Issue no. 8/2016 | Financial Services www.kpmg.com/in Accounting and Auditing Update IN THIS EDITION Ind AS impact on the financial services sector p1 Impact of new adjustments on derivative valuation p7 Conversation with Mr. Keki Mistry p11 Private equity/venture capital funds p15 The Reserve Bank of India’s framework for revitalising distressed assets in the economy p21 Non-performing assets recognition for banks in India p25 Financial statement ratios: Are they always comparable? p29 Deferred tax liability on special reserve under the Income Tax Act, 1961 p31 Impact of ICDS on the financial services sector p35 Impact of GST on the financial services sector p39 Regulatory updates p43
Transcript
Issue no. 8/2016 | Financial Services
www.kpmg.com/in
Accounting andAuditing UpdateIN THIS EDITION
Ind AS impact on the financial services sector p1
Impact of new adjustments on derivative valuation p7
Conversation with Mr. Keki Mistry p11
Private equity/venture capital funds p15
The Reserve Bank of India’s framework for revitalising distressed assets in the economy p21
Non-performing assets recognition for banks in India p25
Financial statement ratios: Are they always comparable? p29
Deferred tax liability on special reserve under the Income Tax Act, 1961 p31
Impact of ICDS on the financial services sector p35
Impact of GST on the financial services sector p39
Partner and HeadAccounting Advisory Services KPMG in India
Naresh Makhijani
Partner and HeadFinancial Services KPMG in India
The Indian financial services sector comprising commercial banks, Non-Banking Finance Companies (NBFCs), insurance companies, mutual fund and Asset Management Companies (AMCs) and broking companies has witnessed significant growth over the last decade. This growth has been delivered through a combination of factors such as product innovation, enhanced customer focus and active use of technology to bring approaches to customers in a smooth and cost effective manner.
Having recognised the importance of this sector, the government is actively leveraging upon it to promote financial inclusion in the country. Bearing this objective in mind, the Reserve Bank of India (RBI) granted differentiated banking licences to 10 small finance banks and 11 payment banks.
On the consumer side, entities such as the RBI, the Insurance Regulatory and Development Authority (IRDA) and the Securities and Exchange Board of India (SEBI) have introduced various measures to promote customer protection, thereby ensuring that the growth of financial institutions does not take place at the expense of the customers they serve.
In this context, the Companies Act, 2013 (2013 Act) was also a major step towards raising the bar on corporate governance. Amongst other things, the 2013 Act has placed tremendous emphasis on a robust internal control environment by introducing additional responsibilities on the board, the audit committee, management as well as the auditors. Further, it has also introduced reporting on Internal Financial Controls (IFCs) which requires the management and auditors to certify the effectiveness of IFC in the organisations which they run and audit respectively.
From an accounting standpoint, the government has put forward the road map for implementation of Ind AS by banks, insurance companies and NBFCs. This will require scheduled commercial banks to prepare their financial statements as per Ind AS from 1 April 2018 with comparatives for 31 March 2018. The adoption of Ind AS by banks, insurance companies and NBFCs could have a significant impact on financial reporting as well as on the way entities are managed and conduct their business. This publication summarises the impact of Ind AS on the financial services sector.
Further, this publication also provides a keen perspective on key regulatory updates issued by the RBI, the impact of the Income Computation and Disclosure Standards (ICDS) and the proposed Goods and Services Tax (GST) on the financial services sector. We also strive to undertake an analysis of the Expert Advisory Opinion on Special Reserves issued by the Institute of Chartered Accountants of India.
As always, we would be delighted to receive any kind of feedback on the topics that we have covered.
Ctrl+Alt+Delete the current accounting framework and imbibe the new. Ind AS brings with it, its own set of challenges and significant changes to the current treatment of certain type of transactions and arrangements. As the sector stands at the threshold of embracing the new accounting framework, this article attempts to demystify some of the significant impact areas on account of adoption of Ind AS on financial services companies.
1. Classification and measurement of financial assetsClassification of financial assets under the Indian GAAP for certain type of assets is based on the guidelines issued by the Reserve Bank of India (RBI) e.g. banks’ investments are to be classified as Held to Maturity (HTM), Available for Sale (AFS) and Held for Trading (HFT) and for other companies classification is per AS 13, Accounting for Investments, as current and long-term. Ind AS would require classification either as assets measured at the amortised cost, Fair Value Through Profit and Loss (FVTPL) or Fair Value through Other Comprehensive Income (FVOCI). This classification will be driven by the business model test as well as the cash flow characteristics of the asset.
Ind AS 109 will generally limit the ability to classify certain portfolios of securities as akin to HTM (on an amortised cost basis) compared to current practices e.g. excess Statutory Liquidity Ratio (SLR) securities. Ind AS 109, Financial Instruments provides an ability to classify debt instruments at FVOCI, if the asset is held within a business model, whose objective is achieved by collecting contractual cash flows and selling financial assets and cash flows comprising solely the payments of principal and interest.
Further, investments in equity shares (quoted or unquoted) have to be fair valued and may be classified as FVTPL or FVOCI (an irrevocable accounting election on initial recognition). Any profit on the sale of equity shares classified as FVOCI would not be reclassified to the statement of profit
and loss, even on the sale of such investments.
Moreover, assets which are managed in a business model whose objective is to hold the assets to its maturity, would also have to consider if the cash flows of the asset represent solely the payment of principal and interest. For example, a debt instrument having a conversion option would not meet the amortised cost classification as the contractual cash flow does not represent only the principal and interest.
Additionally, investments in mutual funds, structured instruments such as equity linked notes, etc. would also fail the cash flow characteristic test and therefore, need to necessarily be accounted for at FVTPL.
In case of regular way purchase or sale, Ind AS 109 allows the option to use either the trade date or settlement date accounting. The standard requires that entities shall apply the same method consistently for all purchases and sales of categories of financial assets. Banks currently follow the settlement date accounting for investment trades.
2. Financial liabilitiesInd AS 109 provides for two measurement categories for financial liabilities, vis-à-vis the FVTPL and amortised cost. In general, most financial liabilities are expected to be accounted at the amortised cost.
Ind AS 109 requires transaction costs (incremental costs in nature and directly attributable to the issue of financial liability) to be recognised as part of the Effective Interest Rate
(EIR) of the instrument issued. For example, costs incurred in relation to the issuance of debentures or securing a borrowing would have to be recognised over the life of the loan. Similarly, debentures with embedded derivatives such as index linked debentures would require separation of the derivative from the underlying liability. The liability would then be accounted subsequently on an amortised cost basis.
3. OffsettingInd AS places a high threshold for any balances to qualify for offsetting or net presentation in the balance sheet. The requirements include:
a. A current legally enforceable unconditional right to settle an asset and liability on a net basis
b. An intention to either settle on a net basis or to realise the asset and settle the liability simultaneously (which may be backed by past practise).
Companies in the broking business may have to evaluate the terms of settlement with the stock exchanges to assess if these transactions (settlement balances) are required to be reported on a gross or net basis. For example, whether the receivables in the cash segment would be permitted to be offset against the payables in the derivatives segment for the same exchange. Similarly balances representing derivative trades undertaken by banks and Non-banking Financial Companies (NBFCs) will also go through the same assessment for presentation in financial statements.
Significant differences from the current accounting framework
4. Equity or liabilityAs per Ind AS 32, Financial Instruments: Presentation, classification as equity or liability for a financial instrument is based not on its legal form but in accordance with the substance of the contractual arrangement. Accordingly, instruments like redeemable preference shares issued would have to be classified as a liability.
Additionally, there are a number of instruments such as equity instruments with a change in control or IPO linked clause (that requires redemption) which will now require liability classification and accounting.
Ind AS 32 does not recognise economic compulsion as a characteristic of a liability and some instruments such as those with a contractually specified but a non-mandatory coupon could be classified as equity even though both the holder and the issuer fully expect to make payments on the coupon of the instrument.
5. Derivative and hedge accounting guidelinesAll derivatives are required to be marked to market with changes in fair value recognised in the statement of profit and loss, unless the principles of hedge accounting are applied. This is different from the current accounting guidance under AS 1, Disclosure of Accounting Polices (accounting only for the mark to marked losses) and AS 11, the Effects of Changes in Foreign Exchange Rates (amortisation of forward premium).
The likely changes are as following:• Current guidelines by the RBI for
banks require accrual accounting treatment for interest rate swaps (except for swaps designated with an asset or liability that is carried at lower of cost or market value) which are held for hedging purposes. Such swaps under Ind AS will be require to be marked to market.
• Additionally, certain transactions such a reciprocal deposit arrangements that are currently accounted for by some banks as
deposits and placements could be accounted for as swaps with resultant volatility due to FVTPL measurement requirement.
6. Impairment of financial instrumentsInd AS requires impairment on financial assets to be recognised on an Expected Credit Loss (ECL) model as compared to the incurred loss approach/days past due approach mandated by the RBI or otherwise generally followed.
ECL requirements are applicable to all financial assets classified under amortised cost, FVOCI debt instruments, lease receivables, trade receivables, commitments to lend money and financial guarantee contracts.
Off balance sheet credit facilities such as financial guarantee contracts will also be required to be accounted for and ECL provisions need to be made against such facilities even before they devolve.
Ind AS 109 has a rebuttable presumption that default does not occur later than when a financial asset is 90 days past due, unless there is reasonable and supportable information to demonstrate that a more lagging default criteria is appropriate.
Initially, on origination or purchase of a financial instrument, 12-month expected credit losses are recognised in the statement of profit and loss and a loss allowance is established [stage 1]. Subsequently, if the credit risk increases significantly and the resulting credit quality is not considered to be low credit risk, full lifetime expected credit losses are recognised [stage 2]. Ind AS 109 has a rebuttable presumption that credit risk on a financial asset has increased significantly since initial recognition, if contractual payments are more than 30 days past due.
Once the credit risk of a financial asset increases to the point that it is considered credit-impaired, interest revenue is calculated after netting the impairment allowance from the gross carrying amount [stage 3].
