement to disclose finance lease
obligations as borrowings, or alternatively to require all lease obligations
(other than low-value and short-term leases) to be disclosed as borrowings.

 

Between Option 1 and 2, MCA
needs to make its position clear, either through a separate notification or by
amending Schedule III. In the absence of that, an ITFG clarification will be
necessary to ensure consistency in the financial reporting.  

 

ACCOUNTING OF DIVIDEND DISTRIBUTION TAX

Started as “Accounting Standards” in
August, 2001. Dolphy Dsouza was the first contributor and had at that time
“agreed to write a series of eight articles on AS 16 to AS 23”. However, till
date – to the joy of the readers – continues as the sole contributor giving the
most important aspects of accounting standards. The feature got a suffix to its
name in July, 2002 – gap in GAAPs – and was called “Accounting Standards: Gap
in GAAPs”. Since the arrival of Ind AS it is renamed as at present.

This monthly feature carries
clarifications, commentary, comparison, and seeks to clarify about accounting
concepts and practices. The author says, “Accounting was never a debated topic
in India as much as tax is. Hopefully, my feature has a small hand in bringing
accounting to the centre stage” He shared another secret benefit: “People know
me because they have seen an unusual name in the BCA Journal for the last 18
years.  I once even got a hefty hotel
discount, as the hotel owner was a CA and an avid reader of the BCAJ!”

 

ACCOUNTING OF DIVIDEND DISTRIBUTION TAX

 

Prior to 1st June, 1997,
companies used to pay dividend to their shareholders after withholding tax at
prescribed rates. The shareholders were allowed to use tax deducted by the
company against tax payable on their own income. Collection of tax from
individual shareholders in this manner was cumbersome and involved a lot of
paper work. To make dividend taxation more efficient, the government introduced
the concept of dividend distribution tax (DDT). Key provisions related to DDT
are given below:

 

(a) Under DDT, each company distributing dividend
needs to pay DDT at stated rate to the government. Consequently, dividend
income will be tax free in the hands of shareholders.

(b) DDT is payable even if no income-tax is payable
on the total income, e.g., a company that is exempt from tax on its entire
income will still pay DDT.

(c) DDT is payable within fourteen
days from the date of (i) declaration of any dividend, (ii) distribution of any
dividend, or (iii) payment of any dividend, whichever is earliest.

(d) DDT paid by a company in this manner is treated
as the final payment of tax in respect of dividend and no further credit
therefore can be claimed either by the company or by the recipient of dividend.
However, dividend received is tax free in the hand of all recipients (both
Indian/ foreign).

(e) Only dividend received from domestic companies
is exempt in the hands of recipient. Dividend received from overseas companies
which do not pay DDT is taxable in the hands of recipient, except for the
impact of double tax relief treaties, if any.

(f)  No DDT is required to be paid by the ultimate
parent on distribution of profits arising from dividend income earned by it
from its subsidiaries. However, no such exemption is available for dividend
income earned from investment in associates/ joint ventures or other companies.
Also, no exemption is available to a parent which is subsidiary of another
company.

 

DDT accounting under Ind AS 12 involves
certain issues. The most important issue is that for the entity paying
dividend, whether DDT is an income-tax covered within the scope of Ind AS 12?
Will DDT be an equity adjustment or a P&L charge or this is an accounting policy
choice?

 

Consider that in the structure below,
company B distributes dividend to its equity shareholders, i.e., company A and
pays DDT thereon.

 

 

For DDT accounting in SFS and CFS of B, one
may consider paragraphs 52A/ 52B and 65A of Ind AS 12.

 

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

 

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

 

“65A.    When
an entity pays dividends to its shareholders, it may be required to pay a
portion of the dividends to taxation authorities on behalf of shareholders. In
many jurisdictions, this amount is referred to as a withholding tax. Such an
amount paid or payable to taxation authorities is charged to equity as a part
of the dividends.”

 

One may argue that DDT is in substance a
portion of dividend paid to taxation authorities on behalf of shareholders. The
government’s objective for introduction of DDT was not to levy differential tax
on profits distributed by a company. Rather, its intention is to make tax
collection process on dividends more efficient. DDT is payable only if
dividends are distributed to shareholders and its introduction was coupled with
abolition of tax payable on dividend. DDT in substance does not adjust the
corporate tax rate, and is a payment to equity holders in their capacity as
equity holders. This aspect is also recognised in the IASB framework. Thus, DDT
is not in the nature of income-taxes under paragraphs 52A and 52B. Rather, it
is covered under paragraph 65A. Hence, in the SFS and CFS of company B, the DDT
charge will be to equity. The Accounting Standards Board (ASB) of the ICAI has
issued a FAQ regarding DDT accounting. The FAQ confirms this position with
regard to accounting SFS and CFS of company B. However, this position is very
contentious globally and there is a strong argument to treat DDT as an
additional tax in substance. Therefore, though there is no difference in the
Ind AS and IFRS standard on DDT, the practice applied in India may be different
from the practice applied globally.

 

In the SFS of the company receiving
dividend, i.e., company  A, net dividend
received is recognised as income. In CFS of company A, there is no dividend
distribution to an outsider. Rather, funds are being transferred from one
entity to another within the same group, resulting in DDT pay-out to an entity
(tax authority) outside the group. Hence, in the CFS of company A, DDT cannot
be treated as equity adjustment; rather, it is charged to profit or loss.

 

If company B as well as company A pay
dividend in the same year, company B will pay DDT on dividend distributed.
Under the income-tax laws, DDT paid by company B is allowed as set off against
the DDT liability of company A, resulting in reduction of company A’s DDT
liability to this extent. In this scenario, an issue arises how should the
company A treat DDT paid by company B in its CFS?

 

One view is that DDT paid relates to company
B’s dividend. From a group perspective, for transferring cash from one entity
to another, cash/tax was paid to the tax authorities. Hence, it should be
charged to P&L in company A’s CFS. The other view is that due to offset mechanism,
no DDT in substance was paid on dividend distributed by company B. Rather,
company A has paid DDT on its dividend distribution to its shareholders. Hence,
DDT should be charged to equity in company A’s CFS to the extent of offset
available.

 

The ITFG has clarified that second view
should be followed. Under this view, the following table explains the amount to
be charged to P&L and to equity in company A’s CFS:

 

Scenario 1

DDT paid by B

A’s DDT liability

Offset used by A

Equity charge in A’s CFS

P&L charge in A’s CFS

I

30,000

30,000

30,000

30,000

Nil

II

30,000

20,000

20,000

20,000

10,000

III

30,000

40,000

30,000

30,000 + 10,000

Nil

 

 

The above is a simple example where both
parent and subsidiary pay dividends concurrently.  It may so happen that a subsidiary has
distributable profits, but will distribute those, beyond the current financial
year.  In such a case, in parent’s CFS, a
DTL should be recognised at the reporting date in respect of DDT payable on
dividend expected to be distributed by the subsidiary in near future. Absent
offset benefit, the corresponding amount is charged as expense to P&L.
However, there is no direct requirement related to recognition of asset toward
offset available.

 

Considering the above, the ITFG (Bulletin 9)
has stated that at the reporting date, the parent in its CFS will recognise DTL
in respect of DDT payable on dividend to be distributed by subsidiary. The
corresponding amount is charged to P&L. In the next reporting period, on
payment of dividend by both entities and realisation of offset, the parent will
credit P&L and debit the amount to equity. Effectively, the ITFG views
require DDT on expected distribution to be charged to P&L in the first
reporting period which will be reversed in the immediate next period. The
authors believe that the ITFG view does not reflect substance of the
arrangement. Moreover, such an approach will create an unwarranted volatility
in P&L for two reporting periods which should be avoided. The standard
requires creation of a DTA if there is a tax planning opportunity in place. If
the parent company has a strategy in place to distribute dividends to its
shareholders out of the dividends it receives from its subsidiaries, within the
same year, then it will be able to save on the DDT. Consequently, corresponding
to the DTL, an equivalent DTA should also be recognised in the first reporting
period. We recommend that ITFG may reconsider its views on the matter.

 

ITFG (Bulletin 18) has subsequently changed
its position and clarified that accounting treatment of DDT credit depends on
whether or not it is probable that the parent will be able to utilise the same
for set off against its liability to pay DDT. This assessment can be made only
by considering the particular facts and circumstances of each case including
the parent’s policy regarding dividends, historical record of payment of
dividends by the parent, availability of distributable profit and cash,
etc.  The revised ITFG position is a step
in the right direction.

 

In light of the ITFG 18, a few important
questions and clarifications are given below:

  •     Firstly, whether the ITFG
    is mandatory? The answer to this would depend upon an assessment of whether the
    ITFG interpretation reflects a reasonable and globally acceptable
    interpretation of the standard. The view in ITFG 18, is in my opinion a
    reasonable and correct interpretation, and should therefore be considered
    mandatory.
  •     Secondly, when changing the
    practice to comply with ITFG 18, would it be a change in estimate or change in
    policy or an error?  In line with global
    practice with respect to issuance of IFRICs from time to time the author
    believes that the change is a change in an estimate rather than a change in an
    accounting policy or an error.
  •     Lastly, should the ITFG be
    implemented as soon as it is issued? This is more of a practical issue. It may
    not always be possible for entities to comply with an ITFG in the accounts of
    the quarter in which it is issued. 
    Nonetheless, entities should give effect to the ITFG in the following
    quarter.      

 

 

ACCOUNTING OF FINANCIAL GUARANTEES

Query

Subsidiary has provided a financial
guarantee to a bank for loan taken by Parent. Subsidiary does not charge Parent
any guarantee commission. How is the guarantee accounted in the separate
financial statements of the Parent and Subsidiary assuming the guarantee is an
integral part of the arrangement for the loan?

 

Response

Subsidiary recognises the financial
guarantee liability (unearned financial guarantee commission) at fair value, in
its books at the date of issuance to the bank. Since the subsidiary does not
receive any consideration from the Parent, it has effectively paid dividends to
Parent.  Consequently, the corresponding
debit should be made to an appropriate head under ‘equity’. It would not be
appropriate to debit the fair value of the guarantee to profit or loss as if it
were a non-reciprocal distribution to a third party as it would fail to
properly reflect the existence of the parent-subsidiary relationship that may
have caused Subsidiary not to charge the guarantee commission. Under Ind AS
115, the unearned financial guarantee commission recognised initially will be
amortised over the period of the guarantee as revenue and consequently, the
balance of the unearned financial guarantee commission would decline
progressively over the period of the guarantee. However, in addition to
amortising the unearned financial guarantee commission to revenue, at each
reporting date, Subsidiary is required to compare the unamortised amount of the
deferred income with the amount of loss allowance determined in respect of the
guarantee as at that date in accordance with the requirements Ind AS 109. As
long as the amount of loss allowance so determined is lower than the
unamortised amount of the deferred income, the liability of Subsidiary in
respect of the guarantee will be represented by the unamortised amount of the
financial guarantee commission. However, if at a reporting date, the amount of
the loss allowance determined above is higher than the unamortised amount of
the financial guarantee commission as at that date, the liability in respect of
the financial guarantee will have to be measured at an amount equal to the
amount of the loss allowance. Accordingly, in such a case, Subsidiary will be
required to recognise a further liability equal to the excess of the amount of
the loss allowance over the amount of the unamortised unearned financial
guarantee commission.

 

As regards the Parent, in the fact
pattern, financial guarantee provided by Subsidiary is an integral part of the
arrangement for the loan taken by Parent from the bank. Therefore, in
accordance with the principles of Ind AS 109, separate accounting of such
financial guarantee is not required. However, the ITFG (Bulletin 16) felt that
as per Ind AS 109, fees associated with the guarantees that are an integral
part of generating an involvement with a financial asset or a financial
liability are taken into account in determining the effective interest rate for
the financial asset/financial liability. Therefore, the provision of guarantee
by Subsidiary without charging guarantee commission is analogous to a distribution/
repayment of capital by Subsidiary to Parent. To reflect this substance, Parent
should credit the fair value of the guarantee to its investment in Subsidiary
and debit the same to the carrying amount of the loan (which would have the
effect of such fair value being included in determination of effective interest
rate on the loan). Subsequently, ITFG revised Bulletin 16. As per the revised
requirement, Parent will debit the fair value of the guarantee to the carrying
amount of the loan. If the investment in subsidiary is accounted at cost or
FVTPL, the corresponding credit will be recognised in the P&L account. If
the investment in subsidiary is accounted at FVTOCI, the credit will be
recognised in the P&L account as dividend received, unless the distribution
clearly represents recovery of part of the cost of the investment.

 

The
author believes that the accounting of the financial guarantee by the grantor
is inevitable because financial guarantee is a financial liability in
accordance with the definition contained in Ind AS 32. However, there is no
requirement for the beneficiary to record a financial guarantee provided by a
grantor for which no commission is charged, in the way suggested by the ITFG.
This is also the global practice. The implication of the ITFG view is that
in all cases, where any transaction between group companies are subsidised, the
transaction will be recorded at its fair value rather than at the transaction
price. This is certainly not required by Ind AS and could have unintended consequences,
particularly in the case of merger and amalgamation transactions. Furthermore,
it will create opportunities for group companies to create unnecessary credit
going to the P&L account of the separate financial statements. The only
requirement under Ind AS for such transactions would be appropriate disclosures
in accordance with the requirements of Ind AS 24 Related Party Disclosures.

Ind AS vs. ICDS Differences

The author Dolphy D’Souza has
provided a detail list of differences between Ind AS and ICDS.  ICDS are closer to Indian GAAP than Ind
AS.  The differences between ICDS and Ind
AS have further exacerbated due to introduction of new standards, such as, Ind
AS 115 Revenue from Contracts with Customers. 
These differences will further increase over time. Consequently, an Ind
AS company will be required to track these differences to enable tax
computation.  If the differences are
numerous, it is best that the tracking is done in the system rather than
outside the system such as on excel spread-sheets.

 

Point of Difference

Ind AS

ICDS

Ind AS 1 vs. ICDS I

Changes in accounting policies –
accounting of the impact

Change in accounting policy allowed only
when required by an Ind AS or results in more reliable and relevant
information. Requires retrospective application of changes in accounting
policies.

Change in accounting policy allowed only
when there is reasonable cause. ICDS does not provide any guidance on how to
account for the impact. Impact of change generally debited or credited to
current P&L.

Correction of prior period errors

Requires correction to be made for the
retrospective period.

Correction is made for the relevant
period, and previously filed ITR’s are revised.

Change in Mark to markup losses / gain

MTM loss/gain on derivative is
recognised in P&L unless designated as hedge.

Losses shall not be recognised unless
recognition is in accordance with provision of other ICDS. Instances of
losses permitted under ICDS are;

 

 

??Inventory valuation loss

 

 

???Loss on construction contract on POCM basis

 

 

??MTM forex loss on monetary item (include forward and option
for hedging)

 

 

??Provision for liability on reasonable certainty basis

 

 

Losses which may not be allowed as
deduction are as given below;

 

 

??Foreseeable loss on construction contract

 

 

??MTM on derivative (for example, commodity contracts) other
than forward and option for hedging covered by ICDS VI

 

 

CBDT FAQ dt 23rd March, 2017
clarified that same principle will apply to MTM gain as well.

Ind AS 2 vs.
ICDS II

Change in cost formula

Considered as change in an accounting
policy

Cannot be changed without reasonable
cause.

Inclusion of statutory levies in value
of inventory

Inventory to be valued net of creditable
statutory levies (like GST)

Inventory to be valued inclusive of
creditable statutory levies (like GST). 
However, this is just a matter of semantics, and the net profit as per
ICDS and Ind AS on this account will not be different.

Ind AS 115
vs. ICDS III and ICDS IV

Scope

Ind AS 115 deals with revenue arising
from contract with customers

ICDS III (Construction Contracts) and
ICDS IV (Revenue) are similar to erstwhile Indian GAAP AS 7 and AS 9.

Revenue recognition principle

Revenue is recognised based on five step
model on transfer of control to customer

For goods, revenue is recognised on
transfer of risk and rewards. For services, revenue is recognised to the
extent of stage of completion of contract

Identification of performance obligation

Detail requirements apply for
identifying and recognising revenue on multiple-element contracts

Do not require or prohibit
identification of performance obligation.

Allocation of transaction price

Allocated to performance obligation
identified based on relative standalone selling price.

Not covered in ICDS

Variable consideration

Methodology for estimating and
recognising variable consideration is set out in detail in the standard.

Currently, entities may defer measurement
of variable consideration until uncertainty is removed. For e.g. claims in
construction contracts are recognised on final certainty.

Sales return

Revenue is recognised after deducting
estimated return. Sales returns result in variable consideration.

No guidance is provided in ICDS

Significant financing

Revenue is adjusted for significant
financing and presented separately as finance cost/income

Revenue is not adjusted for time value
of money

Non-cash consideration

Measured at fair value

No guidance provided

Onerous contract

Expected losses are recognised as an
expense immediately.

Losses incurred on a contract will be
allowed only in proportion to the stage of completion

Real estate revenue

If the entity has a right to receive
payment for work completed to date, POCM is applied. Else completed contract
method needs to be followed.

Exposure draft issued. Requires POCM.

Early stage contract

Revenue recognised to the extent of cost
if there is no reasonable certainty.

Reasonable certainty threshold of 25% is
specified.

 

Revenue is recognised to the extent of
costs incurred when up to 25% of the work is completed otherwise
proportionate method will apply.

Service contract

Revenue is recognised on transfer of
control.

POCM applied. Straight-line method, if
service contract involves indeterminate number of acts over specific period
of time.

 

Completed contract, if duration < 90
days

Retention money

Retention monies are a deduction from
the revenue bill, which is paid by the customer on satisfactory completion of
contract or warranty period. The retention monies are treated as normal
revenue.

Same as Ind AS. Retention is part of
overall contract revenue and is recognised subject to reasonable certainty of
its ultimate collection.

Ind AS 16 vs. ICDS V

Major spare parts

Recognised as Inventory if do not meet
Ind AS 16 criteria. As per Ind AS 16 property plant and equipment are items
that;

??Are held for use in production or supply of good, and


??Are expected to be used during more than
one period.

Machinery spares which can be used only
in connection with a Tangible fixed asset and where use is irregular, have to
be capitalised.

 

E.g., Spares which can be used with
multiple machine will be considered as inventory under ICDS whereas these
will be capitalised and depreciated in Ind AS.

Major inspections

They are capitalised. Remaining amount
from previous inspection is derecognised.

No guidance.

Ind AS 21 vs. ICDS VI

Foreign currency

Functional currency is currency of
primary economic environment in which company operated. Foreign currency is
currency other than functional currency.

Reporting currency is INR except for
foreign operation. Foreign currency is currency other than reporting
currency.

Scope exception

Foreign exchange gain/loss regarded as
adjustment to interest cost is scoped out.

The adjustment is considered as
borrowing cost under
Ind AS.

No such scope exclusion.

Capitalisation of exchange differences
on long term foreign currency monetary item for acquisition of fixed assets

Exchange difference is debited/credited
to P&L

? On imported assets S43A allows capitalisation

 

??With respect to local assets all MTM exchange differences are
included in taxable income

Forward exchange contracts on balance
sheet items, such as forward contract for debtor or creditor

Derivatives are measured at fair value
through P&L, if hedge accounting is not applied.

Any premium or discount shall be amortised
as expense or income over the life of the contract. Exchange difference on
such a contract shall be recognised as expense/income in the period in which
the exchange rate changes.

Forward exchange contract to hedge
foreign exchange risk of firm commitment or highly probable forecast
transaction

Derivatives are measured at fair value
through P&L, if hedge accounting is not applied.

Section 43AA introduced by Finance Act
2018 requires exchange differences on forward exchange contracts to be
recognised as per ICDS. Premium, discount or exchange difference, shall be
recognised at the time of settlement as per ICDS VI.

Foreign exchange contract for trading or
speculative purposes

Derivatives are measured at fair value
through P&L

Section 43AA introduced by Finance Act
2018 requires exchange differences on forward exchange contracts to be
recognised as per ICDS. Premium, discount or exchange difference, shall be
recognised at the time of settlement as per ICDS VI.

Foreign currency translation reserve
(FCTR)

Accumulated in reserves. Recognised in
P&L on disposal, deemed disposal or closure of branch.

FCTR taxed similar to FX
assets/liabilities; ie, monetary items are restated at closing exchange rates
but non-monetary items are stated at historical rates. FCTR balance (excludes
impact on non-monetary items) as on 1 April, 2016 shall be recognised in the
previous year relevant to assessment year 2017-18 to the extent not
recognised in the income computation in the past.

Ind AS 20
vs. ICDS VII

Government Grant – recognition

Not recognised unless there is a
reasonable assurance that the entity shall comply with the conditions
attached to them and the grants will be received.

 

Mere receipt of grant is not criteria of
recognition.

Similar to Ind AS, except recognition is
not postponed beyond the date of actual receipt.

Ind AS 20
vs. ICDS VII

Export Incentive

When it is reasonably certain that all conditions
will be fulfilled and the collection is probable.