The ECL model is expected to result in recognition of losses on a present value basis and therefore, even a full recovery of principal on a loan but at a future date will result in a present value loss provision being booked. As a result, even impaired assets will in effect accrue interest (actual receipts or unwinding of discount rates) which is different from the current practise.
7. Fair valuation and financial statements disclosuresFair valuation as a measurement concept would apply to all captions, either for initial recognition or subsequent measurement.
Ind AS 113 , Fair Value Measurement provides guidance on how fair value is measured and includes guidelines on how changes in credit risk are to be measured, exit price valuation considerations and valuations in illiquid and inactive markets.
In addition, qualitative and quantitative disclosures related to risk management, credit risk, market risk and liquidity risk would also need to be disclosed. For example, this would entail disclosure of amounts past due but not impaired, amounts past due and impaired, for disclosures of credit risk. Similarly, in case of liquidity risk, contractual maturity of financial assets and liabilities would also include derivatives.
8. Accounting for employee benefits and share based paymentsInd AS requires actuarial gains and losses on post-employment benefit plans such as gratuity and pension plans to be recognised in other comprehensive income and not in the statement of profit and loss. This is an area of difference from the current Indian GAAP wherein these are recognised in the statement of profit and loss.
Moreover, Ind AS also requires additional disclosures on the sensitivity analysis of impact of changes in key actuarial assumptions.
Ind AS mandates the use of fair value accounting in case of accounting for employee share based payments such as Employee Stock Option Plans (ESOPs). Under Indian GAAP, companies have an option to recognise such costs on an intrinsic value method. For example, if the employee has an option to exercise an ESOP having the exercise price of INR70 and fair market value of the share being INR80, under Indian GAAP companies recognise a cost of INR10 (80-70) in the statement of profit and loss over the vesting period. Under Ind AS companies would be required to fair value the options issued and recognise this as an expense in the statement of profit and loss over the vesting period. In general, the costs under the fair value model are higher than the costs previously recognised in the intrinsic value model.
9. Consolidation/derecognitionUnder Ind AS, consolidation is not only driven by the ownership structure of an entity. Instead, Ind AS 110 introduces a new control model for consolidation of an investee by the investor. As per Ind AS 110, an investor controls an investee when the investor is exposed to and has rights to variable returns from its involvement with the investee, and has the ability to influence those returns through its power over the investee. Accordingly, an analysis of the relevant activities in respect of entities such as a securitisation trust and the transfer of risks and rewards would be quite different from the current model of considering ownership of voting interests and control over the composition of the board/governing body as is required.
Additionally, many Indian securitisation vehicles are currently structured to meet the Indian GAAP derecognition norms, and would collapse into the transferor’s balance sheet and assets as well as fail the derecognition test under Ind AS.
For example, securitisation transactions where credit collaterals are provided/a guarantee is provided to cover the credit losses in excess of the losses inherent in the portfolio of assets securitised, may not meet the derecognition principles enunciated in Ind AS 109. This is likely to impact the nature and structure of transactions going forward under an Ind AS environment. Existing transactions up to the date of initial adoption are grandfathered under Ind AS.
10. Income recognitionUnder the current principles, interest income is generally recognised on an accrual basis at the contractual rate of interest. Fees such as origination fees, processing fees are generally recognised in the statement of profit and loss upfront. Under the principles of Ind AS, such fees and costs that are directly attributable and incremental to originating the loan are recognised as an adjustment to the carrying value of the loan and are recognised in the statement of profit and loss as interest income over the tenure of the loan as an adjustment to the effective interest rate basis.
In some cases, two or more transactions may be linked wherein individually the transactions have no commercial substance on their own. These are known as linked transactions. In these cases, the combined effect of the two transactions is considered for accounting purposes to reflect the underlying substance of the arrangement. For example, an entity may provide advice on structuring a loan and also make a loan to the client and the two are entered into in contemplation of each other. Ind AS provides specific additional guidance on accounting for such transactions.
Banks and lending institutionsGiven that a lot of underwriting criteria focus on financial parameters and key financial ratios like debt-equity and erstwhile established benchmarks may undergo changes, financial statements prepared under Ind AS can be significantly different from the current Indian GAAP at least from a presentation standpoint. Consequently, majority of the loan covenants, agreements and terms might need to undergo change and need amendment.
OthersMany regulated entities operate with qualifying financial limits e.g. net worth, as stipulated by RBI, SEBI or the stock exchanges. Given that a company’s capital structure might change (differences in equity – liability classification) and that revenues are likely to vary (differences in revenue recognition standard), companies and regulators may be forced to redefine such limits or bring in additional capital.
How do you measure business performance
Revenue recognition standards under Ind AS introduce the concept of an ‘effective interest rate’ and have stricter rules on the timing of recognition of revenue. Some revenue streams, in particular, fee income and interest income may see a change and hence lead to a different matrix to be established for business targets.
Business teams who have been hitherto taking the lead in preparing and drafting budgets might have to evaluate how previous variables which formed a part of the Internal Rate of Return (IRR) assessment might now flow in the financial results in different periods compared to the previous practise.
Technology supportA significant increase in disclosures in financial statements is imminent. Ind AS 1071 and 109, lead the pack in spelling out the disclosure requirements particularly related to entities risk management policies and financial instruments respectively. Amongst others, majorly impacted by these new standards would be financial services companies given their product suite and how the standards directly apply to them. A lot of the disclosures require historical and current information as well as at a much granular level. It requires comparisons across periods, businesses and sectors. Software and hardware support are essential for a smooth transition.
Personnel incentives and remuneration programmesStemming from some of the above discussed matters, where business models and returns may undergo changes, the employee remuneration model could also need a relook. Given that payroll is a large component of any financial services company’s operating expenditure head, a strategic relook of some of the remuneration structures may be warranted – particularly employee share-based payment
schemes (ESOPs). ESOPs would need to be mandatorily fair valued with the impact recorded through the statement of profit and loss over the vesting period.
Managing stakeholder and analyst expectationConstructive and early communication with stakeholders (shareholders, regulators, customers and others) and the financial analyst community is important and critical. As the transition happens pan-industry and across the corporate world, what would benefit is an individual effort in relaying early the possible impact on financial results – so as to avoid surprises, late reactions and speculation.
As financial services organisations maneuver through this transition, they are amongst the most competent and well-positioned firms to get over the fence in spite of the complexities of the new accounting standards. Given the existing level of sophistication and understanding of some of the new concepts which exist in financial services companies, the road ahead, albeit bumpy, will lead to a desirable end destination.
Impact of new adjustments on derivative valuationThis article aims to:
– Provide an overview of the recent derivative valuation models and the impact of credit and debit valuation adjustments on these models while taking into account effects of non-performance into the value of liability.
Derivatives serve many purposes for various sections across the market. For risk managers who believed that derivatives were one of the best forms of hedging their risk exposures and insuring themselves against price movements to traders for whom derivatives provided ample opportunities to make money, and at the same time providing liquidity and stability to the markets. Various market stakeholders have found new and innovative means/uses of trading in these complex products, and as a result the global derivatives markets have increased rapidly over a period of time to multiples of the size of the global economy.
Simply speaking, derivative is a contract that derives value from the performance of an underlying item (with reference to price changes in an underlying price or index, or changes in foreign exchange or interest rates, at a future date). A derivative may have more than one underlying variable. This underlying item could be anything that the entities consider to be a risk factor.
Derivatives are categorised by the way they are traded in the market: those which are traded through an exchange, are popularly known as ‘exchange traded’, while the others are known as ‘Over-the-Counter’ (OTC) trades. These OTC derivatives often involve products like swaps, forward rate agreements and exotic options and are usually free from any standardised regulation as regards to disclosure of information between parties. Estimates of outstanding OTC derivatives are difficult to ascertain since these trades are highly customised and are carried out outside regulated exchanges.
For derivatives, Ind AS 113, Fair Value Measurement requires that the fair value of a derivative should reflect two types of credit related adjustments: a credit valuation adjustment and a debit valuation adjustment.
OTC trades are trades carried out between two counterparties for which there is no central counterparty/exchange intervention. Needless to say, the credit risk inherent in such transactions is high as they are subject to counterparty risk since
each counterparty relies on the other to perform. In the current scenario, systems that support valuation of the derivative contracts, often do not account for any change in the credit risk of the counterparty neither at the initial measurement date nor through the life of the contract. Since it cannot be assumed that the parties to the derivative contracts are bound to perform during the life of the contract, adjustments for credit risk would reflect that risk when pricing a financial instrument.
Credit Valuation Adjustment (CVA) is the adjustment that one makes to the derivative price to account for credit risk of the counterparty. To put things simply, CVA is the difference in the Mark-To-Market (MTM) arrived at by discounting cash flows with a free interest rate curve and MTM after discounting cash flows taking into account the possibility of a counterparty default. On the other hand, a Debit Valuation Adjustment (DVA) is one which is carried out to account for deterioration of one’s own credit risk.
A derivative contract has a positive valuation as on the valuation date i.e. a derivative asset, the CVA would adjust the price of the derivative downwards. For example, if the MTM of the derivative as per the risk free rate is +100, a CVA adjustment of -10 will adjust the credit adjusted MTM downwards to +90. Subsequently, if the counterparty credit risk improves, a gain is realised in the statement of profit and loss and a loss is realised when counterparty credit risk deteriorates.
If the MTM of the derivative as per the risk free rate is -100, a DVA adjustment of +10 will adjust the price of the liability downwards showing a lower liability. Subsequently, if there is an improvement in own credit risk, a loss is in the statement of profit and loss and gain is realised in the statement of profit and loss in the form of lower liability when the own credit risk deteriorates.
Although Ind AS 113 requires the CVA/DVA adjustments to be made, the standard does not prescribe a methodology that needs to be followed. However, over time a few methods (explained below) have evolved wherein an entity needs to apply a fair bit of
judgement on the data assumptions to be used i.e. estimates with respect to the probability of default, loss given default and credit. All the methods have certain advantages and disadvantages and the entity should opt for the most appropriate method so as to be compliant with the requirements of Ind AS 113. Some of the methods are enumerated below:
• Potential Future Exposure (PFE) Method: This method is based on Monte Carlo simulations where the risk factors underlying the derivative are simulated. For example, if the derivative is an interest rate swap, the underlying risk factor would be interest rates. Monte Carlo simulation would forecast what could be the possible interest rates and determine if the derivative can potentially be an asset or a liability in the future. The simulation is run numerous times and averaging the positive and negative exposures will provide the expected positive exposure (asset) and expected negative exposure (liability). Default probabilities are then applied to the exposure to calculate the CVA/DVA charge.
• Current/variable exposure method: In the current exposure method, the CVA/DVA computation is done based on the current information available for the risk factors e.g. current/future interest rates and no simulation of the market parameters is required. Although simple to implement, the biggest drawback of this method is that it does not consider potential future exposure and may not reflect the counterparty risk accurately.
A variation to the current exposure is a variable approach where future exposure is determined through an add-on factor and is added on to the current fair value of the derivative.
• Discounted cash flow method: Under this approach, the derivative is valued twice, once when the cash flows are discounted using the risk free rate; and next when the derivative is priced using the discounting curve which is adjusted for the credit spread of the counterparty/own credit. Again, this method does not take into account the impact of potential future exposure and gives reliable results only when the derivative is a simple one.
With respect to valuation of complex derivative instruments, concepts like CVA and DVA are well established and have been followed by the market fairly diligently. But of late, the concept of Funding Valuation Adjustment (FVA) is gaining momentum gradually.
While CVA and DVA charges are associated with credit risk of the parties involved in the trade, FVA is aligned to the liquidity risk. The following example may help to better understand the concept of FVA.
A bank’s trading desk has entered into a derivative transaction with Party A which is a collateralised trade (i.e. guaranteed by a collateral). The trading desk has entered into a back to back deal with Party B to hedge the same deal, but it is an uncollateralised trade. The swaps have zero Net Present Value (NPV) on day one and as time passes, the swap value undergoes a change. Since these two swaps are back to back deals, the positive NPV on one swap (e.g. INR1,000,000 due to bank trading desk from Party A) will offset the negative NPV (e.g. -INR1,000,000 due by bank trading desk to Party B) on the other swap. Now since the second swap has a negative MTM, the trading desk at the bank will have to fund the negative MTM by depositing a collateral using borrowed funds.
In the pre-crisis era where liquidity was abundant, it was fairly easy to borrow and lend money from the market at low rates of interest, usually at LIBOR. However, the uncertainty and acute liquidity crunch post the 2008 crisis forced banks to lend for a maximum of an overnight. Thus, the lending rate which was originally the LIBOR, now moved to the Overnight Indexed Swap (OIS). The crisis also resulted in the rate of interest paid on borrowed funds to be higher compared to the interest earned on the collateral deposited because of the various spreads that were added to the benchmark to reflect the credit quality of banks. The difference between the two rates is considered to be a cost to the trading desk and thus, is deducted as an expense in the statement of profit and loss to arrive at the correct profit earned by the desk. This cost is known as FVA.
FVA is a type of hybrid adjustment which lies somewhere between CVA and DVA. As seen above, FVA is calculated on the expected positive exposure like the CVA and since the cost of funding depends on the bank’s ability to perform or not perform i.e. the bank’s funding cost, it is more like DVA.
Since FVA is a relatively new concept, its actual impact and the significance of the adjustment is yet to be realised in India. If one ignores this adjustment to fair value, it serves to be a risk that managers cannot afford to take, considering the liquidity challenges in the market. Correctly pricing FVA is critical since it may impact the overall profitability and competitiveness of market participants.
ConclusionThe complexity of valuation of derivatives was traditionally focussed only on complex products. However, recent developments on CVA, DVA and FVA have brought into limelight the fact that large portfolios with even simple derivatives could lead to potentially complex and computationally intensive valuation adjustments. In India, in our experience entities generally do not consider these aspects during fair valuation. Given that the market for derivatives is international, and not considering such elements may lead to mispricing of risk. Therefore, it may represent a far more serious challenge than just keeping up with leading practices.
Conversation withMr. Keki Mistry Vice Chairman and CEO of Housing Development Finance Corporation Limited (HDFC)
Q According to the Ind AS adoption road map, HDFC will be adopting Ind AS from 1 April 2018, with the date of transition being 1 April 2017. How are you addressing the challenges arising in the following areas:
• Technical challenges
• Capacity and infrastructural challenges such as capacity building of the finance department and creating both internal/external awareness, changes to contracts/business practices and changes to IT systems/processes.
• Non-technical challenges such as managing expectations and communication with both internal/external stakeholders.
What learnings or insights are you developing as you gear up to meet these challenges?
We have set up a task force which has been working towards assessing the impact of Ind AS on HDFC’s financial statements. The significant changes in accounting and income recognition at HDFC as a result of Ind AS adoption are expected to arise in the following areas: • Recognition of income based on
effective interest rates.• Fair valuation of certain financial
instruments that would not qualify for valuation on an amortised cost basis. This would include derivatives and investments.
• Application of hedge accounting in appropriate cases.
• Loan loss provisioning based on the expected credit loss model vis-à-vis the incurred credit loss model as is currently followed under the Indian GAAP.
• Consolidation of investments made in subsidiaries based on control vis-à-vis on the basis of ownership as envisaged in the current Indian GAAP.
In respect of each of the aforesaid items, we have identified the gaps vis-à-vis the current method of calculation. Some of these have undergone dry runs in the past when the standards were supposed to be introduced in the year 2011, and to that extent we have already built our technical capabilities.
The Institute of Chartered Accountants of India (ICAI) guidelines on derivatives effectively migrate the accounting treatment of this class of financial instruments in sync with Ind AS. We also need to note that in India companies are required to adopt Ind AS for both stand-alone and consolidated financials. I believe that companies should be allowed to file only consolidated financials for the investor community. The above view is also supported internationally.
Further, HDFC largely operates out of an in-house software system and as such does not have to depend upon external vendors for modifying its IT systems.
Q Given the current economic environment and the RBI’s actions, do you believe that the issue around reporting of Non-Performing Assets (NPAs) in the financial services sector is on weak standards or inappropriate implementation?
We are still awaiting the guidelines over how the differences between the regulatory provisioning and the Ind AS numbers would be treated in financial statements.
My sense is that in case of HDFC, the provisioning requirement under Ind AS may actually be lower than the regulatory provisioning since regulatory provisioning is largely based on the period of default whereas Ind AS is based on the time taken and the realisable value of the security in the event of a foreclosure.
HDFC’s loans are repayable through Equated Monthly Instalments (EMI) which commence immediately after the loan is disbursed. The EMI has a principal and an interest component. Thus, the loan balance keep decreasing
over a period of time. Our average loan to value ratio at origination is around 65 per cent. In other words, the security value at inception is over 150 per cent. This keeps increasing as the EMI is paid. As the security cover of the loan is very high, we do not envisage a situation where we have to write off any amount at the time of foreclosure. This also explains the reason why our historical loan losses have been so very low (cumulative loan losses are only 4 basis points (0.04 per cent) of our total loan disbursements).
Q The Income Computation and Disclosure Standards (ICDS) have been notified and are applicable from Assessment Year 2016-17 onwards. Are you satisfied with the approach of the government on the notification of ICDS and do you think that the standards as currently issued, appropriately balance the perspectives of Revenue authorities and taxpayers? Are there any specific areas where concerns persist?
The ICDS are expected to work as a uniform base for computing the tax profits to bring all taxpayers at par. Although, the government’s intention is good, it has led to the creation of a few ambiguities.
For instance, ICDS states that the Income Tax Act, 1961 shall prevail in case of conflicts between ICDS and the Income Tax Act; however, there are quite a few areas where conflicts arise and it is not clear whether the existing tax position based on judicial precedents will hold good. Moreover, even though the preamble to the ICDS states that they are not for the purpose of maintenance of books of account, deviation from the accepted accounting principles (such as a different formula for capitalising general borrowing costs, non-recognition of expected or Marked-To-Market (MTM) loss, etc.) would result in maintenance of separate books of accounts for tax purposes, which could be burdensome, requiring changes to the existing IT systems and resulting in an increased cost of compliance.
Further, the disclosure requirements under ICDS also need to be clear.
Unfortunately ICDS is being implemented at a time when companies are transitioning to Ind AS, whose implementation comes with its own set of tax issues.
I understand that recently the Central Board of Direct Taxes (CBDT) has invited the stakeholders and general public to bring out issues which in their opinion may require further clarification/guidance for proper implementation of the provisions of the ICDS.
This consultative approach is a welcome move and it is expected that the CBDT shall soon address the taxpayers concerns.
Q The Companies Act, 2013 (2013 Act) has introduced Section 134(5)(e) which requires the Directors’ Responsibility Statement to state that the directors, in the case of a listed company, have laid down Internal Financial Controls (IFC) to be followed by the company and that such internal
controls are adequate and operating effectively. How have you approached this area and what have been the key considerations with respect to the implementation of reporting on IFC?
We have always laid strong emphasis on internal controls and internal audits and introduced a robust system of reporting its adequacy and effectiveness for various regulatory requirements.
The new requirement has the effect of enhancing the standard of documentation of the system. We have built a framework for enterprise-wide uniform documentation in accordance with internationally accepted standards. This is getting tested during the current year by both the internal audit team as well our statutory auditors. We do not see a major challenge in this area.
Q Have there been other areas such as related party transaction approvals required under the 2013 Act that have been challenging when it comes to implementation?
Our transactions with related parties were always at an arm’s length and in the normal course of our business. We get all material transactions vetted by an external third party and have additionally, created a policy adopted by the board. Statutory auditors also give periodic
certifications as guided by the audit committee of the board, confirming that the transactions are in accordance with the adopted policy.
Q What has been your overall evaluation of the 2013 Act and are there any learnings on how such a significant economic legislation could be implemented for the country?