In the year in which reasonable
certainty of its realisation is achieved.

Grant in the nature of promoters
contribution

No such concept.

No such concept.

Sales tax deferral benefit

Grant benefit imputed based on time
value of money. Benefit capitalised, if related to acquisition of asset. Else
credited to P&L.

No benefit imputed

Ind AS 109 /
ICDS VIII

Securities (quoted) – held for trading

Mark to market gain/loss recognised in
the P&L

Lower or cost or NRV to be carried out
category-wise.

 

Securities held by banks and Public
Financial Institutions to be valued as per extant RBI Guidelines.

Ind AS 23
vs. ICDS IX

Qualifying asset

Assets which takes substantial period of
time to get ready for its intended use.

No condition w.r.t substantial period of
time except inventory ( 12 months).

Capitalisation of general borrowing cost

Weighted average cost of borrowing is
applied on funds that are borrowed generally and used for obtaining a
qualifying assets.

Allocation is based on average cost of
qualifying asset to average total assets.

Borrowings – Income on temporary
investments

Reduced from the borrowing costs
eligible for capitalisation

Not to be reduced from the borrowing
costs eligible for capitalisation.

Commencement of capitalisation

Capitalisation of borrowing cost
commences, when the construction activity commences.

In case of specific borrowings, from the
date on which funds were borrowed. In case of general borrowings, from the
date on which funds were utilised.

Suspension of capitalisation

Capitalisation of borrowing cost
suspended during extended period in which active development is interrupted.

No guidance.

Ind AS 37
vs. ICDS X

Recognition of contingent assets
/reimbursement

Virtual certainty is required for
recognition.

Reasonable certainty is required for
recognition. Test of ‘reasonable certainty’ is not in accordance with section
4/5 of Income-tax Act. Hypothetical income not creating enforceable right
can’t be taxed.

Discounting of long term provision

Required

Not allowed.  

 

 

WHAT’S IN A NAME? PREFERENCE SHARE VS. FCCB

Query


Top Co, whose functional
currency is INR, has issued preference shares to a foreign investor. As per the
terms, at the end of 3-years from the issuance date, the holder has the option
to either redeem each preference share for cash payment of USD 10 or to get 10
equity shares of Top Co for each preference share. Whether the equity
conversion option represents an equity instrument or a (derivative) financial
liability of Top Co?

 

Response


ITFG
responded to a similar issue in Bulletin No. 17 and its view is reproduced
below.

 

ITFG view


Ind AS 32,
Financial Instruments: Presentation lays down the principles for the
classification of financial instruments as financial assets, financial
liabilities or equity instruments from the issuer’s perspective. As per
paragraph 11 of Ind AS 32, “A financial liability is any liability that is:

 

(a)  a contractual obligation :

(i)    to deliver cash or another financial asset
to another entity; or

(ii)    to exchange financial assets or financial
liabilities with another entity under conditions that are potentially
unfavourable to the entity; or

(b)   a contract that will or may be settled in the
entity’s own equity instruments and is:

(i)    a non-derivative for which the entity is or
may be obliged to deliver a variable number of the entity’s own equity
instruments; or

(ii)    a derivative that will or may be settled
other than by the exchange of a fixed amount of cash or another financial asset
for a fixed number of the entity’s own equity instruments. For this purpose,
rights, options or warrants to acquire a fixed number of the entity’s own
equity instruments for a fixed amount of any currency are equity instruments if
the entity offers the rights, options or warrants pro rata to all of its
existing owners of the same class of its own non-derivative equity instruments.
Apart from the aforesaid, the equity conversion option embedded in a convertible
bond denominated in foreign currency to acquire a fixed number of the entity’s
own equity instruments is an equity instrument if the exercise price is fixed
in any currency. …….

 

As per the
above definition, as a general principle, a derivative is a financial liability
if it will or may be settled other than by the exchange of a fixed amount of
cash or another financial asset for a fixed number of the entity’s own equity
instruments. The term ‘fixed amount of cash’ refers to an amount of cash fixed
in functional currency of the reporting entity. Since, an amount fixed in a
foreign currency has the potential to vary in terms of functional currency of
the reporting entity due to exchange rate fluctuations, it does not represent
“a fixed amount of cash”. However, as an exception to the above general
principle, Ind AS 32 regards the equity conversion option embedded in a
convertible bond denominated in a foreign currency to acquire a fixed number of
entity’s own equity instruments to be an equity instrument if the exercise
price is fixed in any currency, i.e., whether fixed in functional currency of
the reporting entity or in a foreign currency. [It may be noted that the
corresponding standard under IFRSs (viz., IAS 32) does not contain this
exception].

 

Ind AS 32
makes the above exception only in the case of an equity conversion option
embedded in a convertible bond denominated in a foreign currency, even though
it explicitly recognises at several places that other instruments can also
contain equity conversion options. Given this position, it does not seem that
the above exception can be extended by analogy to equity conversion options
embedded in other types of financial instruments denominated in a foreign
currency such as preference shares.

 

In view of
the above, the equity conversion option forming part of terms of issue of
preference shares under discussion would be a (derivative) financial liability.

 

Authors’ point of view


  •  It appears that the above opinion provides unwarranted emphasis
    on the nomenclature of the instrument rather than the terms and conditions of
    the instrument. It may be noted that an instrument is classified based on its
    terms and conditions under Ind AS, rather than its nomenclature. In other
    words, from an Ind AS perspective, there is no difference in how the preference
    share or the bond is accounted, if they contain similar terms and conditions.
    From that perspective, it appears unreasonable that the exemption of treating
    the conversion option fixed in foreign currency as equity is allowed only for
    conversion options in bonds and not for conversion options in preference
    shares, though both instruments are similarly accounted under Ind AS.
  •  Whilst a preference share and a bond under the Indian Companies
    Act have different liquidation rights, from the point of view of RBI
    regulations and Ind AS accounting there is no difference. Consequently, all
    that an entity has to do is to nomenclate a preference share as a bond or
    structure it like a bond. Sometimes debt covenants with existing bond holders
    may prohibit an entity from issuing new bonds. In those cases, there will be a
    restriction on the entity from raising funds using a bond. On the other hand,
    raising foreign funds using a preference share with a conversion option may be
    debilitating from an accounting and balance sheet perspective.
  •    The ITFG opinion has not
    provided a strong case or basis for making a difference between accounting for
    conversion option contained in a bond and that contained in a preference share.
    Neither has it defined the term bond and preference share, which may result in
    different interpretation. However, common practice will be to use the same
    definition contained in the Companies Act. The exemption for a bond and not for
    a preference share appears arbitrary and rule based, rather than based on sound
    and solid accounting principles.

 

Final Remarks


The ITFGs main argument is
that the carve-out from IAS 32 was meant to operate more like an exemption
rather than based on a sound principle. In the long run carve-outs is not the
preferred option, particularly if those are not supported by a strong basis of
conclusion or a well-defined principle. In addition to the possibility of
multiple interpretation of the carve-out, it will camouflage gearing in
financial statements and create confusion in the minds of investors. The
International Accounting Standard Board has issued a discussion paper titled Financial
Instruments with Characteristics of Equity (FICE). The objective of the
discussion paper is to clearly set out the principles of debt vs. equity.
Indian standard setters will have an opportunity of participating in this
discussion and eliminating any differences between the IFRS and Ind AS standard
with respect to debt vs equity classification.

 

At last, I am reminded of a
quote from Shakespeare’s Romeo and Juliet – “What’s in a name? that which we
call a rose by any other name would smell as sweet.” The ITFG has proved
him wrong!!  

 

 

 

KEY DIFFERENCES BETWEEN IND AS 116 AND CURRENT IND AS

Ind AS 116
will apply from accounting periods commencing on or after 1st April,
2019 for all companies that apply Ind AS; once the same is notified by the
Ministry of Corporate Affairs.


The following is a summary of the
key differences between Ind AS 116 and current Ind AS

 

Ind AS 116          1st April 2019

Current Ind AS

Definition of a lease

A lease is a contract, or part of a contract, that conveys the
right to control the use of an underlying asset for a period of time in
exchange for consideration.  To
determine if the right to control has been transferred to the customer, an
entity shall assesses whether, throughout 
the period of use, the customer has the right to obtain substantially
all of the economic benefits from use 
of the identified asset and the right to direct the  use of the identified asset.

Ind AS 17 defines a lease 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. Furthermore, Appendix C
of Ind AS 17 Determining whether an Arrangement contains a Lease, it
is not necessary for an arrangement to convey the right to control the use of
an asset to be in scope of Ind AS 17.

Recognition exemptions

 

 

Short term leases-lessees

Lessees can elect, by class of underlying asset to which the
right of use, relates, to apply a method similar to Ind AS 17 operating lease
accounting, to leases with a  lease
term of 12 months or less and without a purchase option

Not applicable

Leases of low value assets- lessees

Lessees can elect, on a lease-by-lease basis, to apply a method
similar to Ind AS 17 operating lease accounting, to leases of low-value
assets (e.g., tablets and personal computers, small items of office furniture
and telephones).

Not applicable

Classification

 

 

Lease classification-lessees

Lessees apply a single recognition and measurement approach for
all leases, with options not to recognise right-of-use assets and lease
liabilities for short-term leases and leases of low-value assets.

Lessees apply a dual recognition and measurement approach for
all leases. Lessees classify a lease as a finance lease if it transfers
substantially all the risks and rewards incidental to ownership. Otherwise a
lease is classified as an operating lease.

Measurement

 

 

Lease payments included in the initial measurement-lessees

At the commencement date, lessees (except short-term leases and
leases of low-value assets) measure the lease liability at the present value
of the lease payments to be made over the lease term. Lease payments include:

a. Fixed payments (including in-substance fixed payments), less
any lease incentives receivable

b. Variable lease payments that depend on an index or a rate,
initially measured using the index or rate at the commencement date

c. Amounts expected to be payable by the lessee under residual
value guarantees

d. The exercise price of a purchase option if the lessee is
reasonably certain to exercise that option

At the commencement of the lease term, lessees recognise finance
leases as assets and liabilities 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. Minimum lease payments are the payments over the lease term
that the lessee is or can be required to make, excluding contingent rent,
costs for services and taxes to be paid by and reimbursed to the lessor,
together with, for a lessee, any amounts guaranteed by the lessee or by a
party related to the lessee.  Variable
lease payments are not part of the lease liability.

 

e. Payments of penalties for terminating the lease, if the lease
term reflects the lessee exercising an option to terminate the lease

The cost of the right-of-use asset comprises:

a. The lease liability

b. Lease payments made at or before the commencement date, less
any lease incentives received

c. Initial direct costs

d. Asset retirement obligations, unless those costs are incurred
to produce inventories

No assets and liabilities are recognised for the initial
measurement of operating leases.

Reassessment of lease liability-lessees

After the commencement date, lessees shall remeasure the lease
liability when there is a lease modification (i.e., a change in the scope of
a lease, or the consideration for a lease that was not part of the original
terms and conditions of the lease) that is not accounted for as a separate
contract.

Lessees are also required to remeasure lease payments upon a
change in any of the following:

•  The lease term

• The assessment of whether the lessee is reasonably certain to
exercise an option to purchase the underlying asset

• The amounts expected to be payable under residual value
guarantees

• Future lease payments resulting from a change in an index or
rate

Not dealt with by current Ind AS

Lease modifications

 

 

Lease modifications to an operating lease-lessors

Lessors account for a modification to an operating lease as a
new lease from the effective date of the modification, considering any
prepaid or accrued lease payments relating to the original lease as part of
the lease payments for the new lease.

Not dealt with by current Ind AS

Lease modifications which do not result in new separate
leases-lessees and lessors

Lessees:

a) Allocate the consideration in the modified contract

b) Determine the lease term of the modified lease

c) Remeasure the lease liability by discounting the revised
lease payments using a revised discount rate with a corresponding adjustment
to right-of-use asset

In addition, lessees recognise in profit or loss any gain or
loss relating to the partial or full termination of the lease.

Lessors:

If a lease would have been an operating lease, had the
modification been in effect at the inception date, lessors in a finance
lease:

i.  Account for the
modification as a new lease

ii.  Measure the carrying
amount of the underlying asset as the net investment in the lease immediately
before the effective date of the modification.

Otherwise the modification is accounted for in accordance with
Ind AS  109 Financial Instruments.

Not dealt with by current Ind AS

Presentation and disclosure

 

 

Presentation-lessees

Statement of financial position-present right-of-use assets
separately from other assets. If a lessee does not present right-of-use
assets separately in the statement of financial position, the lessee is
required to include right-of-use assets within the same line item as that
within which the corresponding underlying assets would be presented if they
were owned and disclose which line items in the statement of financial
position include those right-of-use assets.

Lease liabilities are also presented separately from other
liabilities. If the lessee does not present lease liabilities separately in
the statement of financial position, the lessee is required to disclose which
line items in the statement of financial position include those liabilities.

Statement of profit or loss-present interest expense on the
lease liability separately from the depreciation charge for the right-of-use
asset. Interest expense on the lease liability is a component of finance
costs, which paragraph 82(b) of Ind AS 1 Presentation of Financial
Statements requires to be presented separately in the statement of profit
or loss.

Cash flow statement – classify cash payments for the principal
portion of the lease liability within financing activities; cash payments for
the interest portion of the lease liability applying the requirements in Ind
AS 7 for interest paid – as operating cash flow or cash flow resulting from
financing activities (depending on entity’s policy); and short-term lease
payments, payments for leases of low-value assets and variable lease payments
not included in the measurement of the lease liability within operating
activities.

Presentation in the statement of financial position- not dealt
with by current Ind AS

 

Statement of profit or loss-operating lease expense is presented
as a single item

 

Cash flow statement- for operating leases, cash payments are
included within operating activities

Disclosure-lessees and lessors

Detailed disclosures including the format of disclosure, are
required under Ind AS 116. In addition, qualitative and quantitative
information about leasing activities is required in order to meet the
disclosure objective.

Quantitative and qualitative disclosures are required, but
generally fewer disclosures are required than under Ind AS 116.

Sale
and leaseback transactions

 

 

Sale and leaseback transactions determining whether a sale has
occurred

Seller-lessees and buyer-lessors apply the requirements in Ind
AS  115 to determine whether a sale has
occurred in a sale and leaseback transaction.

Ind AS 17 focuses on whether the leaseback is an operating or
finance lease and does not explicitly require the transfer of the asset to
meet the requirements for a sale in accordance with Ind AS 18 for
seller-lessees and buyer-lessors.

Sale and leaseback transactions accounting by seller-lessees

The seller-lessee measures the right-of-use asset arising from
the leaseback at the proportion of the previous carrying amount of the asset
that relates to the right-of-use retained by the seller-lessee and recognises
only the amount of any gain or loss that relates to the rights transferred to
the buyer-lessor.

If a sale and leaseback transaction results in a finance lease,
any excess of sales proceeds over the carrying amount are deferred and
amortised over the lease term.

 

If a sale and leaseback transaction results in an operating
lease, and it is clear that the transaction is established at fair value, any
profit or loss is recognised immediately.

Sale and leaseback transactions-accounting by seller-lessees for
transactions not at fair value

If the fair value of the consideration for the sale of an asset
does not equal the fair value of the asset, or if the payments for the lease
are not at market rates, an entity is required to measure the sale proceeds
at fair value with an adjustment either as a prepayment of lease payments
(any below market terms) or additional financing (any above market terms) as
appropriate.

If a sale and leaseback transaction results in an operating
lease and the sale price is

• Below fair value – any profit or loss is recognised
immediately except that, if the loss is compensated for by future lease
payments at below market price, it is deferred and amortised in proportion to
the lease payments over the period for which the asset is expected to be used

• Above fair value – the excess over fair value is deferred and
amortised over the period for which the asset is expected to be used

Business 
Combinations

 

 

Business combinations – acquiree is a lessee – initial
measurement

The acquirer is not required to recognise right-of-use assets
and lease liabilities for leases with a remaining lease term less than 12
months from the acquisition date, or leases for which the underlying asset is
of low value.

The acquirer measures the right-of-use asset at the same amount
as the lease liability, adjusted to reflect favourable or unfavourable terms
of the lease, relative to market terms.

There is no exemption for leases with a remaining lease term
less than 12 months from the acquisition date, or leases for which the
underlying asset is of low value.

 

An intangible asset is recognised if terms of operating lease
are favourable relative to market terms and a liability is recognised if
terms are unfavourable relative to market terms.

 

An intangible asset may be associated with an operating lease,
which may be evidenced by market participants’ willingness to pay a price for
the lease even if it is at market terms.

 

 

 

 

DIFFERENCES BETWEEN IFRS & Ind AS

The author Dolphy D’Souza has provided a detail
list of differences between IFRS and Ind AS. 
Different stakeholders will find this beneficial in different ways.  Companies seeking to prepare pure IFRS
financial statements for fund raising or global listing or group consolidation,
can use this to align their Ind AS financial statements to IFRS.  The standard-setters can use this list to
reduce or eliminate the differences.  If
Ind AS standards are fully aligned to IFRS standards, it will improve India’s
credibility in the global markets.

IFRS 1 differences

Deemed cost exemption for property, plant and equipment

IFRS 1 permits a first-time adopter to
measure its items of property, plant and equipment (PPE) at deemed cost at
the transition date. The deemed cost can be:

  • The
    fair value of the item at the date of transition
  • A
    previous GAAP revaluation at or before transition date, if revaluation meets
    certain criteria

Similar exemption is also available for
intangible assets and investment property measured at cost.

Ind AS 101 also provides similar deemed
cost exemption. In addition, if there is no change in the functional currency
at the transition date, Ind AS 101 allows a first-time adopter to continue
with the previous GAAP carrying value for all of its PPE as recognised in the
previous GAAP financial statements at the transition date. The same is   used as deemed cost at that date, after
making adjustment for decommissioning liabilities.

 

In Ind AS CFS, the previous GAAP amount
of the subsidiary is the amount used in the previous GAAP CFS. If an entity
avails the option under this paragraph, no further adjustments to the deemed
cost so determined is made.

 

Similar exemption is also available for
intangible assets and investment property. 
Fair value as deemed cost exemption is not allowed for investment
property.

Additional exemptions relating to composite leases and land
lease

Under IFRS 1, an entity classifies a
lease based on the lease terms that are in force at its date of transition
based on the circumstances that existed at the inception of the lease.

Ind AS 101 provides the following
additional exemptions:

 

  • When
    a lease includes both land and building elements, a first time adopter may
    assess the classification of each element as finance or operating lease at
    the date of transition to Ind AS based on the facts and circumstances existing
    as at that date.

 

  • If
    there is any land lease newly classified as finance lease, then the first
    time adopter may recognise asset and liability at fair value on that date.
    Any difference between those fair values is recognised in retained earnings.

Exchange differences arising on long-term monetary items

IAS 21 requires exchange differences
arising on restatement of foreign currency monetary items, both long term and
short term, to be recognised in the income statement for the period.

Under the erstwhile Indian GAAP,
companies recognised exchange differences arising on restatement of foreign
currency monetary items, both long term and short term, in the profit or loss
immediately. Alternatively, they were given an irrevocable option to defer/
capitalise exchange differences on long-term foreign currency monetary items.

IFRS 1 differences

 

 

For the companies applying second option
under the erstwhile Indian GAAP, Ind AS 101 provides an additional option.
They may continue to account for exchange differences arising on long-term
foreign currency monetary items recognised in the financial statements for
the period ending immediately before the beginning of first Ind AS reporting
period using the previous GAAP accounting policy. Ind AS 21 does not apply to
exchange differences arising on such long term foreign currency monetary
items.

Additional exemption relating to amortisation of toll roads

IAS 38 has a rebuttable presumption that
the use of revenue-based amortisation method is inappropriate for intangible
assets.

The old Indian GAAP allowed revenue
based amortisation for toll roads. 
Under Ind AS, an entity on first time adoption of Ind AS may decide to
retain the previous GAAP amortisation method for intangible assets arising
from service concession arrangements related to toll roads recognised in
financial statements for the period immediately before the beginning of the
first Ind AS reporting period.

 

Under Ind AS 38, the guidance relating
to amortisation method does not apply to the assets covered in the previous
paragraph.

Additional exemption relating to non-current assets held for
sale and discontinued operations

There is no exemption under IFRS 1
relating to non-current assets held for sale and discontinued operations.

Ind AS 101 allows a first-time adopter
to use the transition date circumstances to measure the non-current assets
held for sale and discontinued operations at the lower of carrying value and
fair value less cost to sell.

Previous GAAP

IFRS 1 defines the term “previous GAAP”
as a basis of accounting that a first-time adopter used immediately before
adopting IFRS. Thus, an entity preparing two complete sets of financial
statements, viz., one set of financial statements as per the Indian GAAP and
another set as per the US GAAP, may be able to choose either GAAP as its
“previous GAAP.”

Ind AS 101 defines the term “previous
GAAP” as the basis of accounting that a first-time adopter used immediately
before adopting Ind AS for its statutory reporting requirements in India. For
instance, the companies preparing their financial statements in accordance
with section 133 of Companies Act, 2013, will consider those financial
statements as previous GAAP financial statements.