The 2013 Act is one of the path-breaking legislations to be enacted in the recent past. It encompasses global leading practices that have been pruned to meet the requirements of an economy like ours.
In respect of a number of provisions of the 2013 Act, details for execution are not prescribed, Rules in this regard are yet to be notified. We hope that there is a check on the executive so as to help ensure that they do not exceed their brief by prescribing subordinate rules that override the provisions of the primary legislation.
I believe that the 2013 Act has been revamped with a view that misdemeanours in businesses are a common practise. Given the above, all
companies have been brought under the same lens and accordingly there is a risk that more time shall now be spent on compliance related matters, rather than business related issues. Further, I also believe that the responsibilities of independent directors are not in commensuration with what they can practically do. There is a risk that the business focus may shift from strategy to compliance.
Q The government has introduced mandatory Corporate Social Responsibility (CSR) requirements in the 2013 Act, which requires companies to spend on social and environmental welfare, making India perhaps one of the very few countries in the world to have such a law. What were the key considerations and challenges for HDFC in implementing this law for the first time? Could you please elaborate on the CSR programmes being undertaken at the company?
CSR activities are intended towards the general welfare of the society and are not in pursuance of the normal course of business of a company. Hence, profits that reflect a company’s operating efficiency would materially change if the mandatory requirement has to be taken into its statement of profit and loss. The company does not have any control or discretion in deciding the quantum that is calculated as a percentage of its profits. This should ideally be treated as an item of appropriation after the Earnings Per Share (EPS) of the company is calculated. Charging these expenses
to the statement of profit and loss will decrease the EPS and increase the Price/Earnings(PE) ratio. This will have the effect of making foreign investment in Indian companies more expensive and less attractive.
HDFC has always supported social and development sector organisations over the last 20 years, through the Shelter Assistance Reserve created specifically for this purpose. With the new CSR provisions being brought into effect, our work is now focussed within a few sectors, as well as on a larger scale than before. Although we are largely sector agnostic, our main social investments over the past two years have been in the education, healthcare, and water and sanitation sectors. HDFC undertakes most of its CSR activities through the HT Parekh Foundation, aptly named after its founder.
Social investing at scale brings with it, its own set of challenges from finding high quality, non-profit organisations with experienced and good teams to a credible Board of Trustees/Directors.
Amongst the small percentage who meet this criteria, finding those who can effectively scale up their work across
states in India with a large amount of CSR funds available, poses further challenges today. Many mid-sized social organisations will need at least three to five years to scale up their operations, hire professional staff and put in place appropriate systems to sustain their work and manage large grants being made available to them through CSR funds.
The HT Parekh Foundation has until now been constrained to a certain extent, on providing grants only to Foreign Contribution (Regulation) Act, 2010 (FCRA) registered organisations as HDFC Ltd is considered a ‘foreign source’ under FCRA. We have had to turn away many good organisations as they do not possess this particular registration. However, the Finance Bill, 2016 has proposed an amendment to this law, which once enacted in the Parliament, would open up the domain for social investing in all non-profits registered in India with or without they being FCRA registered. We look forward to doing a lot more work in this sector in the forthcoming financial year.
Q What are the new learning initiatives that HDFC is undertaking in the area of capacity building, in order to equip the finance department/internal auditors/
stakeholders/board of directors to build their knowledge base is in the areas of challenge?
We had our first all India training programme around 2005-06. Subsequently, many of us have
undertaken certificate courses in IFRS to build up our learning base. As we get closer to migration to Ind AS we are creating specific processes and procedures around the key areas described above.
The views and opinions expressed herein are those of the interviewee and do not necessarily represent the views and opinions either of Housing Development Finance Corporation Limited or of KPMG in India.
Private equity and Venture Capital (PE/VC) funds provide an important source of strategic capital for many growth and early state companies. In some industries that are knowledge/intellectual property intensive and collateral light (like e-commerce, research and development, etc.). PE/VCs provide capital where traditional providers such as banks and financial institutions are unable or unwilling to fulfil such needs.
Fund structurePE/VC funds are typically organised in multi-layer structures that are intended to create an efficient model for pooling capital from local and foreign sources and to achieve tax related efficiencies. Most commonly these funds are organised as having multiple feeder funds that raise resources from investors which pool themselves in a master fund. The master fund (or its step down entities) then make investments in companies that over time generate capital gains, interest and dividend income:
Master feeder structures were created in the past predominately for tax purposes. A very common scenario was for promoters to set-up a master fund based in an offshore jurisdiction and to have feeder funds for local and overseas investors. By the creation of feeders, the master fund benefits from:
• Reduced trading costs as they do not need to trade in several portfolios
• Reduced administrative burden of managing several portfolios
• Better financing arrangements• Promoters and managers promote
their own brand by setting up feeders investing in masters, managed by a specialist of a particular strategy.
Onshore feeder fund
Offshore feeder fund
Investment manager
for all fundsMaster fund which invests in chosen markets/strategies
Investment entities Exception to consolidationBackground
On 31 October 2012, the International Accounting Standards Board (IASB) published investment entities (amendments to IFRS 102, IFRS 123 and IAS 274) so that an ‘investment entity’ fair values its subsidiaries instead of consolidating them. The IASB believed that an investment entity used a different business model in comparison to several other entities. It manages all of its investments on a fair value basis. PE/VC fund stakeholders find fair value information more useful for decision-making than consolidated information.
The amendments became effective for annual periods beginning on or after 1 January 2014. Early adoption was permitted. The investment entities consolidation exception is mandatory for an entity that meets the criteria as described in IFRS 10 (these criteria have been discussed in this article).
As part of its activities, an investment entity is permitted to provide investment-related services to its investors, which include, investment management services, investment advisory services and administrative support. Even if the investment-related services are substantial and are also provided to third parties, this does not preclude an entity from qualifying as an investment entity.
Determining whether an entity is an investment entity Two part approachIn determining whether an entity qualifies as an investment entity, the entity needs to consider all facts and circumstances, including the purpose and design of the entity. To qualify as an investment entity, an entity needs to meet all of the essential elements of the definition of an investment entity and is expected – but not required – to display the typical characteristics of such an entity.
Part one
The three essential elements of the definition of the investment entity are as follows: Investment management services
An investment entity obtains funds from investors to provide those investors with investment management services.
Returns solely from capital appreciation and/or investment income
An investment entity commits to its investors that its business purpose is to invest for returns solely from capital appreciation and/or investment income. This commitment could, for example, be included in the offering memorandum, investor communications and/or other corporate or partnership documents. For an entity to show that its business purpose is to invest for returns solely from capital appreciation and/or investment income, the entity:• Must document potential exit
strategies for substantially all investments.
• Must not obtain other benefits from its investees that are not available to other parties that are not related to the investees (prohibited benefits).
Measure and evaluate performance on a fair value basis
The final element of the definition of an investment entity is the measurement and performance evaluation of substantially all investments on a fair value basis.
Part two
It is expected that an entity which meets the definition of an investment entity typically has the following characteristics:
Holds more than one investment
An investment entity typically holds more than one investment in order to diversify its risks and maximise returns. However, the amendments acknowledge that this may not always be the case. An investment entity might hold a single investment in the following situations:• It is in a start-up period and has not yet
suitable investments and, therefore, has not yet executed its investment plan to acquire several investments. It has not yet made other investments to replace those it has disposed off.
• It is established to pool investors’ funds to invest in a single investment when that investment is unobtainable by individual investors (e.g. when the required minimum investment is too high for an individual investor).
• It is in the process of liquidation.
Has more than one investor
Typically, an investment entity would have several investors who pool their funds to gain access to investment
management services and investment opportunities that they might not have access to individually.
Alternatively, an investment entity may be formed by, or for, a single investor that represents or supports the interests of a wider group of investors (e.g. pension fund, government investment fund or family trust). The standard acknowledges that there could be certain situations where it might be appropriate to conclude that the entity is an investment entity despite having only one investor. These are situations could be as following:• The entity’s initial offering period
has not expired and it is actively identifying additional suitable investors.
• The entity has not identified suitable investors to replace ownership interests that have been redeemed.
• The entity is in the process of liquidation.
Has investors that are not related parties
Typically, an investment entity will have several investors that are not related parties (as defined in IAS 24, Related Party Disclosures) of the entity or other members of the group containing the entity. Having unrelated investors would make it less likely that the entity, or other members of the group containing the entity, would benefit other than capital appreciation or investment income.
However, an entity may still qualify as an investment entity even when its investors are related to the entity. For example, an investment entity may set up a separate ‘parallel’ fund for a group of its employees (such as key managerial personnel or other related party investor(s), which mirrors the investments of the entity’s main investment fund.
Ownership interestsAn investment entity is typically, but is not required to be, a separate legal entity. Ownership interests in an investment entity are typically in the form of equity or similar interests (e.g. partnership interests), to which proportionate shares of the net assets of the investment entity are attributed. However, having different classes of investors, some of which have rights only to a specific investment or groups of investments or which have different proportionate shares of the net assets, does not preclude an entity from being an investment entity.
2. IFRS 10, Consolidated Financial Statements 3. IFRS 12, Disclosure of Interests in Other Entities 4. IAS 27, Separate Financial Statements
It is possible that an entity may not meet one or more of these characteristics and still qualify as an investment entity. In such cases, additional judgement is required by the management in determining whether the entity qualifies as an investment entity. An investment entity is required to disclose its reasons for concluding that it is an investment entity when one or more of these characteristics are not met with.
Parent is an investment entity
The investment entity consolidation exception is mandatory for the parent of an investment entity that itself meets the definition of an investment entity. In such cases, the parent entity is also required to account for its investments in controlled investees at FVTPL, even if the investment entity subsidiary was formed for specific legal, tax or regulatory purposes e.g. in a master-feeder structure. In addition, because the parent is an investment entity, any investments in associates and joint ventures are required to be accounted for at FVTPL.
Parent is not an investment entity
The consolidation exception is not carried through to the consolidated financial statements of a parent that is not itself an investment entity – that is, the parent is nevertheless required to consolidate all subsidiaries. A non-investment entity parent is required to consolidate line by line all entities it controls including those controlled through an investment entity, even though the subsidiary which qualifies as an investment entity would measure its controlled investees at FVTPL. The IASB believed that the key factor in granting the consolidation exception in the first place was the unique business model of investment entities, which the higher level parent may not have. Although many investment entities might have a parent that is an investment entity – which means that the exceptions will be carried through, some will have a parent that is a non-qualifying bank or insurance company, which will have to consolidate all the subsidiaries including investment entity.
Fair value measurementIn measuring the fair value, investment entities will follow the guidance laid down in IFRS 13, Fair Value Measurement, which defines fair value as, ‘the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.’ However, non-consolidation may bring certain challenges/issues for investors of investment entities as discussed below:• The investment entity (feeder fund)
will fair value its investment in the underlying investee entity (master fund) due to which investors of the investment entity will not be able to see the performance of the underlying investments in the portfolio companies as the same will not be disclosed in the financial statements of the investment entity. Investors generally like to see how each of the portfolio companies are performing which will not be available to them under the exemption model. However, this objective can be achieved either by way of providing additional disclosures/information about the portfolio companies in the financial statements or in management discussions and analysis.
• The investee entity (master fund) might have a leverage (borrowings) in its books. Under the consolidation model, these borrowings will be reflected in the feeder fund at an amortised cost. However, under the fair value model, these borrowings will be fair valued and the resultant fair value gains/losses will be recognised for arriving at the fair value of the master fund. Due to this, investors may not be able to see the leverage at the master fund and this may bring about further volatility due to fair valuation of the borrowings.
• Under the consolidation model, realised gains/losses (including operating expenses) and unrealised gains/losses of the master fund are separately disclosed in the feeder fund financial statements. However, under the fair valuation model, all of the above will be subsumed and will be a part of the fair value of the master
fund. Investors will not be made available with separate information on the realised and unrealised gains/losses. In the initial years, the master fund will have realised losses due to ongoing expenses like management fees, other operating expenses, etc. However, these realised losses will be clubbed together with unrealised gains/losses and may not provide separate information about realised losses and unrealised gains/losses.
Changes in status accounted for prospectivelyQualifying for the first time
When an entity qualifies as an investment entity for the first time, it accounts for the change as a deemed loss of control in subsidiaries. The difference between the previous carrying amount of the subsidiaries and their fair value as on the date of the change in the status is recognised as a gain or loss.
Ceasing to qualify
When an entity ceases to qualify as an investment entity, IFRS 3 Business Combinations is applied on that date in its consolidated financial statements (the deemed acquisition date). The fair value of the controlled investees as on the date of the change becomes the deemed consideration transferred to obtain control on the investee.
Investment entities Exception to consolidation: DisclosureInvestment entities would be required to provide following disclosures (the list below is not an exhaustive list):• If a parent determines that it an
investment entity, then it shall disclose information about significant judgements and assumptions made in determining that it is an investment entity.
• If the investment entity does not have one or more of the typical characteristics of an investment, then it shall disclose its reasons for concluding that it is nevertheless an investment entity.
• When an entity becomes, or ceases to be, an investment entity, it shall disclose the change of investment entity status and the reasons for the change.
• An entity that becomes an investment entity, it shall disclose the effect of the change of status on the financial statements for the period presented, including: – The total fair value, as on the
date of change of status, of the subsidiaries that cease to be consolidated
– The total gain or loss, if any, calculated in accordance IFRS 10, and
– The line item(s) in profit or loss in which the gain or loss is recognised (if not presented separately).
• IFRS 12 requires disclosures on information about unconsolidated subsidiaries and unconsolidated structured entities controlled by an investment entity.
• IFRS 7, Financial instruments: Disclosures applies to investments in subsidiaries that are measured at FVPTL. IFRS 7 disclosures are likely to be one of the most significant. For example, the sensitivity analysis disclosures now apply to the investee as a whole rather than to its underlying investments on a consolidated basis.
Indian Accounting Standards (Ind AS) 110, Consolidated Financial StatementsThere are no differences between Ind AS 110 and IFRS 10 with respect to an investment entity exemption.
Key differences between IFRS and U.S. GAAP5
The IFRS definition of an investment entity is substantially converged with the U.S. GAAP definition with the following exceptions:• Only an entity that meets the
definition under IFRS can qualify as an ‘investment entity’. Under U.S. GAAP, an entity that meets the definition can qualify as an ‘investment company’, like IFRS. However under U.S. GAAP, unlike IFRS, an entity also qualifies as an investment company by virtue of being regulated under the Investment Company Act of 1940.
5. KPMG IFRG Limited’s publication: IFRS compared to US GAAP, issued in December 2015
• Under IFRS, the definition of an investment entity requires an entity to meet certain criteria relating to its activities and its measurement and evaluation of investments. Under U.S. GAAP, like IFRS, the definition of an investment company requires an entity to meet certain criteria relating to its activities and its evaluation of investments; however, these criteria differ from IFRS in certain respects. In addition, unlike IFRS, there is no criterion related to the measurement of an entity’s investments.
• Under IFRS, in addition to the definition, the entity is expected to have one or more of certain ‘typical’ characteristics. Under U.S. GAAP, in addition to the definition, the entity is expected to have one or more of certain ‘typical’ characteristics, like
IFRS; however, these characteristics differ from IFRS in certain respects.
• Under IFRS, the investment entity consolidation exception is mandatory for the parent of an investment entity that itself meets the definition of an investment entity. Under U.S. GAAP, unlike IFRS, consolidation by an investment company of an investment company subsidiary is not precluded.
• Under IFRS, a parent that is not itself an investment entity consolidates all subsidiaries. Under U.S. GAAP, unlike IFRS, for the purpose of consolidating an investment company, a non-investment company parent retains the investment company accounting applied by the subsidiary investment company.
ConclusionThe consolidation exceptions for investment entities are a big step towards aligning external financial reporting with the way in which these entities operate. Investment entities have long sought relief from consolidation and this exemption is a response to an industry-specific approach and can bring about consistency in the way financial statements are presented by such entities.
The RBI on 30 January 2014 issued a framework for revitalising distressed assets in the economy, effective from 1 April 2014. The framework lays down the guidelines for early recognition of financial distress, steps for resolution and thereby attempting to ensure fair recoveries for lending institutions. For operationalisation of the above framework, RBI issued various notifications for guidelines on refinancing of loans, formation of the Joint Lenders Forum (JLF), adoption of a Corrective Action Plan (CAP) and other regulatory measures. During the last few years, there have been a number of circulars issued by the RBI, clarifying various aspects on the original guidelines issued.
Joint Lenders Forum (JLF)/Special Mentioned Account (SMA) guidelinesThe RBI requires banks to identify SMAs in the following categories1:
The guidelines broadly cover the following aspects, which banks need to consider and monitor:
• Identification of SMA 0, SMA 1 and SMA 2 borrowers based on the definition provided in the guidelines (refer above) and appropriately reporting these on the Central Repository of Information on Large Credits (CRILC)
• Developing an appropriate mechanism to monitor the various milestones (reporting on CRILC, formation of JLF, agreement on corrective action, etc.) stated in these guidelines and ensure compliance with the circular
• Broadly there can be three outcomes of the CAP - rectification, recovery and restructuring
• Banks need to make an accelerated provision on exposures (over and above the prudential requirements) if there is non-compliance with the requirements laid down by RBI.
Although the RBI circulars dated 21 October 2014 and 25 February 2015 provide some amount of breather to the lead bankers by identifying the responsibilities of lenders other than the lead bankers, the current framework considers lead bankers to be primary drivers for compliance with the guidelines.
The RBI has laid down various milestones for monitoring the progress of the borrower at every stage. In order for banks to ensure compliance with these guidelines, they need to put in place appropriate systems, controls and processes for identification of SMAs and ensuring monitoring and continuous compliance with these guidelines and clarifications that emerge from the RBI from time to time. Therefore, the need for adequate manual and automated controls around completeness and accuracy of the list of SMAs, reporting on CRILC, monitoring various timelines, etc. is becoming increasingly critical as this directly impacts the requirement for provisioning on loans and advances.
Strategic Debt Restructuring (SDR)In continuation with the RBI circular dated 26 February 2014 on ‘Framework for Revitalising Distressed Assets in the Economy – Guidelines on JLF and CAP’, change of management was envisaged as a part of restructuring of stressed assets. The general principle is that shareholders would have to bear the first loss rather than debt providers and that industrialists/promoters need to have more ‘skin in the game’.
The SDR guidelines identify terms such as the reference date, date of decision-making, standstill period, specified period, etc. Most of the borrowers where SDR is expected to be implemented, will have a consortium of lenders and consequently it becomes even more important that banks apply these guidelines consistently across all identified exposures. Further, the
reference date also has relevance in determination of the conversion price as the fair value as on the reference date (as per the method prescribed by the RBI) is considered for the purpose of implementing SDR.
We have summarised a few practical challenges that have been faced by banks while implementing these guidelines:• Similar to monitoring the timelines
for JLF and CAP implementation as stated above, banks will have to consider monitoring timelines stated for SDR implementation as well. Currently, in our experience, a lot of this monitoring is manual in the banking system and considering the growing importance of demonstrating internal controls for banks, it will be imperative that banks have adequate automated controls and checks to help ensure completeness and accuracy of the borrowers which have been restructured.
• The JLF needs to incorporate the necessary terms in the restructuring agreement on the banks’ option to convert loans into equity in the event that the borrower is not able to achieve the viability milestone or certain critical conditions in the restructuring package. In case of non-restructured borrowers, this option shall be included as a part of the original loan agreement. Banks need to consider modifying the original loan agreements wherever required to enable them to exercise the SDR option as part of the CAP.
• The guidelines are not very clear on the recognition of interest income for exposures where SDR has been invoked or implemented. Consistency in accounting treatment will be important and banks should be deliberate and maintain transparency with respect to the accounting policy choices they make in this context.