 

Consequently, it is mandatory for Indian
entities to consider their Indian GAAP financial statements as previous GAAP
for transitions to Ind AS.

Differences from other IFRS standards

Current/ non-current classification on breach of debt covenant

If an entity breaches a provision of a
long-term loan arrangement on or before the period end with the effect that
the liability becoming payable on demand, the loan is classified as current
liability.

 

This is the case even if the lender has
agreed, after the period end and before the authorisation of the financial
statements for issue, not to demand payment as a consequence of the breach.
Such waivers granted by the lender or rectification of a breach after the end
of the reporting period are considered as non-adjusting event and disclosed.

First, Ind AS 1 refers to breach of
material provision, instead of any provision. This indicates that breach of
immaterial provision may not impact loan classification.

 

Second, under Ind AS 1, waivers granted
by the lender or rectification of breach between the end of the reporting
period and the date of approval of financial statements for issue are treated
as adjusting event. A corresponding change has also been made in Ind AS 10.

Analyses of expenses in the statement of profit and loss

IAS 1 requires an entity to present an
analysis of expenses recognised in profit or loss using a classification
based on either their nature or their function within the entity, whichever
provides the information that is reliable and more relevant.

Ind AS 1 requires entities to present an
analysis of expenses recognised in profit or loss using a classification
based on their nature only. Thus, there is no option to use functional
classification for presentation of expenses.

Materiality and aggregation

IAS 1 requires:

??each
material class of similar items to be presented separately in the financial
statements; and

??items
of a dissimilar nature or function to be presented separately unless they are
immaterial

Ind AS 1 modifies these requirement by
adding the words ‘except when required by law.’  Hence, if the applicable law requires
separate presentation/ disclosure of certain items, they are presented
separately irrespective of materiality.

Differences from other IFRS standards

 

Also,
IAS 1 states that specific disclosure need not be provided if the same is
considered immaterial.

 

Presentation of financial statements

IAS 1 provides broad illustrative
format.

In addition to the broad illustrative
format included in Ind AS 1, Schedule III prescribes a detailed format for
presentation of financial statements and disclosures. The disclosures include
information required under certain Indian statutes.  Companies Act, 2013 also requires certain
statutory disclosures (eg contribution to political parties) to be made in
Ind AS financial statements.

Cash flow statement –

Classification of interest paid and interest and dividend
received

For non-financial entities, interest
paid and interest and dividends received may be classified as ‘operating
activities’. Alternatively, interest paid and interest and dividends received
may be classified as ‘financing activities’ and ‘investing activities’
respectively.

Ind AS 7 does not give an option.  It requires non-financial entities to
classify interest paid as part of ‘financing activities’ and interest and
dividend received as ‘investing activities’.

Cash flow statement –

Classification of dividend paid

Dividend paid may be classified either
as operating or financing cash flows.

Dividend paid is classified as financing
cash flows.

Bargain purchase gains

Where consideration transferred for
business acquisition is lower than the acquisition date fair value of net
assets acquired, the gain is recognised in the income statement after a
detailed reassessment.

Ind AS 103 requires bargain purchase
gain to be recognised in OCI and accumulated in the equity as capital
reserve. However, if there is no clear evidence for the underlying reason for
bargain purchase, the gain is directly recognised in equity as capital
reserve, without routing the same through OCI. A similar change has also been
made with regard to bargain purchase gain arising on investment in associate/
JV, accounted for using the acquisition method.

Common control business combinations

IFRS 3 excludes from its scope common
control business combinations.

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

  • Assets
    and liabilities of the combining entities are reflected at their carrying
    amounts.
  • No
    adjustments are made to reflect fair values, or recognise any new assets or
    liabilities.
  • Financial
    information in respect of prior periods is restated as if business
    combination has occurred from the beginning of the earliest period presented.
  • The
    balance of the retained earnings appearing in the financial statements of the
    transferor is aggregated with the corresponding balance appearing in the
    financial statements of the transferee; alternatively, it is transferred to
    general reserves, if any.
  • The
    identity of the reserves is preserved and appear in the financial statements
    of the transferee in the same form in which they appeared in the financial
    statements of the transferor.
  • The
    difference between the amount recorded as share capital issued plus any
    additional consideration in cash or other assets and the amount of share
    capital of the transferor is transferred to capital reserve and presented
    separately from other capital reserves.

Foreign currency convertible bonds (FCCB)

A fixed amount of foreign currency does
not result in fixed amount in the entity’s functional currency. Consequently,
FCCBs, where the conversion price is fixed in foreign currency, do not meet
“fixed-for-fixed” criterion to treat the conversion option as equity. Hence,
FCCBs are generally treated as a hybrid financial instrument containing a
liability component and the conversion option being a derivative. The
derivative element is measured at fair value at each reporting date and
resulting gain/ loss is recognised in the profit or loss for the period.

Ind AS 32 contains an exception to the
definition of financial liability. As per the exception, the equity
conversion option embedded in a convertible bond denominated in foreign
currency to acquire a fixed number of entity’s own equity instruments is
considered an equity instrument if the exercise price is fixed in any
currency. Hence, entities will treat the conversion option as fixed equity
and no fair valuation thereof is required.

Differences from other IFRS standards

Straight-lining of lease rentals in operating leases

Rental under an operating lease are
recognised on a straight-line basis over the lease term unless another
systematic basis is more representative of the time pattern of the user’s
benefit.

Lease payments under an operating lease
are recognised as an expense on a straight-line basis over the lease term
unless either:

a) Another systematic basis is more
representative of the time pattern of the user’s benefit, or

b) Payments to the lessor are structured
to increase in line with expected general inflation to compensate for the
lessor’s expected inflationary cost increases. If payments to the lessor vary
because of factors other than general inflation, then this condition is not
met.

Uniform accounting policies

Compliance with uniform accounting
policies is mandatory.

Ind AS 28 also requires the use of
uniform accounting policies. However, an exemption on the grounds of
“impracticability” has been granted for associates. This is for the reason
that the investor does not have “control” over the associate and it may not be able to
influence the associate to prepare additional financial statements or to
follow the accounting policies that are followed by the investor.

Use of the fair value model for investment property (IP)

An entity has an option to apply either
the cost model or the fair value model for subsequent measurement of its
investment property. If the fair value model is used, all investment
properties, including investment properties under construction, are measured
at fair value and changes in the fair value are recognised in the profit or
loss for the period in which it arises. Under the fair value model, the
carrying amount is not required to be depreciated.  Among other options, companies are allowed
to use fair value as deemed cost exemption for IP at the date of transition
to IFRS.

Ind AS 40 does not permit the use of
fair value model for subsequent measurement of investment property. It
however requires the fair value of the investment property to be disclosed in
the notes to financial statements. 
Also, consequent to the above change, companies are not allowed to use
fair value as deemed cost exemption for IP at the date of transition to Ind
AS.

Grants in the form of
non-monetary assets

IAS 20 provides an option to entities to
recognise government grants in the form of non-monetary assets, given at a
concessional rate, either at their fair value or at the nominal value.

Ind AS 20 requires measurement of such
grants only at their fair value. Thus, the option to measure these grants at
nominal value is not available under Ind AS 20.

Grants related to assets

IAS 20 gives an option to present the
grants related to assets, including non-monetary grants at fair value, in the
balance sheet either by setting up the grant as deferred income or by
deducting the grant in arriving at the carrying amount of the asset.

Ind AS 20 requires presentation of such
grants in the balance sheet only by setting up the grant as deferred income.
Thus, the option to present such grants by deduction of the grant in arriving
at the carrying amount of the asset is not available.

Use of equity method to account for investments in
subsidiaries, joint ventures and associates in SFS

IAS 27 allows an entity to use the
equity method to account for its investments in subsidiares, joint ventures
and associates in its SFS. Consequently, an entity is permitted to account
for these investments either

  • At
    cost
  • In
    accordance with IFRS 9
  • Using
    the equity method

This
is an accounting policy choice for each category of investment.

Ind AS 27 does not allow the use of
equity method to account for investments in subsidiaries, joint ventures and
associates in SFS. This is because Ind AS considers equity method to be a
manner of consolidation rather than a measurement basis.

Confidentiality exemption

IAS 24 does not provide any exemption
from disclosure requirements on the grounds of confidentiality requirements
prescribed in any statute or regulation.

Ind AS 24 exempts an entity from making
disclosures required in the standard if making such disclosures will conflict
with its duties of confidentiality prescribed in a statute or regulation.

Definition of close members of the family of a person

As per IAS 24, “close members of the
family” of a person are those family members who may be expected to
influence, or be influenced by, that person in their dealings with the
entity. They may include

a)
the person’s spouse or domestic partner and children,

Definition “close members of the family”
under Ind AS 24 is similar.

 

In
addition to relations prescribed under IFRS, it includes brother, sister,
father and mother in sub-paragraph (a).

Differences from other IFRS standards

 

b) children of the person’s spouse or
domestic partner, and

c) dependents of the person or the
person’s spouse or domestic partner

 

Differences in local implementation

Classification of refundable deposits received from
customers/ suppliers

Deposits received from the customer/ dealer
are refundable on demand if the connection/ dealership is surrendered.
Deposits being repayable on demand are classified as current.

The ITFG has originally clarified that
refundable deposit repayable on demand should be classified as current. However,
this clarification was subsequently withdrawn by the ITFG.  Consequently, many entities present them as
non-current liabilities.

Application of the pooling of interest method in common
control business combinations

IFRS 3 excludes from its scope common
control business combinations.

Ind AS 103 requires common control
business combination to be accounted for using the pooling of interest
method. The ITFG has provided the following guidance on the use of SFS vs.
CFS numbers:

  • Where
    a subsidiary merges with the parent, then it would be appropriate to
    recognise combination at the carrying amounts appearing in the CFS of the
    parent, since nothing has changed from group perspective.
  • If
    a subsidiary is merged with other fellow subsidiary, then the amount as
    appearing in the SFS of the merging subsidiary should be used for application
    of the pooling of interest method.

Date of accounting for common control business combination

No specific guidance. Globally, business
combinations including those under common control are generally accounted
from the date on which all substantive approvals are received.

In India, many merger & amalgamation
schemes need to be approved by the Court/ National Company Law Tribunal
(NCLT). In Indian scenario, the court/ NCLT approval is considered to be
substantive and is not merely a rubber stamping.  The ITFG has clarified that in a common
control business combination, the court/ NCLT approval received after the
reporting date and before approval of the financial statements for issue
would be treated as an adjusting event.

Determination of 
functional currency for the entity and its branch

Depending on specific facts, functional
currency for a branch can be different from that of the company.

A company is carrying on two businesses
in completely different economic environments, say, one INR and the other
USD. The ITFG has stated that the functional currency is determined at the
company level. Hence, functional currency should be same for both the
businesses.

SFS of parent: Impact of Interest free loan to subsidiary on
transition to Ind AS (Guidance provided by ITFG under Ind AS on matters which
are not relevant under IFRS)

  •  Under the erstwhile Indian GAAP, interest free loans to subsidiaries are
    accounted for at nominal amount. Under Ind AS, such loans are accounted at
    fair value. Any difference in nominal amount and fair value is added to
    investment subsidiary.
  • What
    happens to fair value impact of past loans outstanding at transition date?
    The company has used previous GAAP carrying amount as deemed cost option for
    measuring investment in subsidiary on the date of transition to Ind AS.

The
ITFG has clarified that any difference between the carrying amount and fair
value of loan will be added to the investment measured at cost.

Treatment of dividend distribution tax (DDT) – (Guidance
provided by ITFG under Ind AS on matters which are debatable under IFRS)

As per the tax provision in India,
companies paying dividend are required to pay dividend distribution tax.  The ITFG has clarified that the company is
paying DDT on behalf of shareholders. Hence, it should be treated as
distribution of profit and debited to SOCIE.

 

In
case of DDT paid by subsidiary on dividend distributed to holding company,
the holding company can claim deduction for tax paid by subsidiary against
its own tax liability pertaining to dividend distribution.  The ITFG has clarified that DDT paid by subsidiary
on dividend distributed to holding company is charged to P&L in CFS.  This is because there is a cash outflow for
the group to a third party; i.e., the tax authorities. Timing of charge is
based on Ind AS 12 principles. 
However, if a portion / total tax paid is claimed as set off against
holding company’s DDT liability (on dividends paid to its own shareholders) ,
then the offset amount is recognised in SOCIE and not P&L in CFS.  DDT paid on dividend distributed to NCI is
recognised in SOCIE.

Other minor differences

Variable consideration – Penalties

Under IFRS 15, the amount of
consideration, among other things, can vary because of penalties.

Under Ind AS 115, where the penalty is
inherent in determination of transaction price, it will form part of variable
consideration. For example, where an entity agrees to transfer control of a
good or service in a contract with a customer at the end of 30 days for
INR100,000 and if it exceeds 30 days, the entity is entitled to receive only
INR95,000, the reduction of INR5,000 will be regarded as variable
consideration. In other cases, the transaction price will be considered as
fixed.

Disclosure of reconciliation between revenue and contracted
price

IFRS 15 requires extensive qualitative
and quantitative disclosures including those on disaggregated revenue,
reconciliation of contract balances, performance obligations and significant
judgments.

Ind AS 115 contains all the disclosure
requirement in IFRS 15. In addition, Ind AS 115 requires presentation of a reconciliation
between the amount of revenue recognised in statement of profit or loss and
the contracted price showing separately adjustments made to the contracted
price, for example, on account of discounts, rebates, refunds, price
concessions, incentives, bonus, etc. specifying the nature and amount of each
such adjustment separately.

Exchange differences regarded as adjustment to interest costs

In accordance with IAS 23, borrowing
cost includes exchange difference arising from foreign currency borrowings to
the extent that they are regarded as an adjustment to interest costs.
However, it does not provide any specific guidance on measurement of such
amounts.

Ind AS 23 is similar to IAS 23. However,
Ind AS 23 provides following additional guidance on manner of arriving at
this adjustment:

  • The
    adjustment should be of an amount equivalent to the extent to which the
    exchange loss does not exceed the difference between the costs of borrowing
    in functional currency when compared to the costs of borrowing in a foreign
    currency.
  • If
    there is an unrealised exchange loss which is treated as an adjustment to
    interest and subsequently there is a realised or unrealised gain in respect
    of the settlement or translation of the same borrowing, the gain to the extent
    of the loss previously recognised as an adjustment should also be recognised
    as an adjustment to interest amount.

Statements of comprehensive income/ Statement of profit and
loss

With regard to preparation of statement
of profit and loss, IFRS provides an option either to follow the single
statement approach or to follow the two statement approach. An entity may
present a

  • single
    statement of profit or loss and other comprehensive income, with profit or
    loss and other comprehensive income presented in two sections; or
  • it
    may present the profit or loss section in a separate ‘statement of profit or
    loss’ which shall immediately precede the ‘statement of comprehensive
    income’, which shall begin with profit or loss.

Ind AS 1 allows only the single statement
approach and does not permit the two statements approach.  For deletion of two statements approach,
consequential amendments have been made in other Ind AS also.

Frequency of reporting

In accordance with IAS 1, an entity
consistently prepares financial statements for each one-year period. However,
for practical reasons, some entities prefer to report, for example, for a
52-week period. IAS 1 does not preclude this practice.

Ind AS 1 does not permit entities to use
a periodicity other than one year to present their financial statements.

Earnings Per Share –

Applicability

IAS 33 applies only to an entity whose
ordinary shares or potential ordinary shares are traded in a public market or
that files, or is in the process of filing, its financial statements with a
securities commission or other regulatory organisation for the purpose of
issuing ordinary shares in a public market.

This scope requirement has been deleted
in the Ind AS as the applicability or exemptions is governed by Companies
Act, 2013 and the rules made thereunder. 
Since there is no exemption from disclosing EPS under the Companies
Act, all companies covered under Ind AS need to disclose EPS.

Presentation of EPS in separate financial statements

IAS 33 provides that when an entity
presents both consolidated financial statements (CFS) and separate financial
statements (SFS), it provides EPS related information in CFS.

Ind AS 33 requires EPS related
information to be disclosed both in CFS and SFS. In CFS, such disclosures
will be based on consolidated information. In SFS, such disclosures will be
based on information given in the SFS.

Other minor differences

Segment reporting Application

IFRS 8 applies only to an entity whose
ordinary shares or potential ordinary shares are traded in a public market or
that files, or is in the process of filing, its financial statements with a
securities commission or other regulatory organisation for the purpose of
issuing ordinary shares in a public market.

This scope requirement has been deleted
in the Ind AS as the applicability or exemptions is governed by Companies
Act, 2013 and the rules made thereunder. 
Currently, the Companies Act does not exempt any company (except few
government companies in defence sector) from presentation of segment
information.

Aggregation of transactions for related party disclosure

IFRS does not provide any guidance on
the aggregation of transaction for disclosure purposes.

Ind AS 24 provides an additional
guidance whereby items of similar nature may be disclosed in aggregate by
type of related party. However, this is not done in such a way as to obscure
the importance of significant transactions. Hence, purchases or sales of
goods are not aggregated with purchases or sales of fixed assets. Nor a
material related party transaction with an individual party is clubbed in an
aggregated disclosure.

Regulatory Deferral Accounts 
– Explanation to the definition of “previous GAAP”

IFRS 14 defines the term “previous GAAP”
as a basis of accounting that a first-time adopter used immediately before
adopting IFRS.

Ind AS 114 defines the term “previous
GAAP” as the basis of accounting that a first-time adopter used immediately
before adopting Ind AS for its reporting requirements in India. Further an
explanation has been added to the definition to consider the Guidance Note on
Accounting for the Rate Regulated Activities issued by the ICAI to be the
previous GAAP.

Regulatory Deferral Accounts 
– Scope

An entity is allowed to apply the
requirements of IFRS 14 in its subsequent financial statements if and only
if, in its first IFRS financial statements, it recognised regulatory deferral
account balances by electing to apply the requirements of IFRS 14.

Ind AS 114 contains similar requirement.
In addition, its states that an entity applies the requirements of previous
GAAP in respect of such regulated activities:

  • in
    the case of an entity subject to rate regulation coming into existence after
    Ind- AS coming into effect; or
  • if
    its activities become subject to rate regulation subsequent to preparation
    and presentation of its first Ind AS financial statements.

Repeat application of IFRS/Ind AS

IFRS 1 states that an entity that
stopped applying IFRS in the past and chooses, or is required, to resume
preparing IFRS financial statements has an option to either apply IFRS 1
again or to retrospectively restate its financial statements as if it had
never stopped applying IFRS.

Ind AS 101 does not contain this
provision. Rather, MCA roadmap states that once a company opts to follow Ind
AS, it will be required to follow the Ind AS for all the subsequent financial
statements.

Presentation of comparative information

IFRS 1 requires comparative information
for minimum one year. If an entity elects, it can give comparative
information for more than one year.

The ITFG has clarified that due to the
Companies Act notification, a first-time adopter can give Ind AS comparative
information only for one year.

Exemption relating to borrowing cost

IFRS 1 permits a first time adopter to
apply the requirements of IAS 23 from the date of transition or from an
earlier date as permitted by the transitional requirements of IAS 23.

There is no such exemption under Ind AS
101, since Indian GAAP requires the borrowing cost relating to qualifying
assets to be capitalised if the criteria laid down in AS 16 (Indian GAAP) are
fulfilled.

Small and medium-sized entities

The IASB had issued a separate IFRS for SMEs in July
2009. IFRS for SMEs is based on the fundamental principles of full IFRS, but
in many cases, it has been simplified to make the accounting requirements
less complex and to reduce the cost and effort required to produce the
financial statements. To achieve this, the IASB removed a number of the
accounting options available under full IFRS and attempted to simplify
accounting, including recognition and measurement principles, for SMEs in
certain areas.

Whilst the standard provides a broad
level definition of an SME to help in understanding the entities to which
IFRS for SMEs is applicable, the preface to the standard indicates that the
decision as to which entities are required or permitted to apply the standard
will lie with the regulatory and legislative authorities in each
jurisdiction.

In India, there is no separate standard
for SMEs that will correspond to IFRS for SMEs.  As per the MCA roadmap, Ind AS applies in
phases to:

  • Listed
    companies;
  • Non-listed
    companies having net worth of INR 250 crores or more;
  • Holding,
    subsidiary, joint venture and associate companies of the above companies

 

All other companies will continue to
apply Indian GAAP or they may adopt Ind AS voluntarily. ICAI is separately
upgrading Indian GAAP to bring it closer to Ind AS. In certain cases, the
ICAI may use IFRS for SMEs principles while revising Indian GAAP.  

Percentage Of Completion Method (POCM) Illustration For Real Estate Companies Under Ind AS 115 & Comparison With Guidance Note (GN)

Background

On 28th March
2018, the Ministry of Corporate Affairs (MCA) notified the new revenue
recognition standard, viz., Ind AS 115 Revenue from Contracts with Customers.
Ind AS 115 is applicable for the financial years beginning on or after 1st
April 2018 for all Ind AS companies. It replaces virtually all the existing
revenue recognition requirements under Ind AS, including Ind AS 11 Construction
Contracts, Ind AS 18 Revenue and the Guidance Note on Accounting
for Real Estate Transactions (withdrawn by ICAI vide announcement dated
01-06-2018) (GN).