• The guidelines require lenders to closely monitor the performance of the borrower through the JLF and consider appointing suitable professional management to run the affairs of the company. Identification of such suitable management which may enable the turnaround of fundamentally strong companies is proving to be practically challenging for banks.
SMA categories
Basis for classification
SMA – 0 Principal or interest not overdue for more than 30 days but account showing signs of incipient stress
SMA – 1 Principal or interest payment overdue between 30-60 days
SMA – 2 Principal or interest payment overdue between 60-90 days
1. RBI circular on ‘Early Recognition of Financial Distress, Prompt Steps for Resolution and Fair Recovery for Lenders: Framework for Revitalising Distressed Assets in the Economy’ dated 30 January 2014
Recently, RBI issued a notification dated 26 February 2016, which partly modifies or clarifies certain aspects mentioned in the original guidelines on SDR. These clarifications cover aspects around the need for covenants for invocation of SDR in the agreement, adequate diligence for transfer of ownership within group entities, minimum divestment of 26 per cent instead of 51 per cent during the standstill period, etc. Overall, these guidelines provide some amount of flexibility to the lenders to expedite practical implementation of the identified SDR cases. However, the key takeaway for lenders which the RBI has also reiterated, is that they should consider using the SDR option only in cases where a change in ownership is likely to improve the economic value of the loan asset and that there are prospects of recovery of their dues.
Flexible restructuring of long-term project loans (5/25)In July 2014, RBI came up with the circular on flexible restructuring of long-term project loans to infrastructure and core industries, whereby banks were allowed to fix a longer amortisation period for loans to projects in infrastructure and core industries sectors, say 25 years, based on the economic life or concession period of the project, with project refinancing every five years. These guidelines were primarily applicable to project loans with a view to make good the asset liability mismatch prevalent in such projects. The option is available for term loans to projects, in which the aggregate exposure of all institutional lenders exceeds INR500 crore, in the infrastructure sector (as defined under the Harmonised Master List of Infrastructure of RBI) and in the core industries sector (included in the Index of Eight Core Industries (base: 2004-05) published by the Ministry of Commerce and Industry, Government of India2).
One of the most immediate aspects is to assess the fundamental viability of the project established on the basis of requisite financial and non-financial parameters, indicating capacity to service the loan and the ability to repay over the tenure of the loan. Banks need to clearly articulate the reasons or the basis of their revised viability assessment since a similar assessment have been done at the time of initial sanction of the loan for these projects. Banks also need to be convinced that the 5/25 option can enable the revival of the existing projects.
Further, for existing projects, the RBI has also provided an option to banks to fix a fresh loan amortisation schedule once during the lifetime of the project, after the date of commencement of commercial operations based on the reassessment of project cashflows without being categorised as a restructured loan, subject to compliance with certain conditions laid down in the guidelines.3
Banks need to place appropriate internal control frameworks for compliance with conditions, timelines and milestones laid down by RBI. For many of the above guidelines, especially SDR and the 5/25 guidelines, it will be essential for banks to apply these guidelines in their true spirit and not to use the options provided by RBI to postpone the recognition of stressed NPAs in their lending book.
2. RBI/2014-15/126 DBOD.No.BP.BC.24/21.04.132/2014-15 circular dated 15 July 2014
3. RBI/2014-15/354 DBR.No.BP.BC.53/21.04.132/2014-15 circular dated 15 December 2014
Non-performing assets recognition for banks in India
This article aims to:
– Summarise the current RBI requirements for loan impairment and restructuring
– Provide an overview of the expected credit loss model for measuring impairment under Ind AS.
Assessment and impact under Ind AS
Retail loans (e.g. mortgages, credit cards, personal loans, loan against property)
– Minimum RBI provision of 15 per cent for Non-Performing Assets (NPAs)1.
– Identification of NPAs is on the basis of the Days Past Due (DPD)1 and vintage within an aging bucket.
Whilst there is a DPD trigger and a minimum provision prescribed, in practise, many banks also undertake a probability assessment based on the behavioural trends of retail loans to identify NPAs and make a provision (subject to the minimum 15 per cent).
Restructured loans
– The RBI regulations mandate a 5 per cent provision for restructured loans1.
– Banks also have to recognise the fair value loss (sacrifice) on restructure (future restructured cash flows discounted by the current interest rate at the time of restructure minus the original cash flows on the loan1).
The aggregate of the fair value loss on restructure plus the minimum 5 per cent provision is usually much lower than the minimum NPA provision of 15 per cent for the same loan. Also, restructured loans are not disclosed as NPAs in books (especially for loans restructured prior to April 2015).
Wholesale loans (e.g. term loans/working capital loans for project finance, cash credit)
– Banks as part of their credit monitoring process, set out the objective and qualitative criteria to identify red flag accounts as well as early warning signs of stress1. Generally, loans are recognised as NPAs when the payments are overdue for more than 90 days.
– The industry norm for NPA provision for wholesale loans is largely DPD driven and minimum provision of 15 per cent.
– Complex rules exist for projects under implementation and special situations such as strategic debt restructuring, etc.
Other areas
– Certain banks create provisions for contingencies/against specific assets which are not NPAs currently. These contingent provisions are subject to normal governance considerations relating to the basis of creation, how these provisions are enhanced from time to time and how they are to be utilised.
– Floating provisions: RBI guidelines permit banks to create floating provisions, provided there is a clearly defined policy, objective parameters and conditions set out for the recognition of such provisions1. The release or utilisation of such provisions requires prior RBI approval.
The Reserve Bank of India (RBI) has from time-to-time prescribed the principles around measurement of loan impairment and other financial instruments for Indian banks. The following table provides a brief snapshot of the current accounting practices followed by Indian banks for recognition and measurement of loan assets:
There is frequently debate on whether RBI norms highlighted above represent the minimum level of requirements for provisioning or if they represent the
only level of requirement. In practise, banks have tended to generally follow the RBI norms and only in the area of retail lending do we practically see more
Given the above dismaying trends, the RBI’s key concern are whether: (i) banks by adopting the restructuring route are delaying recognition of NPAs for assets which exhibit imminent stress; and (ii) the balance sheets of Indian banks reflect an adequate provision cover against such stressed assets.
Through the asset quality review undertaken by the RBI in the second half of 20152, the RBI has set a deadline of March 20173 by when it expects banks to recognise their stressed assets, in particular, those which are indicating imminent stress such as but not limited to:• Failed restructurings (continually
deteriorating operating performance; key restructuring terms not met with, such as security perfection or promoter contribution)
• Adequate technical economic feasibility study not completed for borrowers under corrective action plans but limits have been released by banks
• Devolvement of off balance sheet facilities
• Group companies servicing debt obligations of the bank.
Indian Accounting Standards (Ind AS) regimeAmidst all the above, the RBI in February 2016 set out a timeline for financial year 2018-19 (comparative period being financial year 2017-18) for banks to adopt Ind AS as their base financial reporting framework.
The Ind AS framework represents India’s convergence with the International Financial Reporting Standards (IFRS). The advent of Ind AS, especially the standard on financial instruments (Ind AS 109) is expected to bring about a paradigm shifts in the principles of:• Classification of financial assets
driven by business models• Expected credit loss model for
measuring impairment• Debt vs equity.
Expected Credit Loss (ECL) computations are a high priority area in the background of the burgeoning levels of stressed assets in wholesale banking.
Background on the emergence of the ECL modelThe RBI’s extant provisioning framework suggests an incurred loss model for measuring impairment on NPAs. In simple terms, what this means is that banks while assessing impairment, should look for ‘objective indicators’ present as on the measurement date, which imply/indicate stress in an underlying asset. Objective indicators mean indicators which one may be able to validate/verify/check independently from various sources. Practically, in our experience, some of such indicators are as follows (this is not an exhaustive list):
i. DPD (over dues) on a loan
ii. Poor financial performance/operating cash flows for a sustained period
iii. Borrower requesting for restructuring iv. Loss of market share, declining stock
price or credit rating.
Regulator’s perspective and expectations from banksWhen an asset is restructured, there is usually a moratorium (holiday) period wherein the borrower does not have to service any interest/principal obligations. Trends over the last five years indicate that restructured loans are converting to NPAs at an increasing pace after the moratorium period. The following graph provides an overview of the trend in the Corporate Debt Restructuring (CDR).
(Source: Bar chart has been compiled based on data points available on www.cdrindia.org (http://www.cdrindia.org/pdf/CDR-performance-yearly-comparison.pdf))
2. Newspaper article of The Hindu, 9 December 2015, On swachh balance-sheet mission, RBI to review banks’ loan quality http://www.thehindubusinessline.com/money-and-banking/on-swachh-balancesheet-mission-rbi-to-review-banks-loan-quality/article7966890.ece
3. Newspaper report, The Hindu, 15 December 2015, RBI reviews banks’ assets http://www.thehindu.com/business/reserve-bank-of-india-reviews-banks-assets/article7988068.ece Newspaper report, The Economic Times, 14 December 2015,
Banks asks RBI longer time to downgrade the stress loans: Sources http://articles.economictimes.indiatimes.com/2015-12-14/news/69033690_1_provisioning-banks-march-2017
One may note that all of the above illustrative indicators can be corroborated independently in the real world e.g. through review of financial results, movement in stock prices, press new items, etc.
One of the key drivers for the evolution of ECL has been the financial crisis of 2007-08. During the crisis, significant criticism was raised on the incurred loss model as it did not take into account losses that could be expected in a loan portfolio. This model required an event to take place or a circumstance to become evident before impairment could be accounted for. Accordingly, one may argue that recognition of a loan loss provision lagged economic reality.
The ECL model contrarily will estimate losses that are expected over the life of a loan. In comparison with the incurred loss model, the ECL model is expected to result in early losses/provisions and impress more judgement on the part of the management to estimate future losses.
To explain this with a simple example:• Currently, there is stress looming on
the steel industry. Given the sustained decline in steel prices globally, steel plants have excess capacities i.e. they are not functioning at optimum capacities.