 

One of the industries where
the impact is significant is the real estate industry. In addition to not being
able to apply POCM invariably, there are numerous other accounting challenges.
Here we take a look at the following issues:

 

1.  Evaluating if building is a separate
performance obligation (PO) from the underlying land in a single-unit vs. a
multi-unit sale.

2.  Understanding clearly the requirements for
POCM eligibility under Ind AS 115.

3.  Where a real estate sale is eligible for POCM
– the differences in POCM between the GN and Ind AS 115.

4.  POCM illustrations under the GN and Ind AS
115, highlighting the underlying differences.

 

Whether Land &
Buildings are separate POs?

The diagram below depicts
the requirements with respect to identifying goods and services within a
contract.

 


Whether land and building
are two separate POs will depend upon whether the underlying real estate sale
is a single-unit or a multi-unit sale. An example of a single-unit sale is
where a customer is sold an individual plot of land with a construction of a
villa on that plot of land. In this example, the customer receives the
ownership of the land and the villa. On the other hand, a multi-unit sale is
where a customer is sold a flat in a multi-floor, multi-unit building. Here the
customer receives the finished apartment and the undivided interest in the
land.

 

In the case of a
single-unit sale, land and building in most circumstances will be separate POs.
The International Financial Reporting Interpretation Committee (IFRIC)
considered this issue and felt land and building are two separate POs for the
following reasons:

 

–   When
evaluating step 1 above, whether goods/services are capable of being distinct
based on the characteristics of the goods or services themselves; the
requirement in the standard is to disregard any contractual limitations that
might preclude the customer from obtaining readily available resources from a
source other than the entity. Further, customer could benefit from the plot of
land on its own or together with other resources.

 

–   When
evaluating step 2 above, it is important to understand if the relationship
between land and building is functional or transformative. The relationship
between land and building is functional, because building cannot exist without
the land; its foundations will be built into the land. However, in order for
the two POs to be combined as one PO, the relationship has to be
transformative. The relationship between land and building is not
transformative. The building does not alter or transform the land and vice-versa.
There is no integration or the two POs do not modify each other.

 

In the case of a multi-unit
sale, the undivided interest in the land and the building in most circumstances
will be one PO because the customer receives a combined output, i.e. a finished
apartment. The customer does not benefit from the undivided interest in the
land on its own or buy it independently or use it with other readily available
resources. The customer does not receive ownership of the land. The real estate
entity may probably transfer the land after project completion to a society
established by all the home-owners.

 

When is over-time (POCM) revenue recognition
criterion met under Ind AS 115?

An entity shall recognise
revenue when (or as) the entity satisfies a performance obligation by
transferring a promised good or service (i.e. an asset) to a customer. An asset
is transferred when (or as) the customer obtains control of that asset. For
each performance obligation, an entity shall determine at contract inception
whether it satisfies the performance obligation over time or satisfies the performance
obligation at a point in time. If a performance obligation is not satisfied
over time (explained later), an entity satisfies the performance obligation at
a point in time. The Standard describes when performance obligations are
satisfied over time. Consequently, if an entity does not satisfy a performance
obligation over time, the performance obligation is satisfied at a point in
time. The point in time is the time when the control in the goods or service is
transferred to the customer.

 

An entity transfers control
of a good or service over time and, therefore, satisfies a performance
obligation and recognises revenue over time, if one of the following criteria
is met:

 

(a) the customer simultaneously receives and
consumes the benefits provided by the entity’s performance as the entity
performs (for example, interior decoration in the office of the customer);

 

(b) the entity’s performance creates or enhances an
asset (for example, work in progress) that the customer controls (as defined in
the Standard) as the asset is created or enhanced; or

 

(c) the entity’s performance does not create an
asset with an alternative use to the entity and the entity has an enforceable
right to payment for performance completed to date.

 

Let us consider an example,
to see how the above criterion is applied.

 

Example 1 – Application of Over time revenue
recognition criterion

 

Issue

–   An
entity is constructing a multi-unit residential complex

 

–   Customer
enters into a binding sales contract with the entity for a specified unit

 

–   The
customer makes milestone payments as per contract, which cumulatively are less
than work completed to date plus a normal profit margin

 

–    A
significant contract price is paid by customer to entity on delivery (but the
contract is enforceable under Ind AS 115)

 

–   In
case customer wishes to terminate the contract, either customer or entity can
identify a new customer, who will pay the remaining amount as per milestone
schedule.

–    The
new customer compensates the original buyer, for payments made to date. The
compensation may be higher or lower than the cumulative payments made by the
original customer

 

–    The
contract is silent when new buyer cannot be identified. However, as per local
laws, the entity cannot enforce claim for remaining payments from the original
customer.

 

Whether the performance
obligation is satisfied at a point in time or over time?

 

Response

Similar issue was
considered by IFRIC.

 

IFRIC Agenda Decision : Revenue
recognition in constructing a multi-unit building:

Ind
AS 115 Para

Analysis

Met
(v) / Not met (X)

35
(a) – The customer is receiving and consuming the benefits of the entity’s
performance as the entity performs

Entity’s
performance creates an asset, i.e., the real estate unit that is not consumed
immediately.  Therefore this criterion
is not met.

X

35
(b) – The entity creates or enhances an asset that the customer controls as
it is created or enhanced

Control
criterion not  met because:

? Asset created is the real
estate unit itself and not the right to obtain the real estate unit in the future
– The right to sell or pledge this right is not evidence of control

? Customer has no ability to
direct the construction or structural design of the real estate

? Customer’s exposure to
change in market value does not give the customer the ability to direct use
of the unit

X

35
(c) – (i) The entity’s performance does not create an asset with alternative
use and

 

(ii)
the entity has a right to payment for performance completed to date

In
most of the contract, the asset created by an entity’s performance does not
have an alternative use to an entity

v

Entity
may not have enforceable right to payment for performance completed to date,
because:

 

? The customer can walk away
without making the rest of the payment

 

To
meet this criterion, entity should have a contractual/legal right to receive
payments for work completed to date including a reasonable profit
margin.  A satisfactory resolution of
the problem does not mean that the entity has an enforceable right to payment
for work completed to date.

X

Many real estate companies in India may not
qualify for POCM on transition date contracts. 
However, the third criterion discussed above can be incorporated in
future contracts to achieve POCM recognition.

 

 

Example 2 – Over time revenue recognition requirement
met

 

Issue

–   An
entity is constructing a multi-unit residential complex. A customer enters into
a binding sale contract with the entity for a specified unit.

–   The
customer pays a non-refundable deposit upon entering into the contract and will
make progress payments during construction of the unit. The contract has
substantive terms that preclude the entity from being able to direct the unit
to another customer.

 

–    In
addition, the customer does not have the right to terminate the contract unless
the entity fails to perform as promised.

 

–    If
the customer defaults on its obligations by failing to make the promised
progress payments as and when they are due, the entity would have a right to
all of the consideration promised in the contract if it completes the
construction of the unit.

–   The courts have previously
upheld similar rights that entitle developers to require the customer to
perform, subject to the entity meeting its obligations under the contract.

 

Does the
real estate entity meet the criterion for overtime recognition of revenue?

 

Response

–   The
entity determines that the asset (unit) created by the entity’s performance
does not have an alternative use to the entity because the contract precludes
it from transferring the specified unit to another customer.

 

–    The
entity does not consider the possibility of a contract termination in assessing
whether the entity is able to direct the asset to another customer.

 

–   The
entity also has a right to payment for performance completed to date. This is
because if the customer were to default on its obligations, the entity would
have an enforceable right to all of the consideration promised under the
contract if it continues to perform as promised.

 

–   Therefore,
the terms of the contract and the practices in the legal jurisdiction indicate
that there is a right to payment for performance completed to date.

 

Consequently, the criteria
for recognising revenue over time under Ind AS 115 are met and the entity has a
performance obligation that it satisfies over time.

 

What is enforceable right to payment?

There are a couple of
points one needs to consider to understand if a real estate contract provides
an enforceable right to payment:

 

1.  The enforceable right to payment for work
completed to date would include cost incurred to date plus a normal profit
margin.

 

2.  The right should be enforceable both under the
contract as well as legislation.

 

3.  The law may provide contract enforceability,
however the RERA authorities may issue interpretations and judgement that are
consumer friendly. The Maharashtra Estate Regulatory Authority in Mr.
Shatrunjay Singh vs. Arkade Art  Phase 2
opined that the customer is not eligible for refund of the amounts paid to the
developer even if customer is not able to pay due to financial difficulty.
However, it did not rule that the contract was enforceable against the
customer, and that the entity had a right to collect payment for work completed
to date. Real estate entities should therefore clearly evaluate the legal
position and obtain legal opinions to support over time revenue recognition.
Since different RERA authorities may take different positions, a real estate
entity should obtain legal opinion for all major states where it has
operations.

 

4.  The right to payment does not mean that the
entity has the right to invoice every day or week or month or other than based
on mile-stone. Rather, if the customer walks-away from the contract, the entity
should be able to enforce payment for work completed to date (plus normal
profit margin).

 

5.  The existence of the right is important.
Whether the real estate entity chooses to exercise the right is not relevant.

 

6.  A satisfactory resolution of the problem as
explained in Example 1, does not mean that the real estate entity has an
enforceable right to payment. A clear enforceable right to payment should be
granted both under the contract and the legislation.

 

7.  If a customer can walk away by paying a
penalty (which is not equal to or greater than cost incurred to date plus
normal profit margin), then there is no enforceable right to payment.

 

8.  In a 10:90 scheme, the contract itself may not
be enforceable. However, in a mile-stone based real estate contract, a 10%
received upfront, may be sufficient to demonstrate contract enforceability.
Evaluating contract enforceability and right to payment is a continuous process
throughout the project period.

 

POCM under GN vs Ind AS 115

Even when real estate
entities meet the POCM criterion under Ind AS 115, the POCM as per the GN
(withdrawn) and Ind AS 115 are dissimilar in many respects. A comparison is
given below.

 

Point
of difference

GN

Ind
AS 115

Threshold
for revenue recognition

??All
critical approvals obtained

??Construction
and development costs = 25%

??Saleable
project area is secured by
contracts = 25%

??Realised
contract consideration = 10%

 

Revenue
to be recognised straight-away and there is no condition for achieving any
threshold.  However, contract
enforceability criterion is required to be met for recognizing revenue.  Therefore, more revenue will be recognised
upfront under Ind AS 115 as compared to the GN. If the entity is unable to
reasonably estimate progress, an entity should recognise revenue upto cost
incurred to date, unless the contract is onerous.

Borrowing
cost

Included
in POCM

Borrowing
costs cannot contribute to performance. Therefore borrowing costs would be
excluded from the measure of progress.

Land
cost

Included
in POCM, when threshold is achieved.

Preferred
view is that it is included in POCM on commencement of the project.

20:80/
10:90 Schemes

Revenue
can be recognised subject to thresholds

Contract
may not be eligible as valid contract under Ind AS 115

Financing
component

No
requirement to separate financing component

Explicitly
required to separate financing component

 

 

POCM under GN

 

Illustration

 

Particulars

Scenario 1

Scenario 2

Total
saleable area

20,000 sq. ft.

20,000 sq. ft.

Estimated
Project Costs

 

 

Land
cost

INR 300 lakh

INR 300 lakh

Construction
cost

INR 300 lakh

INR 300 lakh

Cost
incurred till end of reporting period

 

 

Land
cost

INR 300 lakh

INR 300 lakh

Construction
cost

INR 60 lakh

INR 90 lakh

Total
Area Sold till the date of reporting period

5,000 sq. ft.

5,000 sq. ft.

Total
Sale Consideration as per Agreements of Sale executed

INR 200 lakh

INR 200 lakh

Total
sales consideration (estimated)

INR 800 lakhs

INR 800 lakh

Amount
realised till the end of the reporting period

INR 50 lakh

INR 50 lakh

Fair
value of the land & building (each)

INR 400 lakhs

INR 400 lakhs

 

Response

 

Particulars

Scenario 1

Scenario 2 – land is considered as contract
activity

Scenario 2 – land is not considered as contract
activity

Construction
and development costs = 25%

60/300 = 20%

90/300 = 30%

90/300 = 30%

Saleable
project area is secured by contracts = 25%

5,000/20,000 = 25%

5,000/20,000 = 25%

5,000/20,000 = 25%

Realised
contract consideration

=
10%

50/200 = 25%

50/200 = 25%

50/200 = 25%

POCM

360/600 = 60%

390/600 = 65%

90/300 = 30%

Revenue
can’t be recognised in scenario 1, as first condition is not met

 

 

 

(i)
Revenue Recognised

–

INR 130 lakhs

(200 * 65%)

INR 60 lakhs

(200*30%)

(ii)
Proportionate Cost /

–

INR 97.5 lakhs

(600 * 65%*1/4)

INR 45 lakhs

(600*30%*1/4)

Profit
[ (i) – (ii) ]

–

INR 32.5 lakhs

INR 15 lakhs

WIP

INR 360 lakhs

(300+60)

INR 292.5 lakhs

(390-97.5)

INR 345 lakh

(390-45)

 

 

1.  In Scenario 1, construction and development
cost criterion of 25% is not fulfilled and since threshold is not met, no
revenue is recognised.

 

2.  Scenario 2 where land is considered as
contract activity is clearly in accordance and as illustrated in the GN. Once
the 25% criterion is met, land is included in the determination of the POCM and
revenue/cost is recognised on that basis.

 

3.  Scenario 2 where land is not considered as
determining the contract activity (POCM) is the author’s interpretation of
Paragraph 5.4 of the GN. Paragraph 5.4 of the GN states that “Whilst the method
of determination of state of completion with reference to project cost incurred
is the preferred method, this GN does not prohibit other methods of
determination of stage of completion, eg, surveys of work done, technical
estimation, etc.”

 

POCM under Ind AS 115 in single-unit apartment

As already discussed above,
in a single-unit apartment, in most cases, land and building will be two
separate POs. The question that arises at what point in time revenue on land is
recognised. Theoretically there are three options on how land revenue is recognised
at (a) commencement, (b) settlement or (c) over time. These options are
presented below based on the earlier illustration (scenario 2).

 

When land revenue is recognised?

View 1 – 
Commencement

 

View 2 – Settlement

 

View 3 –Overtime

POCM

90/300 = 30%

 

90/300 = 30%

 

90/300 = 30%

 

Land

Building

Total

Land

Building

Total

Land

Building

Total

(i)
Revenue Recognised

100

(400*1/4)

30

(400*1/4*

30%)

130

0

30

(400*

1/4*

30%)

 

30

30

(400*

1/4*

30%)

 

30

(400*1/4
*30%)

 

60

(ii)
Proportionate Cost

75

(300*1/4)

 

22.5

(300*1/4*

30%)

 

97.5

0

22.5

(300*

1/4

*30%)

 

22.5

22.5

(300*

1/4*

30%)

 

22.5

(300*1/4*
30%)

 

45

Profit  [(i) – (ii)]

25

7.5

32.5

0

7.5

7.5

7.5

7.5

15

WIP

225

(300-75)

 

67.5

(90-22.5)

 

292.5

300

67.5

(90-22.5)

 

367.5

277.5

(300-22.5)

 

67.5

(90-22.5)

 

345

 

 

Revenue
and cost of land is recognised at the completion of the contract.

 

 

 

The author believes that
View 1 below is the most appropriate response.

 

View 1: Control of the land
at commencement

 

The author believes land
revenue is recognised at commencement since the control of the land transfers
once the contract is enforceable. The contract restricts the ability of the
real estate entity to redirect the land for another use. Besides, the customer
has the significant risks and rewards of ownership from that time. Although the
legal title of the land does not transfer until settlement, this view considers
that the retention of legal title in this fact pattern is akin to a protective
right because the customer will not pay for the land until settlement.
Therefore, this contract is like many other contracts where the asset is
acquired on deferred payment terms. In this view, the real estate entity will
need to confirm that the existence of a contract criteria are met in IND AS
115.9, in particular that it is it is probable that the builder will collect
the consideration to which it will be entitled in exchange for the land and
house (single-unit) construction services.

View 2: Control of the land
transfers at settlement

 

Control of the land
transfers at settlement, which is when legal title transfers to the customer.
This provides clear evidence that the customer has obtained control of the
land. This outcome would also be consistent with other real estate sales
contracts that do not have a specific performance clause.

 

However, the major drawback
of this view is that it is counterintuitive for a  customer
to obtain  control
(forInd AS 115 purposes) of the
house prior to the obtaining control of the land. Hence this view is not
appropriate.

 

View 3: Control of the land
also transfers over time to the customer

 

Over time revenue
recognition is applicable to land because the real estate entity is
contractually restricted from redirecting the land to others. Besides the right
to sue for specific performance applies to the contract as a whole ( i.e land
and house construction). However, the major shortcoming of this view is that
the real estate entity’s performance does not create or enhance the land—the
land already exists. In other words land is not getting created, enhanced or
transformed overtime. Hence, this view is not appropriate.

 

POCM under Ind AS 115 in multi-unit apartment

As already discussed above,
in a multi-unit apartment land and building is treated as one performance obligation.
Theoretically there are 3 options available on how to apply POCM in a
multi-unit apartment where construction meets the overtime requirement in
35(c).

 

Options

If
land and building is a not separate PO

View
1

– Land treated as an input
cost and included in determination of POCM margins

– Consequently significant
revenue/cost gets recognised at commencement

View
2

– Land treated as an input
cost but not included in POCM

– Revenue recognised to the
extent of the input cost – no margins are recognised

– Significant revenue/cost
gets recognised at commencement

View
3

– POC determined on the basis
of development cost to date (excluding land) vs total development cost
(excluding land). POC is then applied on total contract revenue

– Consequently all
revenue/cost (including land) gets recognised overtime

 

 

View 1 and 3 seem
acceptable views, and are demonstrated below (Scenario 2)

 

Particulars

View 1

View 3

POCM

390/600 = 65%

90/300 = 30%

(i)
Revenue Recognised

INR 130 lakhs

(200*65%)

INR 60 lakhs

(200*30%)

(ii)
Proportionate Cost

INR 97.5 lakhs

(600*65%* 1/4)

INR 45 lakhs

(600*30%*1/4)

Profit
[(i) – (ii)]

INR 32.5 lakhs

INR 15 lakhs

WIP

INR 292.5 lakhs

(390-97.5)

INR 345 lakh

(390-45)

 

 

Conclusion

Ind AS 115 is very
complicated. The interpretations around Ind AS 115 are still emerging globally
and in India. Real estate entities will need to carefully study, analyse and
apply the requirements, without jumping to straight-forward conclusions. 

 

USEFUL LIFE UNDER IND AS 16 PROPERTY, PLANT AND EQUIPMENT AND LEASE TERM UNDER IND AS 116 LEASES

QUERY

A lessee enters into a lease for an office
property. The lease has a non-cancellable term of 5 years and contains an
option for the lessee to extend the lease for a further 5 years. The rentals
for the period under the extension option (i.e., years 6-10) are at market
rates. Upon commencement of the lease term, the lessee incurs cost constructing
immoveable leasehold improvements specific to the property. The useful life of
the leasehold improvement is 7 years. At the commencement date of the lease,
the lessee expects, but is not reasonably certain, to exercise the extension
option. The economic penalty of abandoning the leasehold improvement at the end
of the non-cancellable term of the lease is not so significant as to make
exercise of the renewal option reasonably certain. Over what period does the
lessee depreciate leasehold improvements?

 

RESPONSE

View 1 – The
useful life of the leasehold improvements is 5 years

 

Appendix A to Ind
AS 116 defines lease term as: “The non-cancellable period for which a lessee
has the right to use an underlying asset, together with both:

u    (a) periods covered by an
option to extend the lease if the lessee is reasonably certain to exercise that
option; and…”

 

In this case, since
the lessee is not reasonably certain to exercise the option to extend the
lease, the lease term is 5 years for the purpose of Ind AS 116. 

 

Ind AS 16 (56)
states that:

“…all the following
factors are considered in determining the useful life of an asset:

u    (a) expected usage of the
asset. Usage is assessed by reference to the asset’s expected capacity or
physical output.

u    (b) expected physical wear
and tear, which depends on operational factors such as the number of shifts for
which the asset is to be used and the repair and maintenance programme, and the
care and maintenance of the asset while idle.

u    (c) technical or commercial
obsolescence arising from changes or improvements in production, or from a
change in the market demand for the product or service output of the asset…

u    (d) legal or similar limits
on the use of the asset, such as the expiry dates of related leases.” (emphasis
added.)

Keeping in mind the
legal limits, the useful life of the leasehold improvements is 5 years.

 

View 2 – The
useful life of the leasehold improvements is 7 years

 

The useful life of
the leasehold improvement is based on its expected utility to the entity [Ind
AS 16(57)]. To determine the expected utility, the lessee would consider all
the factors in paragraph 56 of Ind AS 16. While paragraph 56(d) of 16 should be
considered, the factor regarding “expected usage of the asset” in paragraph
56(a) of Ind AS 16 is equally relevant in determining the useful life. The
condition contained in paragraph 56(d) of Ind AS 16 reflects the necessity to
consider the existence of legal or other externally imposed limitations on an
asset’s useful life. The ability to extend the lease term is within the control
of the lessee and is at market rates so there are no significant costs or
impediments to renewal.   The term
“expected usage of the asset” for the determination of useful life of an asset
indicates a lower threshold than the “reasonably certain” threshold for
including the extension period in the lease term for Ind AS 116 purposes.

 

In accordance with
Ind AS 16 (51), if the assessment of useful life changes (for example, the
lessee no longer expects to exercise the lease renewal option) the change shall
be accounted for as a change in an accounting estimate. In such circumstances,
the entity may also need consider whether there is an impairment.

 

AUTHOR’S VIEW

The author believes
that there is greater merit in View 1, because it  results in harmony between the way lease term
and useful life of the leasehold improvements are determined.  

 

 

 

CONSOLIDATION OF CSR TRUSTS UNDER Ind AS

Background

Many Indian corporates have set up
Special Purpose Not-for-Profit Entities (NFP) to undertake corporate social
responsibility (CSR) activities as required u/s. 135 of the Companies Act,
2013. The CSR activities are either undertaken by the Company directly or
through a charitable trust under The Indian Trusts Act, 1882, section 8 company
under the Companies Act 2013 or a society under the Societies Registration Act,
1860. The sponsoring company will provide adequate funds or donations to the
trust, society or the section 8 company so that it can carry out the relevant
activities as required under the Companies Act, 2013. A question arises as to
whether such NFP should be consolidated under Ind AS 110, Consolidated
Financial Statements by the sponsoring company.

 

Under Ind AS 110, an investor
controls an investee and consequently consolidates it 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 and only 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
investor’s returns.

 

Arguments supporting consolidation of the
NFP

Following are the arguments
supporting consolidation:

 

  • Under Ind AS 110, variable returns are seen more broadly, and
    will include exposure to loss or expenses from providing funds, donation,
    credit or liquidity support and intangible benefits on reputation and image
    from good governance practices. By hand-picking the members of the governing
    body of the NFP, the sponsor of the NFP ensures that it has power over the NFP
    either explicitly or implicitly. Using these powers, the sponsoring company
    ensures that the NFP undertakes the desirable CSR activity, which meets its compliance
    and other needs.

 

Ind AS 110 does not apply to
post-employment benefit plans or other long-term employee benefit plans to
which Ind AS 19, Employee Benefits, applies. However, there are no such
exemptions for NFPs. Moreover, the accounting for long term employee benefit
plans under Ind AS 19 effectively recognises the net assets and liabilities of
the Trust, i.e., the net defined benefit liability (asset) is determined after
taking into account the fair value of the plan assets and the relevant disclosures
are included in the separate financial statements and CFS of the company.

 

The NFP is controlled by the
sponsoring company for its own benefit and is not specifically exempted from
preparing CFS. Hence, an NFP should be consolidated.

 

  • CSR activities prior to the Companies Act, 2013 were undertaken
    voluntarily. After the Companies Act, 2013, it has also become a
    quasi-mandatory requirement. If a company does not spend on CSR, as required by
    the Companies Act, 2013 it has to make appropriate disclosures in the
    Director’s report. There are numerous activities a company has to undertake for
    the purposes of complying with the various laws of the land. The cost of all
    such compliance activities are included in the separate and consolidated
    financial statements (CFS). Since CSR is a cost incurred to conduct business in
    the country as required by legislation, it should be included and consolidated
    in the financial statements. The NFP is merely an extension of the Company
    created to ensure compliance with the Companies Act, 2013. A company that
    undertakes CSR activities directly would have in any case included the CSR
    spend in its separate financial statements and CFS. Whether the CSR activities
    are under taken directly or through a trust, society or company, the outcome
    with respect to financial statements should be the same.

 

  • Even in cases, where the CSR activity is not linked to compliance
    but is undertaken for altruistic purposes, consolidation will still be
    required. This is because in such cases, for reasons already described above,
    the company has an exposure to variable returns in the form exposure to loss
    from funding or providing liquidity support for running the CSR entity. In
    addition, there will be intangible returns by way of enhancement or damage to
    reputation and image.

 

Conclusion

The
author believes that the NFP created for CSR activities should be consolidated
in accordance with the requirements of Ind AS.

Ind AS 115 – Revenue From Contracts With Customers

The impact
of revenue is all pervasive and encompasses all entities. The standard brings
about a fundamental change in how entities will envision, recognise and measure
revenue. In this article the author briefly discusses the date of applicability
of Ind AS 115, the fundamental changes from current practice, key impacts for
certain industries and disclosure and other business implications. Given the
pervasive and fundamental impact of the standard, entities that have not
already started, should waste no time in preparing for Ind AS 115.

 

When does Ind AS 115
apply?

The Exposure Draft (ED)
issued by the ICAI states that the standard would apply from accounting periods
commencing on or after 1st April 2018.

 

However, it is not yet
notified by the Ministry of Corporate Affairs (MCA). In the past we have
observed instances where standards have been notified on the last day of the
financial year. Whilst there is no 100% guarantee that the standard would apply
from 1st April, 2018, companies should anticipate that it would be
notified by MCA before the end of the financial year, given the past
experience.

 

Whilst this is an unhappy
outcome, it may be noted that the ICAI had clarified the applicability date in
April 2017 and the ED was issued much earlier; providing enough opportunity to
prepare for implementation of the new standard. By the time this article is
published, it will be clear whether the standard has become applicable. It may
be noted that listed companies will have to churn out numbers under Ind AS 115
in the first quarter of 2018-19, and hence this is a highly onerous obligation,
than what may initially appear.

 

What are the fundamental
changes compared to the existing Ind AS 18 Revenue?

Ind AS 115 requires
perceiving revenue from the customer’s point of view; which is whether the
customer has received a stand-alone benefit from the goods or services it has
received. This is likely to impact accounting of connection, activation,
installation, admission, and similar revenue. This can be observed across
several industries, such as, telecom, power, cable television, education,
hospitality, etc. Consider for example, an electricity distribution
company installs an electric meter at the customer’s site. The meter certainly
benefits the customer, but it does not provide to the customer any independent
stand-alone benefit, because the meter is useless without the subsequent
transfer of power to the customer. Neither the customer can use the meter to
procure power from other distributors. Therefore, the customer has not received
any benefit from the meter on its own and consequently such connection income
is recognised overtime by the distribution company.

 

The other fundamental
change is that under Ind AS 115, an entity recognises revenue when control of
the underlying goods or services are transferred to the customer. This is
different from the current “risk and reward” model under Ind AS 18, where
revenue is recognised on transfer of risk and rewards to the customer. Consider
an entity transfers legal title and control of goods to a customer on free on
board (FOB) delivery terms. However, the entity reimburses the customer for any
damages or transit losses in accordance with its past practice. Under the Ind
AS 18, risk and reward model, some entities may have delayed recognition of
revenue till the time the customer has received and accepted the goods. This is
on the basis that the risk and rewards are transferred when the customer
receives and accepts the goods. Under the control model in Ind AS 115, revenue
will be recognised on shipment because control is transferred to customers at
shipment. As soon as the goods are boarded, the customer has legal title to the
goods, the customer can direct the goods wherever it wants and the customer can
decide how it wants to use those goods. In this situation, the entity will have
two performance obligations (1) sale of goods, and (2) reimbursing transit
losses. The total transaction price will be allocated between the goods and the
transit losses, and recognised when those respective performance obligations
are satisfied. However, in most situations, the performance obligation relating
to reimbursement of the transit losses may be insignificant, in which case it
may be ignored.

 

There are numerous other
changes that may not be fundamental, but still be very important. Take for
example, the discounting of retention monies. Currently under Ind AS 18 there
is debate on whether retention monies need to be discounted. This is because of
contradictory requirements in the standard. One view is that since revenue is
recognised at fair value, the retention monies need to be discounted to
determine the fair value of revenue. Ind AS 18 also states that “when the
arrangement effectively constitutes a financing transaction, the fair
value of the consideration is determined by discounting all future receipts
using an imputed rate of interest…………….The difference between the fair value
and the nominal amount of the consideration is recognised as interest revenue
in accordance with Ind AS 109.” This means that discounting is only required
when the arrangement contains a financing arrangement. Ind AS 18 was therefore
debatable.

 

On the other hand, Ind AS
115, is absolutely clear. Paragraph 62 states that “notwithstanding the
assessment in paragraph 61, a contract with a customer would not have a
significant financing component if any of the following factors exist: ………….(c)
the difference between the promised consideration and the cash selling price of
the good or service (as described in paragraph 61) arises for reasons other
than the provision of finance to either the customer or the entity, and the
difference between those amounts is proportional to the reason for the
difference. For example, the payment terms might provide the entity or the
customer with protection from the other party failing to adequately complete
some or all of its obligations under the contract.

 

Since retention monies are
held by customers as a measure of security to enforce contractual rights and
safeguard its interest, retention monies are not discounted under Ind AS 115.

 

Explain the five step model
in

Ind AS 115 and briefly
outline the impact on industry.

The model in the standard
is based on five steps, which are given below.

 

Step 1:
Identify the contract: A contract has to be enforceable and the transaction
price should be collectable on the day the contract is entered into. The
contract can be written or oral, but has to be enforceable. If the contract is
not enforceable revenue cannot be recognised.

 

Step 2:
Identify performance obligations: Within a contract there could be several
performance obligations. Performance obligations are basically distinct goods
and services within a contract from which the customer can benefit on its own.

 

Step 3: This
step requires determining the transaction price in the contract. Whilst in most
cases this would be fairly straight-forward, in certain contracts, it could be
complicated because of:

 

– Variable consideration (including application of the constraint)

– Significant financing component

– Consideration paid to a customer (for example, free mobile
offered to a customer that buys a telecom wireless package)

– Non-cash consideration

 

The standard deals in
detail on how to recognise, measure and disclose the above components.

 

Step 4: Allocate
the transaction price to the various performance obligations in the contract.

 

Step 5:
Recognise revenue when (or as) performance obligations are satisfied. This can
be at a point in time or over time.

 

The construct of the model
is very simple but when applied, can throw huge challenges and is very
different from current Ind AS 18. It may be noted, that there would be numerous
areas of differences and challenges for each industry. Below is a broad outline
of the impact of the standard and the interplay of the five steps on various
industries. It is a very brief summary of a few of the many issues, used only
for illustration purposes.

 

Real estate

Real estate entities offer
a 10:90 or similar schemes to customers. As per the scheme, the customer pays
10% of the contract value on signing the offer letter, followed by a 90%
payment when the unit is delivered to the customer. If real estate prices fall
significantly, the customer may simply decide not to take delivery, and allow
the 10% to be forfeited. In many jurisdictions, such contracts may not be
legally enforceable against the customer and when enforceable the legal system
could be a huge deterrent to recover the monies from the customer. If this is
the situation, there is no enforceable contract under Ind AS 115, and
consequently no revenue is recognised till such time the contract is enforceable
or the remaining 90% is received by the real estate entity.

 

Another hot topic for real
estate entities would be the method for recognition of revenue, i.e. whether
percentage of completion method (POCM) or completed contract method (CCM) would
apply when a building is constructed which has several units sold to different
customers. In this case, since the customer does not control the underlying
asset itself, as it is getting constructed, revenue is recognised only on
delivery of the real estate unit to the customer. This issue was discussed in
detail by IFRIC at a global level. IFRIC observed the following: although the
customer can resell or pledge its contractual right to the real estate unit
under construction, it is unable to sell the real estate unit itself without
holding legal title to the completed unit. Consequently, the real estate entity
is not eligible for overtime recognition of revenue. However, the standard
allows overtime recognition of revenue, in situations where the real estate entity
has the right to collect payments from the customer for work completed to date.
Such amounts should include cost and an appropriate margin. If the real estate
entity does not have such a right, in statute and contract, POCM recognition of
revenue is not allowed. In other words, revenue is recognised when the
completed unit is delivered to the customer. Real estate entities in India that
want to apply POCM should verify if the statute entitles them with such a
right. If such a right is provided in the statute, they should ensure that the
contract with the customer also provides such a right.

 

Pharmaceutical

Some Indian pharmaceutical
companies have sales in US, through a few large US distributors on a principal
to principal basis. However, the amount of revenue to be received from the US
distributors may be variable, as the contract may have a price capping
mechanism or provide an unlimited right of return to the US distributors. The
price capping mechanism ensures that if the entity sells the same products at a
lower price to other customers, the distributor would be entitled to a
proportionate refund.

 

The US distributors will
send a sales report containing quantity and value to the pharma company on a
quarterly basis. Under current standards, some pharmaceutical companies may not
recognise revenue on dispatch to the US distributor, but recognise revenue
based on reported sales at the end of each quarter; effectively treating the US
distributor as an agent. This is because the risks and rewards may not have
transferred to the US distributor who has an unlimited right of return and is
also entitled to the benefit from the price capping mechanism. Under Ind AS
115, the control of goods is transferred to the distributor on dispatch since
the US distributor has legal title and ownership of the goods.

 

The pharma company does not
have any rights to recover the products, except as a protective right in rare
situations. Consequently, the pharma company recognises revenue upfront when
the control of the goods is transferred to the distributor. Since revenue is
variable because of the price capping mechanism and the unlimited right of
return, the transaction price will need to be estimated in accordance with the
methodology prescribed in the standard.

 

Software Company

Many Indian software
companies applied the US GAAP accounting for Indian GAAP as well. Under US
GAAP, a software company needs to separately account for elements in a software
licensing arrangement only if Vendor Specific Objective Evidence (VSOE) of fair
value exists for the undelivered elements. An entity that does not have VSOE
for the undelivered elements generally must combine multiple elements in a
single unit of account and recognise revenue as the delivery of the last
element takes place. VSOE is not required under Ind AS 115. The standard
prescribes a methodology for determining and allocating the transaction price
to various elements, which uses VSOE but in its absence prescribes other
methods of determining the allocation of the transaction price to the various
elements.

 

Telecom

Telecom companies may offer
a free handset to customers along with a wireless telecom package (voice and
data). Currently, some telecom companies recognise the telecom package overtime
and the cost of the free handset is recognised as a sales promotion cost. Under
Ind AS 115, the total consideration will be split between the telecom package
and the handset, and recognised as those performance obligations are satisfied.
This would give a completely different revenue, cost and margin pattern
compared to current practice.

 

Engineering and
Construction

The standard contains a
detail set of requirements on how to account for contract modifications. For
example, an unpriced change order is common in construction contracts; wherein
the scope of work is changed by the customer but the price for the change is
not agreed. The standard would require that the revenue and cost estimates on
the contract are immediately updated, consequently percentage of completion
margins would change. The problem is that revenue from the change in scope is
variable and the standard requires caution in estimating the variable revenue,
whereas costs are fully estimated. Consequently, the initially estimated POCM
margins may decline.

 

Consumer products and other

industries

An entity may have sold
goods, but on request from the customer, would have held those goods in its
storage facility. This is often referred to as bill and hold sales and is
common across all industries. For example, some pharmaceutical companies may
have a stock pile program for vaccinations based on government directives or a
consumer goods company may hold goods sold at its storage location on request,
as the distributor may be short of storage space. Contrary to current practice,
under Ind AS 115, in many cases bill and hold sales may not qualify for revenue
recognition because the underlying goods are fungible. For example, the stock
pile program may not qualify for revenue recognition, if they are subject to rotation,
i.e., the entity can sell some from the pile to another customer and replace it
with fresh supplies. These arrangements do not meet the criterion for
recognition of revenue on bill and hold sales, though they may have fulfilled
the criterion under Ind AS 18.

 

Another common topic
relevant for a consumer goods and other companies is warranties. If the
warranties are sold separately, or warranty entails a service in addition to
assurance (such as an extended warranty period), they are accounted for as a
separate performance obligation, rather than as a cost accrual.

 

Currently, the entire
revenue is recognized upfront and estimated cost for warranty is provided.
Under Ind AS 115, revenue will be allocated between the goods and the warranty.
Revenue and cost of goods is recognised as soon as the goods are sold. Revenue
and cost on warranties is recognised overtime as the warranty service is
provided.

 

This will result in a
different revenue, cost and margin profile compared to current practice under
Ind AS 18. It may be noted, that if the warranties are assurance type
warranties, and not sold separately or contain extended terms, the accounting
under Ind AS 18 and Ind AS 115 is the same.

 

Which are the disclosure
requirements that are onerous?

There are numerous
disclosure requirements. Entities should not underestimate the disclosure
requirements. Here we discuss two key disclosure requirements.

 

1. Entities will be
required to provide disaggregated revenue information in the financial
statements. The standard requires such disclosure on the basis of major product
lines, geography, type of market or customer (government, non-government, etc.),
contract duration, sales channel, etc., whichever is the most
appropriate and relevant for the entity. The standard provides guidance on how
this disclosure is made, and suggests that existing information provided to the
CEO, board, analysts, etc. may be used, and one need not reinvent the wheel.

 

2. For contracts or orders
that require more than one year to execute, the standard requires disclosure of
(a) transaction price allocated to the unsatisfied or partially satisfied
performance obligations, and (b) time bands by which the obligations will be
fulfilled and revenue recognised. For the said purpose, quantitative or
qualitative measures can be used.

 

What are the business

implications of Ind AS 115?

Certainly when top line and
margins change compared to current accounting, it will have numerous
implications, such as on income-tax, bonuses that are dependent on
revenue/margins, revenue sharing arrangements, contract terms and conditions,
internal control over financial reporting, etc. For example, companies
may change the sales arrangement with their distributors, to provide them
control at the point of shipment, so that revenue can be recognised at
shipment, rather than when the customer accepts the goods.

 

Certain business implications may
not be immediately obvious. Some companies may accept onerous contracts, to
recover some portion of the fixed costs/capacity. The IFRIC is currently
discussing whether when providing for onerous contract full cost provision or
only incremental cost needs to be provided for. Now if full cost absorption is required,
more onerous losses get recognised earlier. This may be a deterrent for
companies to accept a contract that is onerous.

Accounting For Uncertainty Over Income Tax Treatments

Background

IAS 12 (Ind AS 12) Income
Taxes specifies requirements for   
current   and   deferred  
tax   assets  and  
liabilities. However, there was no
clarity with respect to recognition and  
measurement   of   uncertain  
tax   treatments.  An‘uncertain tax treatment’
is a tax treatment for which there is uncertainty over whether the relevant
taxation authority will accept the entity’s tax treatment under tax law. For
example,   an   entity’s  
decision   not to include
particular income in taxable profit,
is an uncertain tax treatment if its acceptability   is  
uncertain   under  tax 
law. IFRIC 23 Uncertainty over Income Tax
Treatments is an interpretation of IAS 12 that deals with recognition and
measurement of uncertain tax treatments. A corresponding interpretation is not
yet issued under Ind AS, but is expected shortly.

 

Uncertainty over Income Tax Treatments

In assessing whether
uncertainty over income tax treatments exists, an entity may consider a number
of indicators including, but not limited to, the following:

 

–    Ambiguity in the drafting of relevant tax
laws and related guidelines (such as ordinances, circulars and letters) and
their interpretations

–    Income tax practices that are generally
applied by the taxation authorities in specific jurisdictions and situations

–    Results of past examinations by taxation
authorities on related issues

–    Rulings and decisions from courts or other
relevant authorities in addressing matters with a similar fact pattern

–    Tax memoranda prepared by qualified in-house
or external tax advisors

–    The quality of available documentation to
support a particular income tax treatment.

 

Unit of Account

The Interpretation requires
an entity to determine whether to consider each uncertain tax treatment
separately or together with one or more other uncertain tax treatments. This
determination is based on which approach better predicts the resolution of the
uncertainty. In determining the approach that better predicts the resolution of
the uncertainty, an entity might consider, for example, (a) how it prepares its
income tax filings and supports tax treatments; or (b) how the entity expects
the taxation authority to make its examination and resolve issues that might
arise from that examination. 

 

The author believes that
interdependent tax positions (i.e., where the outcomes of uncertain tax
treatments are mutually dependent) should be considered together. Significant
judgement may be required in the determination of the unit of account. In
making the judgement, entities would need to consider the approach expected to
be followed by the taxation authorities to resolve the uncertainty. The
judgement required in the selection of a unit of account may be particularly
challenging in groups of entities trading in various jurisdictions where the
relevant tax laws or taxation authority treat similar elements differently.

 

Example 1 – Unit of account

Entity A is part of a
multinational group and provides intra-group loans to affiliates. It is funded
through equity and deposits made by its parent. Whilst the entity can show that
its interest margin earned on many loans is at an appropriate market rate,
there are loans where the rate is open to challenge by the taxation
authorities. However, Entity A determines that, across the loan portfolio as a
whole, the existence of rates above and below a market comparator results in an
overall interest margin that is within a reasonable range accepted by the
taxation authorities.