• If a bank has initiated a new loan to a borrower engaged in steel production, the extant guidelines (incurred loss model) do not require the bank to recognise any provision in the books, unless there has been any objective indicator/event e.g. the borrower defaulted on servicing interest/principal.
• Though the borrower may not have defaulted, the economic reality remains that the borrower indeed is under stress. Therefore, it may be imprudent on the part of the bank to wait for an event to recognise this stress (by way of a provision) in the books.
The ECL model in that sense is a more forward looking approach as it attempts to align the recognition of loan loss provisions to the underlying merits of the economic environment in which the borrower operates.
Key challenges expected on the anvilInd AS 109, Financial Instruments suggests a two-fold approach for ECL.
The approach is as follows:
i. 12 month expected credit loss, and
ii. Lifetime expected credit loss.
At the time of initial recognition of a loan, a bank would be expected to measure loan impairment by ascertaining the future losses expected to emerge over the next 12 months on that loan. Subsequently, should there be a significant increase in credit risk due to significant deterioration of the credit grade/asset quality of the same loan, then the bank is expected to move to measure loan impairment on a lifetime expected loss basis.
The above approach is expected to require management teams of banks to consider all reasonable and supportable information that is available without undue cost or effort that is relevant for estimation and exercise significant judgement. Since banks will be expected to estimate losses that are expected over the life of a loan, the ECL model requires the bank to bring together data and assumptions from various sources to determine such losses. Some of the examples of such sources are as following:• Risk management and credit
management systems which may not have necessarily been part of traditional accounting/financial reporting systems
• Data from outside the entity such as economic forecasts, loss statistics published by credit bureaus or government agencies. Such data points may or may not have been historically subject to audit procedures
• Unlike the incurred loss model, the ECL model requires an entity to estimate future losses using forward-looking data and assumptions which may not be intrinsic to the entity but rather maybe macroeconomic. The increased use of forward-looking data points is expected to highlight further considerations such as: (i) how many and which scenarios to consider; (ii) probability/weights for
each scenario; (iii) how data points need to be aggregated and linked to credit quality; (iv) where to obtain information; and so on. (The above is not an exhaustive list.)
The Companies Act, 2013 has cast a specific responsibility on those charged with governance and audit committees to certify to stakeholders the operating effectiveness of Internal Financial Controls (IFCs) of a company. This creates another challenge in itself as to how senior management and audit committees shall ring-fence the control environment relative to the above ECL model processes.
ConclusionWith the oncoming of the ECL approach, there may be a more judgemental basis of ascertaining loan impairment for the purposes of financial reporting. In the case of wholesale and restructured loans particularly, the present day impairment assessment may warrant a fundamental change in thought process, approach and tools.
Whilst ECL can certainly unleash pertinent challenges in the process of financial reporting as well as result in elevated volatility in the statement of profit and loss (given that it will entail early recognition of provisions), it is still in its early stages to gauge its pros and cons. In its present form, it does tend to be a more forward looking approach, given that there is a clear expectation to align the measurement of loan impairment with the economics of the market environment in each case (underlying asset).
This principles’ based approach is also expected to help in ironing out the present day anomalies on divergence in classification of stressed assets by banks.
A lot, however, is in the details and how ECL computations will be done in practise. For regulators and other stakeholders, the shift will be significant too and they will have to adjust to a new world of estimates where the process followed by individual banks may be consistent but the outcomes may not be so.
Performance of financial services companies is measured through an analysis of key ratios such as Net Interest Income (NII), Net Interest Margin (NIM), Cost to Income Ratio, Non-Performing Asset (NPA) Ratio, etc.
Whilst the derivation of the aforesaid performance ratios is well understood by the preparers and readers of financial information, the significant accounting policies adopted by an entity and its consequential impact on the components used for the purpose of computation of the aforesaid ratios requires careful consideration.
A few illustrations of aspects that could impact the computation of these key performance ratios have been outlined below:
i. Accounting policy towards recognition of loan origination costs and Direct Selling Agent (DSA) commission: Certain entities upfront recognise the loan origination costs as an operating expenditure, upon incurrence; however, other entities amortise loan origination costs and treat it as an adjustment to the effective interest rate as part of Schedule 13 ‘Interest earned’ under
the Third Schedule to the Banking Regulation Act, 1949 in the financial statements. Both of these accounting practices require deliberation and are acceptable accounting practices based upon their underlying facts. However, the resultant impact upon the Cost to Income Ratio and NII/NIM analysis could potentially be significant. This difference is particularly relevant in the context of comparing performance/NIMs of NBFCs and banks. Certain banks expense such loan origination costs immediately while a number of NBFCs have an accounting policy to amortise them.
Further, even within banks that account for such costs upfront, certain banks account for such costs as part of their operating expenses and certain other banks account for these costs as a deduction from their reported interest income.
ii. Constituents of Schedule 13 ‘Other Interest Income’ under the Third Schedule to the Banking Regulation Act, 1949 may include items such as interest on income tax refunds, which could often be significant
items of non-recurring nature and may translate into significant variance in the period on period NII and NIM and/or comparability amongst peer institutions.
iii. The policy towards recognition of a floating provision and its disclosure either net of advances or as a part under Schedule 5 ‘Other Liabilities’ under the Third Schedule to the Banking Regulation Act, 1949 has an impact on the computation of provision coverage ratio.
iv. The constituents of average interest earning assets i.e. whether it reckons average total loan assets or average performing loan assets impacts the computation of NIM.
TakeawayAs seen above, diverse practices are prevalent relating to presentation/disclosures which could potentially impact comparison of key performance indicators amongst peers. As always, challenges are seen when it comes to detailing and when widely followed ratios are susceptible to definitional risk. Therefore, it is important to understand the assumptions and key components of a ratio before drawing any conclusion.
Deferred tax liability on a special reserve under the Income tax Act, 1961This article aims to:
– Summarise an accounting implementation issue arising from the requirements of the Income tax Act, 1961 on recognition of the deferred tax liability on a special reserve
– Highlight the challenges in accounting of such deferred tax liabilities under the current Indian GAAP and Ind AS.
The accounting treatment of a Deferred Tax Liability (DTL) in respect of a special reserve created and maintained by eligible financial institutions under the Income tax Act, 1961 (IT Act) has been an area where differences of opinions and interpretations have existed for some time in India. In the recent past regulators like the Reserve Bank of India (RBI) and the National Housing Bank (NHB) have mandated banks and Housing Finance Companies (HFC) to create a DTL on the special reserve in line with an opinion from the Expert Advisory Committee (EAC)1. This article examines the accounting position under Indian GAAP and its likely treatment under Ind AS.
Provisions of the IT ActAs per Section 36(1)(viii) of the IT Act, a financial institution is allowed to claim a deduction not exceeding 20 per cent of the profit derived from the business of providing long-term finance for industrial or agricultural development or development of an infrastructure facility in India or by a public company formed and registered in India with the main objective of carrying on business of providing long-term finance for construction/purchase of houses for residential purposes in India. The section also provides that the balance lying in a special reserve account is allowed as a deduction only up to twice the paid-up share capital and general reserve of a financial institution as of first day of the previous year.
Further, Section 41(4A) of the IT Act provides that in case the special reserve is utilised/withdrawn, the same will become taxable in the year in which it is so utilised/withdrawn.
Based on the aforesaid provision, it is evident that the transfer of a certain portion of income to the special reserve is an appropriation of profit from the eligible business. However, the same is done with the primary objective of claiming tax exemption. This gives rise to the difference between accounting income and taxable income. The key point of contention is whether this difference should be described as a timing difference resulting in the creation of a DTL or whether this difference could be determined as permanent in nature and therefore, not requiring the creation of the DTL per se.
AS 22, Accounting for Taxes on IncomeAS 22 defines ‘timing differences’ as differences between the taxable income and accounting income for a period that originates in one period and are capable of reversal in one or more subsequent periods. Thus, various financial institutions have interpreted this to mean that this would refer to the reversal of timing differences which is automatic and independent, similar to depreciation on a fixed asset or provision for doubtful debts. Since, the utilisation/withdrawal of a special reserve is in the control of the company, the same should be described as a timing difference and in fact would be more akin to a permanent difference as the company can postpone its utilisation/withdrawal to an indefinite period.
Opinion of the Expert Advisory CommitteeThe argument for classifying the difference arising out of the creation of a special reserve as a permanent difference was referred to the Expert Advisory Committee (EAC) of the Institute of Chartered Accountants of India (ICAI). The querist also argued that the entity (in the case of a specific query) had healthy profits and sufficient balances lying in ‘other reserves’, and that there would be no need for the entity to utilise/withdraw the special reserve and incur a substantial penalty in the form of tax charge. Accordingly, the difference should be characterised as permanent in nature.
The EAC examined the matter in its two separate opinions finalised on 15 May 2006 and 9 August 20071 and opined in the favour of creation of a DTL on the amounts transferred to a special reserve. The key argument that the EAC placed weight on was that so long as the utilisation/withdrawal was capable of taking place, the creation of a special reserve results in timing differences for which deferred tax should be provided. Eventuality of utilisation/withdrawal of a special reserve or past experience in this regard is not of relevance.
Impact of the EAC opinionBased on the EAC opinion, certain financial institutions started creating a DTL on the special reserve retrospectively, whereas certain other
institutions did not create a DTL on their special reserve balances. This mixed position on the creation of the DTL was supported by many accounting experts on the basis that the deduction on account of creation of the special reserve was one of many tax planning/incentive provisions in the IT Act and as long as there was a demonstrated intent and corresponding ability on the part of the entity to conclude that no reversal/withdrawal of the special reserve was likely to occur, no DTL creation would be required. In effect, the terms ‘capable of reversal’ under AS 22 was interpreted more widely to cover only situations where reversal would happen for certain or happen outside of the express control of the entity and not include situations which were theoretically possible but remote in their likelihood of occurring.