 

Depending on the applicable
tax law and practice in a specific jurisdiction, a taxation authority may accept
a tax filing position on the basis of the overall interest margin if it is
within a reasonable range. However, there might be other taxation authorities
that would examine the interest rate separately for each loan receivable. In
considering whether uncertain tax treatments should be considered separately
for each loan receivable or combined with other loan receivables, Entity A
should adopt the approach that better reflects the way the taxation authority
would examine and resolve the issue.

 

Detection risk

The Interpretation requires
an entity to invariably assume that a taxation authority will examine amounts
it has a right to examine and have full knowledge of all related information
when making those examinations.

 

In some jurisdictions,
examination by taxation authorities is subject to a time limit, sometimes
referred to as a statute of limitations. In others, examination by taxation
authorities might not be subject to a statute of limitations, which means the
authorities can examine the amounts at any time in the future. Some respondents
to the draft Interpretation suggested in their comment letter that an
assessment of the probability of examination would be relevant in this latter
case. However, the IFRS Interpretation Committee (IC) decided not to change the
examination assumption, nor to create an exception to it, for circumstances in
which there is no time limit on the taxation authority’s right to examine
income tax filings.

 

The IC also noted that the
assumption of examination by the taxation authority, in isolation, would not
require an entity to reflect the effects of uncertainty. The threshold for
reflecting the effects of uncertainty is whether it is probable that the
taxation authority will accept an uncertain tax treatment. In other words, the
recognition of uncertainty is not determined based on whether a taxation
authority examines a tax treatment.

 

The Interpretation does not
explain what is meant by ‘results of examinations’. The examination procedures
vary by jurisdiction and, in some jurisdictions, an examination can have
multiple phases. In the author’s view, the communication between an entity and
the taxation authorities during the course of such examinations may provide
relevant information that could give rise to a change in facts and
circumstances before the actual ‘results’ of the examination are formally issued.

 

Example 2 – Detection risk

Entity A is based in
Country B. It is generally known that the taxation authorities in Country B
have limited resources. As a consequence, their examination procedures are
usually limited to a summary assessment of the income tax filings. Scrutiny tax
examinations are only performed in very rare circumstances and if there is a
clear indication of a tax fraud. Entity A has never been subjected to such a
scrutiny examination by the taxation authorities.

 

Prior to the application of
IFRIC 23, Entity A argued that it was unlikely that the taxation authorities
would identify any key income tax exposures not already identified through
their summary assessment, because they could be identified only by analysing
the underlying accounting records. Therefore, Entity A did not recognise any
uncertain tax treatments.

 

With the adoption of IFRIC
23, Entity A would need to consider underlying tax positions even though
scrutiny by the taxation authorities is unlikely. Entity A should assume that
the taxation authority can and will examine amounts it has a right to examine
and have full knowledge of all related information when making those
examinations.

 

Recognition and Measurement

Under IFRIC 23, the key
test is whether it’s probable that the taxation authority would accept the tax
treatment used or planned to be used by the entity in its income tax filings.
If yes, then the amount of taxes recognised in the financial statements would
be consistent with the entity’s income tax filings. Otherwise, the effect of
uncertainty should be estimated and reflected in the financial statements. This
would require the exercise of judgement by the entity. The recognition of
current and deferred taxes including uncertain tax treatments continues to be
on the underlying principle of “probability”. The measurement requirements in
IFRIC 23 do not distinguish between a probability of 51% and a probability of
100%. This is consistent with the objective of IAS 12 (Ind AS 12) that refers
to a probable threshold and with the Conceptual Framework for Financial
Reporting which refers to a probability threshold for the recognition of
assets and liabilities in general. It should be noted that deferred tax assets
on carry forward of losses can be recognised only if there is convincing
evidence that it will be utilised in future years.

 

Example 3 – Current and deferred tax impact

 

Entity C, constructs and
leases wooden chalet at hill stations, and claims 100% depreciation on the
basis that they are temporary structures. However, the tax laws may not
consider them as temporary structures and therefore there is a risk that the
100% depreciation claim may be disallowed. On application of IFRIC 23, Entity C
should reflect the impact of such uncertainties in the measurement of current
and deferred tax assets and liabilities as at the reporting date.

 

An entity may need to apply
judgement in concluding whether it is probable that a particular uncertain tax
treatment will be acceptable to the taxation authority. An entity may consider
the following:

 

–  Past experience related to similar tax
treatments

–   Legal advice or case law related to other
entities

–  Practice guidelines published by the taxation
authorities

–   The entity obtains a pre-clearance from the
taxation authority on an uncertain tax treatment.

 

In defining ‘uncertainty’,
the entity only needs to consider whether a particular tax treatment is probable,
rather than highly likely or certain, to be accepted by the taxation
authorities. If an entity concludes it is probable that the taxation authority
will accept an uncertain tax treatment, the entity shall determine the taxable
profit or loss, deferred taxes, unused tax losses, unused tax credits or tax
rates consistently with the tax treatment used or planned to be used in its
income tax filings. If an entity concludes it is not probable that the taxation
authority will accept an uncertain tax treatment, the entity shall reflect the
effect of uncertainty in determining the related taxable profit or loss,
deferred taxes, unused tax losses, unused tax credits or tax rates. An entity
shall reflect the effect of uncertainty for a unit of uncertain tax treatment
by using either of the following methods, depending on which method the entity
expects to better predict the resolution of the uncertainty:

 

a)   the
most likely amount—the single most likely amount in a range of possible
outcomes. The most likely amount may better predict the resolution of the
uncertainty if the possible outcomes are binary or are concentrated on one
value.

 

b)   the
expected value—the sum of the probability-weighted amounts in a range of
possible outcomes. The expected value may better predict the resolution of the
uncertainty if there is a range of possible outcomes that are neither binary
nor concentrated on one value.

 

If an uncertain tax
treatment affects current tax and deferred tax (for example, if it affects both
taxable profit used to determine current tax and tax bases used to determine
deferred tax), an entity shall make consistent judgements and estimates for
both current tax and deferred tax.

 

Example 4 – Application of Expected Value Method

 

–  Entity A’s income tax filing in a
jurisdiction includes deductions related to transfer pricing. The taxation
authority may challenge those tax treatments.

 

–  Entity A
notes that the taxation authority’s decision on one transfer pricing matter
would affect, or be affected by, the other transfer pricing matters. Entity A
concludes that considering the tax treatments of all transfer pricing matters
in the jurisdiction together better predicts the resolution of the uncertainty.
Entity A also concludes it is not probable that the taxation authority will
accept the tax treatments. Consequently, Entity A reflects the effect of the
uncertainty in determining its taxable profit.

 

–  Entity A estimates the probabilities of the
possible additional amounts that might be added to its taxable profit, as
follows:

 

 

Estimated additional amount, INR

Probability, %

Estimate of expected value, INR

Outcome 1

–

15%

–

Outcome 2

200

5%

10

Outcome 3

400

20%

80

Outcome 4

600

10%

60

Outcome 5

800

30%

240

Outcome 6

1,000

20%

200

 

 

100%

590

 

           

–   Outcome 5 is the most likely outcome.
However, Entity A observes that there is a range of possible outcomes that are
neither binary nor concentrated on one value. Consequently, Entity A concludes
that the expected value of INR 590 better predicts the resolution of the
uncertainty.

 

–  Accordingly, Entity A recognises and measures
its current tax liability that includes INR 650 to reflect the effect of the
uncertainty. The amount of INR 590 is in addition to the amount of taxable
profit reported in its income tax filing.

Example 5 – Application of the Most Likely Outcome Method

 

–  Entity B acquires for INR 100 a separately
identifiable intangible asset that has an indefinite life and, therefore, is
not amortised applying IAS 38 (Ind AS 38) Intangible Assets. The tax law
specifies that the full cost of the intangible asset is deductible for tax
purposes, but the timing of deductibility is uncertain. Entity B concludes that
considering this tax treatment separately better predicts the resolution of the
uncertainty.

–   Entity B deducts INR 100 (the cost of the
intangible asset) in calculating taxable profit for Year 1 in its income tax
filing. At the end of Year 1, Entity B concludes it is not probable that the
taxation authority will accept the tax treatment. Consequently, Entity B
reflects the effect of the uncertainty in determining its taxable profit and
the tax base of the intangible asset. Entity B concludes the most likely amount
that the taxation authority will accept as a deductible amount for Year 1 is
INR20 and that the most likely amount better predicts the resolution of the
uncertainty.

–   Accordingly, in recognising and measuring its
deferred tax liability at the end of Year 1, Entity B calculates a taxable
temporary difference based on the most likely amount of the tax base of INR 80
(INR 100 – INR 20) to reflect the effect of the uncertainty, instead of the tax
base calculated based on Entity B’s income tax filing (INR 0).

–   Entity B reflects the effect of the
uncertainty in determining taxable profit for Year 1 using judgements and
estimates that are consistent with those used to calculate the deferred tax
liability. Entity B recognises and measures its current tax liability based on
taxable profit that includes INR 80 (INR 100 – INR 20). The amount of INR80 is
in addition to the amount of taxable profit included in its income tax filing.
This is because Entity B deducted INR 100 in calculating taxable profit for
Year 1, whereas the most likely amount of the deduction is INR 20.

 

Changes in facts and circumstances

An entity shall reassess a
judgement or estimate required by this Interpretation, if the facts and circumstances
on which the judgement or estimate was based change or as a result of new
information that affects the judgement or estimate. For example, a change in
facts and circumstances might change an entity’s conclusions about the
acceptability of a tax treatment or the entity’s estimate of the effect of
uncertainty, or both. An entity shall reflect the effect of a change in facts
and circumstances or of new information as a change in accounting estimate
applying IAS 8 (Ind AS 8) Accounting Policies, Changes in Accounting
Estimates and Errors. An entity shall apply IAS 10 (Ind AS 10) Events
after the Reporting Period to determine whether a change that occurs after the
reporting period is an adjusting or non-adjusting event.

 

Examples of changes in
facts and circumstances or new information that, depending on the
circumstances, can result in the reassessment of a judgement or estimate
required by this Interpretation include, but are not limited to, the following:

 

(a)  examinations
or actions by a taxation authority. For example:

(i)  agreement
or disagreement by the taxation authority with the tax treatment or a similar
tax treatment used by the entity;

(ii) information
that the taxation authority has agreed or disagreed with a similar tax
treatment used by another entity; and

(iii) information
about the amount received or paid to settle a similar tax treatment.

(b)  changes
in rules established by a taxation authority.

(c)  the
expiry of a taxation authority’s right to examine or re-examine a tax
treatment.

 

Example 6 – Change in facts and circumstances

Entity A claimed a
tax-deduction for a particular expense item. In the prior year, Entity A had
concluded that it was probable that the taxation authority would accept the tax
deduction. However, during the current year, Entity A is alerted by a similar
issue where a tax deduction was denied in a ruling by the Supreme Court. The
recent court ruling is considered a change in facts and circumstances. As a
result, Entity A has to reassess the uncertain tax treatment, taking into
account the recent Supreme Court decision.

 

Example 7 – Events after the reporting date

 

Scenario A

Entity C had claimed a tax
deduction for a particular expense item in its tax return related to the
financial year ending 31st December 2018. However, for the purpose
of recognising current and deferred taxes in that year, Entity C had concluded
that it is not probable that the taxation authorities will accept the tax
deduction. Accordingly, Entity C had recognised an additional tax liability
relating to the uncertainty. In February 2020, before the approval of the
financial statements for the year ending 31st December 2019, Entity
C receives the final tax assessment for 2018. The tax assessment confirms the
full deductibility of the expense item. The confirmation of tax deduction
received after the reporting period and prior to authorisation of the financial
statements for 2019 is considered as an adjusting event after the reporting
period. Accordingly, the additional tax liability that was recognised in 2018
relating to the uncertainty is released in the 2019 period.

 

Scenario B

Entity B claimed a
tax-deduction pertaining to interest expense on a loan granted by an affiliated
company, amounting to INR 500,000 in its tax return related to the financial
statements for the year ending 31st December 2018. However, for the
purposes of recognising current and deferred taxes for that year, Entity B had
concluded that the taxation authorities will only accept a deduction of INR 100,000.
In March 2020, before the approval of the financial statements for the year
ending 31st December 2019, Entity B learns from its tax advisor that
the taxation authorities have confirmed that they will accept, on a
retrospective basis, another method of determining interest rate at arm’s
length that would lead to a tax deduction of INR 300,000 in year 2018. In this
example, it appears that the taxation authorities have issued a new guideline
on deductibility of interest expenses relating to a loan from an affiliated
company. Accordingly, in contrast to Scenario A above, the information received
in March 2020 is considered as a non-adjusting event after the reporting period
for the 2019 financial statements.

 

Absence of an explicit
agreement or disagreement by the taxation authorities on its own is unlikely to
represent a change in facts and circumstances, or new information that affects
the judgements and estimates made. In such situations, an entity has to
consider other available facts and circumstances before concluding that a
reassessment of the judgements and estimates is required.

 

An uncertain tax treatment
is resolved when the treatment is accepted or rejected by the taxation
authorities. The Interpretation does not discuss the manner of acceptance
(i.e., implicit or explicit) of an uncertain tax treatment by the taxation
authorities. In practice, a taxation authority might accept a tax return
without commenting explicitly on any particular treatment in it. Alternatively,
it might raise some questions in an examination of a tax return. Unless such
clearance is provided explicitly, it is not always clear if a taxation
authority has accepted an uncertain tax treatment. An entity may consider the
following to determine whether a taxation authority has implicitly or
explicitly accepted an uncertain tax treatment:

 

–   The tax treatment is explicitly mentioned in
a report issued by the taxation authorities following an examination

–   The treatment was specifically discussed with
the taxation authorities (e.g., during an on-site examination) and the taxation
authorities verbally agreed with the approach; or

–   The treatment was specifically highlighted in
the income tax filings, but not subsequently queried by the taxation
authorities in their examination.

 

Disclosures

There are no new disclosure
requirements in IFRIC 23. However, entities are reminded of the need to
disclose, in accordance with existing IFRS (Ind AS) standards. When there is
uncertainty over income tax treatments, an entity shall determine whether to
disclose: judgements made in determining taxable profit (tax loss), tax bases,
unused tax losses, unused tax credits and tax rates; and information about the
assumptions and estimates made in determining taxable profit (tax loss), tax
bases, unused tax losses, unused tax credits and tax rates under IAS 1 (Ind AS
1) Presentation of Financial Statements. If an entity concludes it is
probable that a taxation authority will accept an uncertain tax treatment, the
entity shall determine whether to disclose the potential effect of the
uncertainty as a tax-related contingency under IAS 12 (Ind AS 12).

 

Effective date and transition

IFRIC 23 applies to annual
reporting periods beginning on or after 1st January 2019. Earlier
application is permitted. Entities can apply the Interpretation using either of
the following approaches:

 

–   Full retrospective approach: this approach
can be used only if it is possible without the use of hindsight. The
application of the new Interpretation will be accounted for in accordance with
IAS 8, which means comparative information will have to be restated; or

 

–    Modified retrospective approach: no
restatement of comparative information is required or permitted under this
approach. The cumulative effect of initially applying the Interpretation will
be recognised in opening equity at the date of initial application, being the
beginning of the annual reporting period in which an entity first applies the
Interpretation.

     It
is not clear as to when this interpretation will apply under Ind AS. It is most
likely that this Interpretation may apply from annual reporting periods
beginning on or after 1st April 2019.

 

Key challenges

–    Applying the Interpretation could be
challenging for entities, particularly those that operate in more complex
multinational tax environments.

 

–    It would be challenging for entities to
estimate the income tax due with respect to tax inspections, when tax
authorities examine different types of taxes together and issue a report with a
single amount due therein.

 

–   Entities may also need to evaluate whether
they have established appropriate processes and procedures to obtain
information, on a timely basis, that is necessary to apply the requirements in
the Interpretation and make the required disclosures.

 

–    IFRIC 23 requires an entity to assume a
detection risk of 100%. An entity should not take any credit for the
possibility that uncertain tax treatments could be overlooked by the taxation
authority. This is a different approach compared to existing practice that may
lead to changes when the Interpretation is first applied. This could be a
challenging task in some cases.

 

Frequently Asked Questions

 

Will this
Interpretation apply to uncertain treatments of other taxes, for example GST?

 

Although uncertainty exists
in the determination of GST liability, IFRIC 23 is not applicable since GST is
not a tax on income and not in the scope of IAS 12 (Ind AS 12)/IFRIC 23. Rather
they would be covered under IAS 37 (Ind AS 37) Provisions, Contingent
Liabilities and Contingent Assets. It may be noted that whilst the
underlying principle for recognition in both standards is “probability”, the
measurement basis under the two standards are significantly different.

 

In a
particular jurisdiction, if tax is not deducted at source with respect to
royalty payments to non-resident the entity is subjected to penalty and also
disallowance of the royalty expenses in computation of taxable income. Is the
penalty and disallowance of the royalty expense covered under IFRIC 23?

 

Penalty is not a tax on
income and hence are not covered under IFRIC 23. Rather they would be covered
under IAS 37 (Ind AS 37) Provisions, Contingent Liabilities and Contingent
Assets. The disallowance of royalty expenses which is included in the
taxable income will be subjected to the requirements of IAS 12 (Ind AS 12) and
IFRIC 23.

 

Will
Interest and penalties levied by Income tax Authorities be covered under this
Interpretation?

 

IAS 12 (Ind AS 12) does not
explicitly refer to interest and penalties payable to, or receivable from, a
taxation authority, nor are they explicitly referred to in other IFRS
Standards. A number of respondents to the draft Interpretation suggested in
their comment letter that the Interpretation explicitly include interest and
penalties associated with uncertain tax treatments within its scope. Some said
that entities account for interest and penalties differently depending on
whether they apply IAS 12 (Ind AS 12) or IAS 37 (Ind AS 37) Provisions,
Contingent Liabilities and Contingent Assets to those amounts.

 

The IC decided not to add
to the Interpretation requirements relating to interest and penalties
associated with uncertain tax treatments. Rather, the IC noted that if an
entity considers a particular amount payable or receivable for interest and
penalties to be an income tax, then that amount is within the scope of IAS 12
and, when there is uncertainty, also within the scope of this Interpretation.
Conversely, if an entity does not apply IAS 12 to a particular amount payable
or receivable, then this Interpretation does not apply to that amount,
regardless of whether there is uncertainty.

 

An entity
determines that an uncertain tax treatment is not probable but is possible and
hence disclosure as contingent liability is required. Whether the contingent
liability disclosure will also include the consequential interest and penalty
amount?

 

Interest amount will be
included in the contingent liability amount if there is no or very little
likelihood of waiver. On the other hand, penalty amount may be waived by the
tax authorities. If it is probable that the penalties may be waived by the tax
authorities, they are not included in the contingent liability amount.

 

In evaluating
the detection risk, should an entity consider probability of detection by the
Income-tax authorities rather than assuming an examination will occur in all
cases?

 

The IC decided that an
entity should assume a taxation authority will examine amounts it has a right
to examine and have full knowledge of all related information. In making this
decision, the IC noted that IAS 12 (Ind
AS 12) requires an entity to measure tax assets and liabilities based on tax
laws that have been enacted or substantively enacted.

 

A few respondents to the
draft Interpretation suggested that an entity consider the probability of
examination, instead of assuming that an examination will occur. These
respondents said such a probability assessment would be particularly important
if there is no time limit on the taxation authority’s right to examine income
tax filings.

 

The IC decided not to
change the examination assumption, nor create an exception to it for
circumstances in which there is no time limit on the taxation authority’s right
to examine income tax filings. Almost all respondents to the draft
Interpretation supported the examination assumption. The IC also noted that the
assumption of examination by the taxation authority, in isolation, would not
require an entity to reflect the effects of uncertainty. The threshold for
reflecting the effects of uncertainty is whether it is probable that the
taxation authority will accept an uncertain tax treatment. In other words, the
recognition of uncertainty is not determined based on whether a taxation
authority examines a tax treatment.

 

Will the
principles of “virtual certainty” apply for recognition of current and deferred
tax assets in cases where there is uncertainty of tax treatments?

 

When the key test of the
Interpretation would result in the entity recognising tax assets (i.e. based on
the probability that the taxation authorities would accept the entity’s tax
treatment), the entity is not required to demonstrate the ‘virtual certainty’
of the tax authority accepting the entity’s tax treatment in order to recognise
such a tax asset. The underlying principle of “probability” will apply for
recognition of current and deferred tax asset arising from uncertain tax
treatments. Consider the example below.

 

Example 8 – Measurement of tax positions

The management of Entity B
decides to undertake a group-wide restructuring and records a restructuring
liability of INR 1,000,000. Entity B has tax loss carry-forwards of INR
1,200,000. Excluding the restructuring liability, taxable profit for the
current year is INR 2,000,000. Entity B is uncertain whether the local taxation
authorities will accept a deduction for the restructuring costs. However, it
analyses all available evidence and concludes that it is probable that the
taxation authorities will accept the deduction of the INR 1,000,000 in the year
when it is recorded.

 

Entity B therefore
estimates its taxable profit to be INR 1,000,000 and that this will be fully
offset with tax loss carry-forwards from the INR 1,200,000 available. As a
consequence, there is no current income tax charge in the period and Entity B
determines a remaining tax loss carry-forward balance of INR 200,000. As
management has convincing evidence that Entity B will realise sufficient
taxable profits in the future, it records a deferred tax asset for the unused
tax losses of INR 200,000. Though convincing evidence is required to record a
deferred tax asset on carry forward losses (INR 200,000), the acceptability of
uncertain tax treatments (INR 1,000,000) by the tax authorities is based on the
principle of “probability”.

 

Conclusion

For many large sized
entities or those with significant income tax litigations or complications,
this Interpretation may well be a significant change. Management and Audit
Committees should ensure that the Interpretation is properly understood and
complied with. Tax advisors too need to get upto speed on the standard, since
this standard may have significant impact on income tax computation and
assessments. _

Voluntary Revision Of The Financial Statements

Background

With respect to voluntary
revision of financial statements, following is the provision of The Companies
Act, 2013 (as amended). 


131.(1)
If it appears to the directors of a company that— (a) the financial statement
of the company; or (b) the report of the Board, do not comply with the
provisions of section 129 or section 134, they may prepare revised financial
statement or a revised report in respect of any of the three preceding
financial years after obtaining approval of the Tribunal on an application made
by the company in such form and manner as may be prescribed and a copy of the
order passed by the Tribunal shall be filed with the Registrar…….


The MCA notified section
131 of the Act dealing with voluntary revision of financial statements on 1
June 2016 and the section is applicable from the notification date. In
accordance with the section, if it appears to the directors of a company that
its financial statement or the board report do not comply with the requirements
of section 129 (dealing with preparation of financial statements, including
compliance with accounting standards) or section 134 (dealing with aspects such
as signing of financial statements and preparation of the board report), then
directors may prepare revised financial statements or a revised report for any
of the three preceding financial years after obtaining the National Company Law
Tribunal (NCLT) approval. The section and related rules prescribe the procedure
to be followed in such cases. The procedure include:


– The company will make an application to the NCLT in prescribed
manner.

– Before passing any orders for revision, the NCLT will notify the
Central Government and the Income tax authorities and will consider
representations received, if any.

– The company will file a copy of the NCLT order with the
Registrar.

 –  Detailed reasons for revision of financial statements or report
will also be disclosed in the board’s report in the relevant financial year in which such revision is being made.


Ind AS 1 Presentation of
financial statement and Ind AS 8 Accounting Policies, Changes in Accounting Estimates and Errors


A company may decide to
change one or more accounting policies followed in the preparation of financial
statements or change classification of certain items or correct an error in
previously issued financial statements. In these cases, Ind AS 8/ 1 requires
that comparative amounts appearing in the current period financial statements
should be restated.


In the case of an error,
there may be rare circumstances when the impact of error in financial
statements is so overwhelming that they may become completely unreliable. In
such cases, the company may need to withdraw the issued financial statements
and reissue the same after correction. The auditor may also choose to withdraw
their audit report. However, in majority of cases, the impact of error will not
be so overwhelming requiring withdrawal of already issued financial statements.
Rather, the company will correct the error in subsequent financial statements.
Ind AS 8 requires that comparative information presented in subsequent
financial statements will not be the same as originally published. Those
numbers will be restated/ updated to give effect to the correction of the
error. Similar treatment applies for change in accounting policy or
reclassification. The subsequent financial statements in which correction is
made will also include appropriate disclosures to explain impact of the
changes.


Issue


Whether restatement of
comparative amounts in subsequent financial statements is tantamount to
revision of financial statements? Consequently, whether such restatement will
trigger compliance with section 131 of the Act?


Author’s View


Section 131 of the Act is
triggered only in cases where the company needs to withdraw previously issued
financial statements and re-issue the same. For example, this will be required
when the impact of error on previously issued financial statements is so
overwhelming that they have become completely unreliable.


Section 131 will not be
triggered in cases related to restatement of comparative information appearing
in the current period financial statements. This view can be supported by the
following key arguments:


– Restatement of comparative information appearing in subsequent financial
statements is not tantamount to change or revision or reissuance of
previously issued financial statements. If one reads section 131 carefully, it
is about preparing (and consequently reissuing) revised financial statements,
at the behest of the board of directors. It cannot be equated to restating
comparative numbers for errors or changes in accounting policies where there is
no revision or reissuance of already issued financial statements. There
is a change in the comparative numbers in subsequent financial statements; but
there is no revision or reissuance of already issued financial
statements.


– Section 131 can be triggered only if
the previously issued financial statements were not in compliance with section
129. In the case of a change in accounting policy or reclassification, there
was no such non-compliance in previously issued financial statements. Hence,
section 131 does not apply. The Ind AS 8 requirement to restate an error in
subsequent financial statements is the same as change in accounting
policy/reclassification. Hence, section 131 should apply in the same manner for
correction of errors as well.

ICDS – Post Delhi High Court Decision

The Central Government (CG)
has notified 10 Income Computation and Disclosure Standards (ICDS) u/s. 145(2)
of the Income-tax Act (ITA). Section 145 of the ITA provides that the taxable
income of a taxpayer falling under the heads “Profits and Gains from Business
and Profession” (PGBP) or “Income from Other Sources” (IFOS) shall be computed
in accordance with either the cash or mercantile system of accounting,
whichever is regularly employed by the taxpayer. Section145(2) grants power to
the CG to prescribe the ICDS to be followed by any class of taxpayers or in
respect of any class of income. The notified ICDS are applicable from 1st
April, 2016, (financial year 2016-17) to taxpayers following the mercantile
system of accounting and for the computation of income chargeable under the
heads PGBP or IFOS. They do not apply to taxpayers who are individuals or Hindu
Undivided Families, which are not liable for tax audit under the provisions of
the ITA.

 

A writ petition was filed
by The Chamber of Tax Consultants (Chamber) on the constitutional validity of
section 145(2) as also the validity of notified ICDS, to the extent they are in
conflict with the principles laid down in binding judicial precedents rendered
prior to ICDS. The Chamber urged that while section 145(2) of the ITA permits
the CG, as a delegate of the Legislature, to notify ICDS, it cannot be read as
granting unfettered powers to the CG, in the guise of delegated legislation, to
notify ICDS modifying the basis of taxation which can, if at all, be done only
by the Parliament by amending the ITA. The notified ICDS, to the extent they
seek to unsettle binding judicial precedents and modify the basis of
chargeability and computation of taxable income, are ultra vires the ITA
and the Constitution of India.

 

The Chamber further argued
that “the accounting standards (AS) issued by the ICAI were applicable to all
corporate entities and non-corporate entities following the mercantile system
of accounting. ICDS was applicable only to taxpayers following mercantile
system of accounting (i.e. to all assesses except individuals and HUFs whose
accounts are not required to be audited u/s. 44B of the Act). There was no
reasonable basis on which such differentiation or classification can be made
for the applicability of the ICDS, since the Assessee following the cash system
of accounting would escape from the implications and compliance requirements of
the ICDS. This is violative of Article 14 of the Constitution.”

 

The Delhi High Court (HC)
upheld the constitutional validity of section145(2), but struck down several
contentious provisions of individual ICDS. In a landmark ruling, the HC held
that ICDS cannot override binding judicial precedents or statutory provisions.
It held that the force of judicial precedents can be overridden only by a valid
law passed by the Parliament. Such power cannot be exercised by the Executive.
The provisions of ICDS, being a delegated legislation, have to be so read down
such that they do not modify the basis for computation of taxable income as
recognised by the provisions of the ITA or the binding judicial precedents laid
down by the Supreme Court (SC) or High Courts.

 

In the following
paragraphs, we discuss the provisions of individual ICDS that are struck down
by the HC.

 

ICDS I on Accounting Policies

–  ICDS I provides that expected or mark to
market (MTM) losses are not to be allowed as deduction, unless specifically
permitted by any other ICDS and, thus, does away with the concept of
“prudence”, which was present in the earlier Tax Accounting Standard (TAS) I.

–  The provision of ICDS I is contrary to the
settled judicial position. Many High Court rulings have recognised the
principle of ”prudence” by allowing deduction for provision for expected losses
on contracts recognised in the books of account by the taxpayer in compliance
with GAAP.

–  The ITA also grants deduction for revenue
expenses “laid out” or “expended” for the purpose of business in which the
concept of “prudence” is inherent.

–   The removal of the concept of prudence is
also not consistent with the prudence principles inherent in other ICDSs. A few
examples are given below.

•    Inventory
valuation at lower of cost and market price (ICDS II).

•    Provision
for expected losses on contracts in ICDS III, with the only modification that
the said loss will be allowed in proportion of completion of the contract,
rather than allowing the same for the unfinished portion of the contract. This
was primarily for bringing horizontal equity of treating the contract profit
and contract loss on the same principle.

•    The
principle of reasonable certainty is adopted for recognising revenue in ICDS
IV.

•    Provision
for the losses on forward cover transactions in the nature of hedging (except
to the extent the same pertains to highly probable transactions or firm
commitment) in ICDS VI.

•    Valuation
of inventory (of investments) under ICDS VIII at lower of cost and market price

•    Recognising
provisions for present obligation of future liabilities in ICDS X.

–  Accepting the above contentions, the HC held
that non-acceptance of the “prudence” concept is contrary to the ITA and,
hence, ICDS I is unsustainable to that extent.

–   It may be noted that the CBDT Circular (No 10
dated 23rd March, 2017) provides horizontal equity by not taxing MTM
gains.

 

ICDS II on Valuation of Inventory

–   As per the settled judicial position, if the
business of a partnership firm continues after dissolution of the firm, then
the inventory has to be valued at lower of the cost and the market price. On
the other hand, if the business is discontinued on dissolution of the firm,
then the inventory has to be valued at market price.

–   ICDS II requires that inventory, as on the
date of dissolution of the firm, is to be valued at market price, irrespective
of continuance or discontinuance of the business. This leads to notional
taxation of income contrary to the judicial position.

–   Furthermore, there is a specific provision of
the ITA [section 145A], which provides that the inventory shall be valued as
per the method of accounting regularly employed by the taxpayer.

–   The HC held that: (a.) It is not permissible
for ICDS II to override the settled judicial position. (b.) Where the taxpayer
follows a certain method of accounting for valuation of inventory, the same
shall override ICDS II by virtue of the specific provision in the ITA. Thus,
the HC held that ICDS II is ultra vires the ITA and, to that extent, it
is struck down.

 

ICDS III on Construction Contracts –
Retention money

–  ICDS III provides that retention money should
form part of the contract revenue and taxed on the basis of percentage of
completion method (POCM). The CBDT Circular reiterates this position.

–  However, as per the settled judicial
position, retention money accrues to the taxpayer only when the defect
liability period is over and the Engineer-in-Charge certifies that no liability
is attached to the tax payer. Retention money cannot form part of the revenue
unless the same has accrued as “income” as per the charging provisions of the
ITA.

–   The HC held that taxation of retention money
would need to be seen on a case-to-case basis depending upon the contractual
terms, conditions attached to such amount and keeping in mind the settled tax
principles of accrual of income. ICDS III, to the extent it seeks to bring
retention money to tax at the earliest stage even when the receipt is uncertain
or conditional, is contrary to the settled position. Therefore, to that extent
ICDS III was struck down.

–   Whilst as per law, retention money is taxable
on completion of defect liability period, in practice, many companies prefer to
offer it for tax on its recognition in the accounts, which is much earlier than
completion of the defect liability period. This is done predominantly because
it is the method of accounting regularly followed by the tax payer (section
145) and to avoid any possible litigation. Since the item involves mere timing
difference, tax payers find it convenient to offer retention money for tax as
per accounts, and thereby avoid cumbersome offline calculation for tax
purposes. It also meets the Tax Officers’ intent of taxing it at the earliest
point of time. Therefore, the risks and consequences to the tax payer of
continuing with its existing practice is very limited.

 

ICDS III on Construction Contracts –
Incidental income

 

–   The SC, in the case of CIT vs. Bokaro
Steel Ltd., held that receipts which are inextricably linked to the setting
up of plant or machinery can be reduced from the cost of asset.

–   However,
ICDS III, read with the provisions of ICDS IX on Borrowing Cost, provides that
incidental income earned cannot be reduced from the borrowing cost forming part
of the cost of the asset.

–   The
HC held that, to the extent the provisions of ICDS III are contrary to the settled
judicial position, they are not sustainable.

 

ICDS IV on Revenue Recognition – Export
incentives

 

–   As
per the SC ruling in the case of CIT vs. Excel Industries Ltd., export
incentives are taxable only in the year in which the claim is accepted by the
Government, as the right to receive the payment accrues in favour of the
taxpayer when the corresponding obligation to pay arises for the Government.

–   However,
ICDS IV requires recognition of such income in the year of making claim if
there is a reasonable certainty of ultimate collection.

–   ICDS
IV, being contrary to the SC ruling, is ultra vires the ITA provisions
and, hence, struck down to that extent.

–  In
the case of Excel Industries, exports were made in Year 1, which
entitled the tax payer to duty free imports. The benefit arising to the tax
payer on exports was recognised in the books in Year 1 and duty free imports
were made in Year 2. In other words, from an accounting parlance, the incentive
was earned in Year 1 and utilised in Year 2. Taxpayer claimed that for tax
purposes, the benefit is taxable in Year 2 when there is corresponding
liability on Government to pay which was upheld by the SC. In more complicated
export incentives or Government grants, the taxability will depend upon facts
and circumstances and may not be straight-forward. As already explained in the
context of retention monies, most tax payers may be offering these incentives
for tax in the year in which it is accrued in the accounts.

 

ICDS IV on Revenue Recognition –
Completed contract method (CCM)

–   Accounting
principles (AS-9) permit the taxpayer with respect to service related contracts
to follow either CCM or POCM for revenue recognition. As per AS-9, the choice between CCM and POCM is
dependent on whether there is only a single act in performance of service
contract or more than one act. It may be noted that the AS are not binding on
all categories of assesses, firms, etc. Such assessees are free to
follow any method of accounting.

–   Judicial
precedents have recognised both methods as valid for tax purposes under the
mercantile system of accounting.

–   ICDS
IV, which only permits POCM, is contrary to the above judicial position and,
hence, liable to be struck down to that extent.

–   It
may be noted that with respect to construction contracts (not service contracts,
covered under AS-9), AS-7, permits only POCM. ICDS III on Construction
Contracts also allows only POCM. The HC did not strike down ICDS III, on this
account, probably because the POCM method is the only acceptable method
provided under AS-7 for construction contracts.

 

ICDS IV on Revenue Recognition – Interest
Income

–   The
Chamber contended that under ICDS IV, interest income on non-performing assets
(NPAs) of Non-banking Financial Companies (NBFCs) would become taxable on time
basis even though such interest is not recoverable.

–  The
HC noted that the CBDT Circular clarifies that while interest income is to be
taxed on time basis alone, bad debt deduction, if any, can be claimed under the
provisions of the ITA. Furthermore, the Parliament has inserted a specific
provision in the ITA to grant bad debt deduction for incomes recognised under
ICDS (without recognition in the books) in the year in which they become
irrecoverable.

–  The
HC held that this provision of ICDS IV cannot be held to be ultra vires
since a corresponding bad debt deduction can be claimed by the taxpayer if the
amount of interest is irrecoverable. Also, the Chamber has not demonstrated
that ICDS IV is contrary to any ruling of the SC or any other Court.

–  The
HC further observed that once interest income is offered to tax on time basis
by claiming corresponding bad debt deduction, if the amount is not recoverable,
ICDS creates a mechanism to track unrecognised interest amounts for future
taxability, if so accrued.

 

ICDS VI on Foreign Exchange Fluctuations

–   The
SC held, in the case of Sutlej Cotton Mills Ltd .vs. CIT, that exchange
fluctuation gain/loss in relation to loan utilised for acquiring a capital item
would be capital in nature.

–   ICDS
VI provides that exchange fluctuation loss/gain in case of foreign currency
derivatives held for trading or speculation purposes shall be allowed on actual
settlement, and not on MTM basis. The HC held that this is not consonant with
the ratio laid down by the SC in the Sutlej Cotton Mills ruling and,
therefore, struck it down.

–   The
CBDT Circular clarifies that the opening balance of Foreign Currency
Translation Reserve Account as on 1 April 2016 (i.e., on the date ICDS first
became applicable), which comprises of accumulated balance of exchange
fluctuation gains/losses in relation to non-integral foreign operations, is
taxable to the extent it relates to monetary items.

–   In
line with the SC decision in the case of Godhra Electric Supply Company Ltd
vs. CIT, the HC held that valuation of monetary assets and liabilities of
the foreign operations as at the end of the year cannot be treated as real
income as it is only in the nature of notional or hypothetical income which
cannot be subjected to tax.

 

ICDS VII on Government Grants

–   ICDS
VII provides that recognition of government grants cannot be postponed beyond
the date of actual receipt. This is in conflict with the accrual system of
accounting since, many times, conditions are attached to the receipt of
government grant which need to be fulfilled in the future. In such instance, it
cannot be said that there is any accrual of income although the money has been
received in advance.

–   Therefore,
the HC struck down ICDS VII to that extent.

 

ICDS VIII on Securities held as Inventory

–   ICDS
VIII provides for valuation of securities held as inventory and is divided into
two parts.

–   Part
B of ICDS VIII, which applies to banks and public financial institutions,
provides that recognition of securities should be in accordance with the RBI guidelines.

–   Part
A applies to taxpayers other than banks and public financial institutions. It
requires valuation of inventory on “bucket approach” i.e., category-wise
application of lower of cost and market instead of individual valuation of each
security. However, this is different from the normal accounting principles and,
thus, taxpayers will need to maintain separate records for tax purposes every
year.

–  The
HC held that Part A of ICDS VIII, which prescribes “bucket approach”, differs
from ICDS II on valuation of inventory which, under similar circumstances, does
not prescribe the ”bucket approach”. This shows that ICDS has adopted separate
approaches at different places for valuation of inventory. This change is not
possible without a corresponding amendment in the ITA. Hence, to that extent,
Part A of ICDS VIII is ultra vires the ITA.

 

Comparison between Indian GAAP, ICDS and Delhi HC Decision

Point  of Difference

Indian GAAP

ICDS

Delhi HC Decision/Judicial pronouncements

Revenue
during early stage of construction, when outcome cannot be estimated
reliably.

Revenue
recognised to the extent costs are recoverable. No threshold is prescribed
for early stage.

Same
as Indian GAAP. However, the early stage shall not extend beyond 25%
completion. (ICDS III – Construction Contracts).

No
change.

Retention
money.

Forms
part of contract revenue and POCM is applied to entire contract revenue.

Same
as Indian GAAP (ICDS III – Construction Contracts).

Retention
money accrues to the taxpayer only when the related performance conditions
are fulfilled, for eg. when the defect liability period is over and the
Engineer-in-Charge certifies that no liability is attached to the tax payer.
Retention money cannot form part of the revenue unless the same has accrued.

Export
incentive.

When
it is reasonably certain that all conditions will be fulfilled and the
ultimate collection will be made.

In
the year of making claim, if there is a reasonable certainty of ultimate
collection. (ICDS VII – Government Grants).

Income
will not accrue, till the time conditions attached to it are fulfilled and
there is corresponding liability on Government to pay the benefit. (SC in Excel
Industries case).

Revenue
from construction contracts.

POCM

POCM

Not
discussed.

Revenue
from service contracts.

POCM
or CCM

u  Only POCM for long duration contracts (>
90 days).

u   CCM permitted for short duration contracts (< 90 days) (ICDS
IV – Revenue Recognition).

Accounting
principles and Judicial precedents permit, both POCM and CCM.

Real
estate developers.

As
per Guidance Note on Accounting for Real Estate Transactions, only
POCM is allowed.

No
ICDS for real estate developers. 
Judicial precedents will apply. 
Therefore, POCM or CCM will be allowed per the method of accounting
regularly employed by the taxpayer. 
The acceptance of CCM by the tax authorities for real estate
developers is a contentious issue and generally resisted by the Tax
Department. There are also cases where CCM has been disallowed by courts.
Currently, if taxpayer is following POCM in books, it would be bound u/s.145,
which requires income to be computed as per method of accounting regularly
followed by the taxpayers in its books. Most corporate real estate developers
follow POCM. A few corporates and non-corporates that followed CCM had to
face severe litigations and an audit qualification from the auditor on the
financial statements.

Not
discussed.

Onerous
Contract.

Expected
losses are recognised as an expense immediately.

Losses
incurred on a contract will be allowed only in proportion to the stage of
completion (ICDS III – Construction Contracts).

Prudence
is inherent in section 37(1) and hence expected losses allowable as per
judicial precedents.

Borrowing
Cost capitalisation – whether substantial period of time is required.

Applies
only when assets require substantial period of time for completion.

No
condition w.r.t substantial period of time except for inventory and general
borrowing costs ( 12 months) (ICDS IX – Borrowing Costs).

No
change.

Capitalisation
of specific borrowing cost.

Actual
borrowing cost.

Actual
borrowing cost.

No
change.

Capitalisation
of general borrowing cost.

Weighted
average cost of borrowing is applied on funds that are borrowed generally and
used for obtaining a qualifying assets.

Allocation
is based on average cost of qualifying asset to average total assets (ICDS IX
– Borrowing Costs).

No
change.

Borrowings
– Income on temporary investments.

Reduced
from the borrowing costs eligible for capitalisation.

Not
to be reduced from the borrowing costs eligible for capitalisation. Thus, it
will be taxable income (ICDS IX – Borrowing Costs).

Accounting
principles and Judicial precedents permit reduction of incidental income
where it has close nexus with construction activity. (SC in Bokaro Steel).

Contingent
Assets.

Recognition
is based on virtual certainty.

Recognition
is based on reasonable certainty (ICDS X – Provisions, Contingent Liabilities
and Contingent Assets).

Test
of ‘reasonable certain’ is not in accordance with S. 4/5 of ITA. Hypothetical
income not creating enforceable right cannot be taxed.

Government
Grant
classification.

u   Income related grant

u   Assets related grant

u   Grant in the nature of promoter’s contribution (credited to
capital reserve).

u     Income related grant

u     Assets related grant

     (ICDS VII – Government Grant).

 

No
change.

Government
Grant – recognition.

Not
recognised until there is a reasonable assurance that the entity shall comply
with the conditions attached to them and the grants will be received.

Similar
to Indian GAAP, except recognition is not postponed beyond the date of actual
receipt. (ICDS VII – Government Grant).

Taxable
when conditions attached to the receipt of government grant are fulfilled
and, there is corresponding liability on Government to pay.

Capitalisation
of exchange differences on long term foreign currency monetary item for
acquisition of fixed assets
(AS 11.46A).

Paragraph
46/ 46A of AS 11 provides option for capitalisation.

u   On imported assets S43A allows capitalisation

u   On local assets S43A does not apply.

u     With respect to local assets, all MTM exchange differences are included
in taxable income (ICDS VI – Foreign Exchange)

Distinguish
between capital and revenue nature of exchange fluctuation (Sutlej Cotton Mills).  Thus, exchange
differences on local capital assets, are not revenue in nature; nor, are
capitalisable under 43A.

Forward
contracts under AS 11 for hedging purpose.

Premium/
discount to be amortised over the contract period. Spot-to-spot gains/ losses
are recognised in P&L.

Same
as Indian GAAP. (ICDS VI – Foreign Exchange).

No
change.

Foreign
currency risk of a firm commitment or a highly probable forecast transaction.

As
per Guidance Note on Accounting for Derivative Contracts (GN)
derivatives are measured at fair value through P&L, if hedge accounting
is not applied.

Premium,
discount or exchange difference, shall be recognised at the time of
settlement. (ICDS VI – Foreign Exchange).

ICDS
cannot override judicial precedents (which will implicitly include SC ruling
in Woodward Governor’s case (312 ITR 254) which upheld MTM treatment
as per accounting principles). Thus MTM losses/gains are deductible/taxable.

Foreign
currency risk on contract for trading or speculative purposes.

As
per GN, derivatives are measured at fair value through P&L.

Premium,
discount or exchange difference shall be recognised at the time of
settlement. (ICDS VI – Foreign Exchange).

MTM
losses are tax deductible

[SC
in Sutlej Cotton Mills].

MTM
gains – No clarity but on principles, it is taxable.

MTM
losses on commodity derivatives.

As
per GN, derivatives are measured at fair value through P&L, if hedge
accounting is not applied.

u   MTM losses are not tax deductible. (ICDS I – Disclosure of
Accounting Policies)

u     CBDT Circular – MTM Gains are not taxable.

u     Consequently, tax will apply on settlement.

ICDS
cannot override judicial precedents (which will implicitly include SC ruling
in Woodward Governor’s case (312 ITR 254) which
permitted MTM treatment as per accounting principles).  Thus MTM losses/gains are
deductible/taxable.

 

The Road Ahead

The ICDS has far-reaching implications on tax
liability of assessees, which are debilitating. The introduction of Ind AS
should have been tax neutral, with minimal or no impact on tax liability. It is
unfortunate that Ind AS was used as an excuse to introduce ICDS that had severe
tax consequences on tax payers, which were mostly negative. The standards were
framed by a part time committee and that too in a great hurry. The ICDS
standards appear to be one sided, determined to maximise tax collection, rather
than routed in sound accounting principles. Such a backhanded and concealed
manner of bringing in an important piece of legislation, many of the provisions
of which were in conflict with the ITA or judicial precedents was deservedly
struck down by the HC. To the extent, the provisions were in conflict with the
ITA, the ICDS itself provided that those would prevail over ICDS. However,
there was no such exemption for ICDS provisions that were in conflict with
judicial precedents. The CBDT’s clarification in the Circular that ICDS shall
prevail over judicial precedents on ‘transactional issues’ was also highly
unsatisfactory.

 

There were also many interpretative
challenges that could have created a very litigious environment. Consider this;
the preamble of the ICDS states that where there is conflict between the
provisions of the ITA and ICDS, the provisions of the ITA shall prevail to that
extent. If a company has claimed mark-to-market losses on derivatives as
deductible expenditure u/s. 37(1) of the ITA – Can the company argue that this
is a deductible expenditure under the ITA (though the matter may be sub
judice) and hence should prevail over ICDS which prohibits mark-to-market
losses to be considered as deductible expenditure?

 

Some of the transitional provisions in ICDS
had significant unanticipated effect. For example, the ICDS requires contingent
assets to be recognised based on reasonable certainty as compared to the
existing norm of virtual certainty. Consider a company has filed several
claims, where there is reasonable certainty that it would be awarded
compensation. However, it has never recognised such claims as income, since it
did not meet the virtual certainty test under AS 29 Provisions, Contingent
Liabilities and Contingent Assets. Under the transitional provision, it
will recognise all such claims in the first transition year 2016-17. If the
claim amounts are significant, the tax outflow could be devastating. This could
negatively impact companies that have these claims. The interpretation of “reasonable
certainty” and “virtual certainty” would also come under huge stress and
debate.  This may well be another
potential area of uncertainty and litigation.

 

The struck down ones of some contentious
provisions of ICDS by the HC is a huge relief to tax payers. It will not only
bring fairness and tax neutrality but will also avoid a litigious environment,
provided the HC decision is upheld by the SC and not contested by the
Government.

 

Taxpayers which have already filed returns
for tax year 2016-17 can explore revising their returns on the basis of the law
laid down by the present ruling. While there may be no difficulty in case of
the SC ruling which is binding on all lower Courts in India, there could be
difficulties in the case of a High Court ruling. A High Court ruling would be
binding on a lower judicial authority in the jurisdictional area of the High
Court. Whether a High Court ruling would bind lower judicial authority in other
jurisdictional areas is a highly contentious and debatable matter.

 

In this respect, different High Courts have
taken different views. If other High Courts step into this issue, the situation
can get very muddy and complicated, particularly if they take a conflicting
position from that taken by the Delhi HC. Therefore, it is natural to expect
that the CG may intervene, either by filing a special leave petition with the
SC for stay of the HC decision or alternatively, incorporating the ICDS as part
of the Act. _

Impact of Ind AS 115 on Real Estate Companies

An Exposure draft namely Ind AS 115 Revenue from Contracts with
Customers is awaiting approval by the Ministry of Corporate Affairs.  There is uncertainty on the effective date of
the Standard, but it may apply as early as from accounting periods beginning on
or after 1 April, 2018.  In this article,
we discuss the impact of Ind AS 115 on real estate companies, particularly in
the context of development and sale of multi-unit residential or commercial
property before the entity constructs the property.

 

Ind AS 115 specifies the requirements an entity must apply to measure
and recognise revenue and the associated costs. The core principle of the
standard is that an entity will recognise revenue when it transfers control of
the underlying goods and services to a customer. The principles in Ind AS 115
are applied using the following five steps:

1.  Identify the contract with a customer

2.  Identify the performance obligations in the contract

3.  Determine the transaction price

4.  Allocate the transaction price to the performance obligations

5.  Recognise revenue when or as the entity satisfies each performance
obligation.

 

Ind AS 115 requires recognition of revenue when or as the entity
satisfies each performance obligation. This requirement is one of the key
hurdles for real estate companies. Currently, the Guidance Note on
Accounting for Real Estate Transactions (GN) requires real estate companies
to apply the percentage of completion method.

 

Under Ind AS 115, an entity will have to evaluate whether it satisfies
the performance obligation to its customer at the time of delivery of the real
estate unit or over time as the construction is in progress. If an entity
cannot demonstrate that the performance obligation is satisfied over time, it
will not be able to recognis e revenue over time. In simpler terms, the entity
will have to record real estate sales on the completed contract method, instead
of the percentage of completion method (POCM).

 

Satisfaction of
performance obligations

An entity recognises revenue only when it satisfies a performance
obligation by transferring control of a promised good or service to a customer.
Control may be transferred at a point in time or over time. Control of the good
or service refers to the ability to direct its use and to obtain substantially
all of its remaining benefits. Control also means the ability to prevent other
entities from directing the use of and receiving the benefit from a good or
service. The benefits of an asset are the potential cash flows (inflows or
savings in outflows) that can be obtained directly or indirectly in many ways,
such as by:

 

a)  using the asset to produce goods or provide services;

b)  using the asset to enhance the value of other assets;

c)  using the asset to settle liabilities or reduce expenses;

d)  selling or exchanging the asset;

e)  pledging the asset to secure a loan; and

f)   holding the asset.

 

The control model is different from the ‘risks and rewards’ model in
current Ind AS 18 and the GN. As per the GN, the completion of revenue
recognition process is usually identified when the following conditions are
satisfied.

 

a)  the entity has transferred to the buyer the significant risks and
rewards of ownership of the real estate;

b)  the entity retains neither
continuing managerial involvement to the degree usually associated with
ownership nor effective control over the real estate sold;

c)  the amount of revenue can be measured reliably;

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.

 

The differences in the model may result in different accounting
outcomes.

 

Performance
obligations satisfied over time

An entity transfers control of a good or service over time, rather than
at a point in time when any of the following criteria are met:

 

1)  The customer simultaneously receives and consumes the benefits
provided by the entity’s performance as the entity performs. For example, when
cleaning services are provided, the customer simultaneously receives and
consumes the benefits.

 

2)  The entity’s performance creates or enhances an asset that the
customer controls as the asset is created or enhanced. For example, an entity
constructs an equipment for the customer at the customer’s site.

 

3)  The entity’s performance does not create an asset with an
alternative use to the entity and the entity has an enforceable right to
payment for performance completed to date.

 

The first criterion is not applicable because the entity’s performance
creates an asset, i.e., the real estate unit that is not consumed immediately.
The second and the third criteria are discussed below. The Standard contains
requirements on when performance obligations are satisfied over time. When a
performance obligation is not satisfied over time, it will be deemed to have
been satisfied at a point in time.

 

Customer
controls asset as it is created or enhanced

The second criterion in which control of a good or service is
transferred over time, is where the customer controls the asset as it is being
created or enhanced. For example, many construction contracts contain clauses
indicating that the customer owns any work-in-progress as the contracted item
is being built. In many jurisdictions, the individual units of an apartment
block are only accessible by the purchaser on completion or near completion.
However, the standard does not restrict the definition of control to the
purchaser’s ability to access and use (i.e., live in) the apartment. In Ind AS
115.33, the standard specifies: The benefits of an asset are the potential cash
flows (inflows or savings in outflows) that can be obtained directly or
indirectly in many ways, such as by:

a)  using the asset to produce goods or provide services (including
public services);

b)  using the asset to enhance the value of other assets;

c)  using the asset to settle liabilities or reduce expenses;

d)  selling or exchanging the asset;

e)  pledging the asset to secure a loan; and

f)   holding the asset.

 

In some jurisdictions, it may be possible to pledge, sell or exchange
the unfinished apartment. Careful consideration will be required of the
specific facts and circumstances. The September 2017 Update of IFRIC, discusses
this issue in detail, and concluded that the second criterion is not fulfilled
in most developments of a multi-unit complex. Consequently, PCOM cannot be
applied in such cases. Particularly, the IFRIC emphasised the following:

 

1)  In applying the second criterion, it is important to apply the
requirements for control to the asset that the entity’s performance creates or
enhances. In a contract for the sale of a real estate unit that the entity
constructs, the asset created is the real estate unit itself. It is not, for
example, the right to obtain the real estate unit in the future. The right to
sell or pledge this right is not evidence of control of the real estate unit
itself.

 

2)  The entity’s performance creates the real estate unit under
construction. Accordingly, the entity assesses whether, as the unit is being
constructed, the customer has the ability to direct the use of, and obtain
substantially all of the remaining benefits from, the part-constructed real estate
unit. The Committee observed the following:

 

a)  although the customer can resell or pledge its contractual right to
the real estate unit under construction, it is unable to sell the real estate
unit itself without holding legal title to it;

b)  the customer has no ability to direct the construction or
structural design of the real estate unit as the unit is constructed, nor can
it use the part-constructed real estate unit in any other way;

c)  the customer’s legal title (together with other customers) to replace
the entity, only in the event of the entity’s failure to perform as promised,
is protective in nature and is not indicative of control.

d)  the customer’s exposure to changes in the market value of the real
estate unit may indicate that the customer has the ability to obtain
substantially all of the remaining benefits from the real estate unit. However,
it does not give the customer the ability to direct use of the unit as it is
constructed.

 

Thus, the customer does not control the part-constructed unit. In
simpler terms, the performance obligation is satisfied when the real estate
entity delivers the constructed unit to the customer. At that point in time the
real estate entity recognises revenue.

 

Asset with no
alternative use and right to payment

The third situation in which control is transferred over time has the
following two requirements that must both be met:

–The
entity’s performance does not create an asset with alternative use to the
entity.

–  The
entity has an enforceable right to payment for performance completed to date.

 

Asset with no
alternative use

An asset created by an entity has no alternative use if the entity is
either restricted contractually or practically from readily directing the asset
to another use (e.g., selling it to a different customer). A contractual
restriction on an entity’s ability to direct an asset for another use must be
substantive. In other words, a buyer could enforce its rights to the promised
asset if the entity sought to sell the unit to a different buyer. In contrast,
a contractual restriction may not be substantive if the entity could instead
sell a different unit to the buyer without breaching the contract or incurring
significant additional costs. Furthermore, a practical limitation exists if an
entity would incur significant economic losses to direct the unit for another
use. A significant economic loss may arise when significant costs are incurred
to redesign or modify a unit or when the unit is sold at a significantly
reduced price.

 

Enforceable
right to payment for performance completed to date

An entity has an enforceable right to payment for performance completed
to date if, at any time during the contract term, the entity would be entitled
to an amount that at least compensates it for work already performed. This
right to payment, whether by contract or by law, must be present, even in
instances in which the buyer can terminate the contract for reasons other than
the entity’s failure to perform as promised. The entity’s right to payment by
contract should not be contradictory to any law of the land.

 

Many real estate companies sell real estate on a small down payment,
followed by the rest of the payment being made at the time of delivery of the
real estate; for example, a 20:80 scheme, wherein 20% of the consideration is
paid upfront on booking, followed by 80% payment on delivery of the unit. The
customer can walk away without making the rest of the payment, if he is not
interested in taking delivery of the unit. Such real estate contracts do not
meet the criterion of enforceable right to payment for performance completed to
date.

 

To meet this criterion, the amount to which an entity is entitled must
approximate the selling price of the goods or services transferred to date,
including a reasonable profit margin. The standard clarifies that including a
payment schedule in a contract does not, by itself, indicate that the entity
has an enforceable right to payment for performance completed to date. The
entity needs to examine information that may contradict the payment schedule
and may represent the entity’s actual right to payment for performance
completed to date (e.g., an entity’s legal right to continue to perform and
enforce payment by the buyer if a contract is terminated without cause).

 

In some contracts, a customer may have a right to terminate the contract
only at specified times during the life of the contract or the customer might
not have any right to terminate the contract. If a customer acts to terminate a
contract without having the right to terminate the contract at that time
(including when a customer fails to perform its obligations as promised), the
contract (or other laws) might entitle the entity to continue to transfer to
the customer the goods or services promised in the contract and require the
customer to pay the consideration promised in exchange for those goods or
services. In those circumstances, an entity has a right to payment for
performance completed to date, because the entity has a right to continue to
perform its obligations in accordance with the contract and to require the
customer to perform its obligations (which include paying the promised
consideration).

 

Conclusion

In light of the requirements of Ind AS 115, many real estate companies
in India may not qualify for POCM. However, the third criterion discussed above
is a small window available for real estate companies in India to achieve POCM
recognition. To qualify for POCM recognition, real estate companies should
ensure that they have a contractual right to collect payment from the customer
for work completed to date and that the contractual right is not in
contradiction with any law of the land.  _

 

Ind AS 115 – Revenue From Contracts With Customers

Identifying the customer

Ind AS 115 defines a customer as a
party that has contracted with an entity to obtain goods or services that are
an output of the entity’s ordinary activities in exchange for consideration.
Beyond that, Ind AS 115 does not contain any definition of a customer. In many
transactions, a customer is easily identifiable. However, in transactions
involving multiple parties, for example, in the credit card business, it may be
less clear which counterparties are customers of the entity. For some
arrangements, multiple parties could all be considered customers of the entity.
However, for other arrangements, only some of the parties involved are
considered as customers. The identification of the performance obligations in a
contract can also have a significant effect on the determination of which party
is the entity’s customer.

 

Identifying the customer becomes
very important under Ind AS 115, because depending on who and how many
customers are identified, it will determine, the performance obligations in a
contract, the presentation and accounting of sales incentives, determination
and presentation of negative revenue, etc. The example below shows how the
party considered to be the customer may differ, depending on the specific facts
and circumstances.

 

Example — Travel Agents

An entity provides internet-based
airline ticket booking services. In any transaction, there are three parties
involved, the airline is the principal, the entity is an agent, and the
end-customer who purchases the ticket on the entity’s website. The entity gets
its majority of the income from the airline, to whom it charges a commission
(say INR 500 per ticket). The entity also receives a small convenience fee from
the end-customer (INR 20). To attract customers, the entity provides a cash
back of INR 120 to each end-customer.

 

If the entity considers, the
airline and the end-customer as two customers in a transaction, it will
determine revenue to be INR 400 (500+20-120). On the other hand, if the entity
had not received any convenience fees from the end-customer, and reduced the
cash back to INR 100, the entity will determine revenue to be INR 500. The
entity will also present INR 100 paid to third parties (end-customers) as a
selling cost.

 

Consideration paid to Customers’ Customer

Consideration payable to a customer
includes cash amounts that an entity pays, or expects to pay, to the customer.
Such amounts are reduced from revenue. This requirement also applies to
payments made to other parties that purchase the entity’s goods or services
from the customer. In other words, consideration paid to customers’ customer is
also reduced from revenue. For example, if a lubricant entity pays a
consideration to mechanics that purchases lubricants from the entity’s customer
(distributor), that amount will be reduced from the revenue of the lubricant
entity.

 

In some cases, entities provide
cash or other incentives to end consumers that are neither their direct
customers nor purchase the entities’ goods or services within the distribution
chain. One such example is depicted below. In such cases, the entity will need
to identify whether the end consumer is the entity’s customer under Ind AS 115.
This assessment could require significant judgment. The management should also
consider whether a payment to an end consumer is contractually required
pursuant to the arrangement between the entity and its customer (e.g., the
merchant in the example below) in the transaction. If this is the case, the
payment to the end consumer is treated as consideration payable to a customer
as it is being made on the customer’s behalf.

 

Example – Consideration paid to other
than customers

An entity provides internet-based
airline ticket booking services. In any transaction, there are three parties
involved, the airline is the principal, the entity is an agent, and the
end-customer who purchases the ticket on the entity’s website. The entity gets
its income from the airline, to whom it charges a commission (say INR 500 per
ticket). To attract users, the entity provides a cash back of INR 100 to each
end-customer on its own (i.e. without any contractual requirement from the
airline company).

 

If the entity considers, the
airline and the end-customer as two customers in a transaction, it will
determine revenue to be INR 400 (500-100). On the other hand, if the entity
determines that the end-customer is not its customer (because convenience fee is
not charge to the end-customer), the entity will determine revenue to be INR
500 and present INR 100 paid to third parties (end-customers) as a selling
cost. In case, the cash back to end user is paid because of a contractual
requirement between the airline and the entity, then such cash back paid will
be deducted from revenue, even when it is concluded that the end-user is not a
customer.  This is because, the entity is
making a payment on behalf of the customer as per agreement.

 

Both examples in the article are economically
the same; however, they provide different accounting consequences, based on how
a customer is identified. In the second example, a convenience fee is not paid
to end-customer, and hence it is concluded that the end-customer is not the
customer of the entity.