Circulars issued by the regulators prescribing2 accounting treatmentMore complexity was added to this area when the regulators vis-à-vis the RBI and NHB intervened and decided to prescribe the accounting treatment for a DTL on a special reserve. Interestingly, the two regulators have mandated banks and HFCs to create a DTL on the special reserve. However, they have taken a slightly different step for the treatment of the expenditure on creation of a DTL for the first time on the opening special reserve. The RBI issued a circular in December 2013 stating that if the expenditure due to creation of a DTL on the special reserve as on 31 March 2013 has not been fully charged to the statement of profit and loss, banks may adjust the same directly from ‘reserves’.
Whereas NHB issued a circular in August 2014 stating that if the expenditure due to the creation of a DTL on a special reserve as on 31March 2014 has not been fully charged to the statement of profit and loss, HFCs may adjust the same directly from the ‘reserves’ over a period of three years starting with the current financial year, in a phased manner in the ratio of 25:25:50, in case if it prefers so, based on prudence. Thus, in the initial years, there could be potential divergent practices followed by banks and HFCs with respect to accounting and one needs to read the financial statements’ disclosures carefully for meaningful comparison.
1. EAC opinion Volume - XXVI – Query No. 18 - Creation of a deferred tax liability on a special reserve created under Section 36(1)(viii) of the Income-t axAct, 1961 finalised on 15 May 2006. EAC opinion Volume - XXVII – Query 18 - Creation of a deferred tax liability on a special reserve created under Section 36(1)(viii) of the Income tax Act, 1961 finalised on 9 August 2007.
2. NHB circular: NHB(ND)/DRS/Policy Circular 65/2014-15 dated 22 August 2014 and RBI circular: RBI/2013-14/412 DBOD.No.BP.BC.77/21.014.018/2013-14 dated 20 December 2013.
Impact on the audit opinionAdditionally, the suggested accounting treatment by the regulators also has raised yet another debate on the appropriateness of recognising expenditure on creation of a DTL on the opening balance of a special reserve directly to the ‘reserves’, which is not in line with the accounting standards issued by the ICAI. In response to the said departure, the ICAI vide its announcement3, clarified that the statutory auditors need not modify their audit opinion in respect of such a prescribed accounting treatment; however, statutory auditors may bring out this fact in their audit report by way of an ‘emphasis of matter’ paragraph in accordance with the Standard on Auditing 706, Emphasis of Matter Paragraphs and Other Matter Paragraphs in the Independent Auditor’s Report. This serves as guidance for an auditor for appropriately disclosing it in the auditor’s report of the year in which such an adjustment was carried out directly to the ‘reserves’ for both banks and HFCs.
As far as NBFCs and other central public sector enterprises are concerned, some entities continue to not create a DTL on the special reserve, resulting in inconsistency in the accounting treatment within the same industry.
Treatment under Ind AS 12, Income TaxesUnder Ind AS 12, one of the key principles is to recognise deferred tax liabilities and assets for the estimated future tax effects of temporary differences between the financial statements carrying the value of assets and liabilities and their tax bases. Ind AS 12 defines temporary differences as differences between the tax basis of an asset or liability and its reported amount in the financial statements that would result in taxable or deductible amounts in future years, when the amount reported in the financial statements is recovered or settled.
Considering the nature and intent of transferring a certain amount to the special reserve for claiming tax deduction on such transfer and supporting the intent of non-withdrawal or utilisation in future (for example through a board resolution), one could consider this as sufficient evidence to classify such a difference as a permanent difference. Accordingly, no DTL may need to be created in respect of such special reserves under Ind AS 12.
This matter was also considered by the ‘Working Group on Implementation of Ind AS by Banks in India’ formed by the RBI and the group recommended that the ICAI may be requested to provide clarification on the matter of creation of a DTL on a special reserve under Ind AS 12.
While the debate is still on as to whether a DTL on a special reserve needs to be created or not, an entity should exercise judgement in evaluating whether to create a DTL on a special reserve based on the facts and circumstances in each case. As a good practise, an entity should also provide a detailed disclosure of its position and explain the accounting rationale for the approach adopted.
3. The ICAI announcement on Manner of Reporting by the Auditors In Respect of RBI’s Circular on Deferred Tax Liability on a Special Reserve created under Section 36(1) (viii) of the Income Tax Act, 1961 dated 30 April 2014.
Brief overview and applicabilitySection 145 of the Income-tax Act, 1961 (IT Act) provides that income chargeable under the head ‘Profits and gains of business or profession’ or ‘Income from other sources’ shall be computed in accordance with either the cash or mercantile system of accounting regularly adopted by the assessee. It further provides that the central government may notify the Income Computation and Disclosure Standards (ICDS) to be followed by any class of assessees in respect of any class of income.
Earlier, two tax accounting standards viz. (i) disclosure of accounting policies; and (ii) disclosure of the prior period and extraordinary items and changes in accounting policies were prescribed.
Pursuant to Section 145 of the IT Act, 10 ICDS were notified to be applicable from 1 April 2015 (financial year 2015-16 onwards). ICDS supersedes the earlier tax accounting standards and are required to be followed by all asseessees following the mercantile system of accounting for the purposes of computation of income chargeable to tax under the heads ‘Profit and gains of business or profession’ and ‘Income from other sources’.
ICDS are not applicable for the purposes of maintenance of books of account.
While the objective of ICDS is to reduce alternatives as well as litigation and provide certainty, in its current form it has given birth to a host of tax issues including interplay between ICDS and the settled judicial precedents.
Jurisprudence vs ICDSThe preamble to each ICDS provides that in case of conflict between the provision of the IT Act and ICDS, the provisions of the IT Act shall prevail. In this context, a point to ponder is what shall be the bearing of judicial precedents on ICDS.
Article 141 of the Constitution of India embodies the doctrine of precedence of law. Article 141 provides that the law declared by the Supreme Court (SC) of India shall be binding on all courts in India. The decisions of the courts, specifically the SC, interpret the law as framed by the parliament.
In the scheme of provisions of the IT Act, income is determined or recognised as per the provisions of Section 4, 5, Chapter IV as well as the definition of income. The recording and method to be adopted in the books of accounts is provided under Section 145 which is a procedural provision.
In view of the above discussion, it can be argued that all such decisions dealing with identification, recognition, determination of the nature of receipts, etc. should continue to govern the computation of taxable income. However, as ICDS are applied in respect of quantification of income, it may impact certain decisions which relied on commercial and accounting principles. This understanding finds support from the views expressed by the SC in case of CIT vs Woodward Governor India Private Ltd1 wherein it was mentioned that with legislative sanction, the principle of commercial accounting can be modified pursuant to notification under Section 145(2) of the IT Act.
ICDS I - Accounting policies• This ICDS requires that fundamental
accounting assumptions of going concern, consistency and accrual should be followed. At the same time, it does not recognise the concept of prudence. As a result, it does not allow recognition of Mark-To-Market (MTM) losses, unless such a loss is in accordance with any other ICDS. However, ICDS I is silent on the treatment in respect of MTM gains. Taking into consideration the matching concept, if MTM loss is not required to be recognised, then MTM gain should also be ignored for tax purposes. However, given that it is not explicitly mentioned to ignore MTM gains, the tax authorities may adopt a different stand.
• Further, ICDS I restricts the change of accounting policy unless there is a reasonable cause. The term ‘reasonable cause’ in context of change in accounting policy is not defined. This may lead to difference in opinions between the taxpayers and tax authorities and invite litigation.
ICDS IV - Revenue recognition• ICDS on revenue recognition requires
revenue from service transactions to be recognised on basis of the Percentage of Completion (POC) method. Revenue from service transactions should be matched with the costs incurred in reaching the stage of completion, resulting in determination of revenue, expenses and profit which can be attributed to the proportion of work completed as against the completed contract method whereby revenue is recognised upon completion.
• It also provides that in case of revenue from service transactions, the requirements of ICDS on construction contracts shall mutatis mutandis apply to recognition of revenue and its associated expenses for a service transaction.
• As per the ICDS on construction contracts, revenue shall be recognised when there is reasonable certainty of its ultimate collection. The term ‘reasonable certainty’ has not been defined. This again may lead to interpretational issues.
• The POC method may be typically relevant in those sectors where there is correlation between the work done and the revenue, such as in case of construction activities. However, in case of the financial services industry, the POC method may not be best suited. To elaborate, certain resources of banks, NBFCs and investment bankers simultaneously work on multiple projects. Allocating costs of these resources on each project would be a mammoth administrative task. Further, fees for many types of services are milestone/success based. Computing of such income on POC basis may be an onerous exercise in itself and might increase the administrative burden for these entities, resulting in unmanageable reconciliation of revenue as per books vis-à-vis revenue for the purposes of tax on a year on year basis.
1. CIT vs Woodward Governor India Private Ltd (2009 (312 ITR 254) SC)
• ICDS on revenue recognition requires interest income to be recognised on a time basis, determined by the amount outstanding and the applicable rate. While Section 43D of the IT Act permits banks to offer interest (in case of bad loans) on a receipt basis, there is no such benefit available to NBFCs. While there are divergent judicial precedents on this issue, many NBFCs offer interest on sticky loans on receipt basis. ICDS requiring to recognise revenue on sticky loans on an accrual basis may add a new dimension to this issue.
ICDS VI - Effects of changes in foreign exchange rates• The ICDS defines the term ‘forward
exchange contract’ to include a foreign currency option contract or another financial instrument of a similar nature. Given this, it is not very clear as to whether currency swaps are included in the said definition.
• Premium/discount and exchange differences on forward contracts (including foreign currency options) entered into for trading, speculation and hedging of firm commitment or a highly probable forecast transaction are to be recognised on settlement.
• Exchange differences on forward contracts other than the aforesaid, would be allowed at the year end and the premium or discount is to be amortised over the life of the contract.
• In the case of this sector, especially banks, MTM losses on forward contracts are recognised at the year-end based on RBI guidelines and accounting principles. Further, for tax purposes, this position has been accepted as the basis for settled judicial precedents.
• Typically, forward contracts are treated as trading in nature for banks, except those entered into for hedging of on-balance sheet items. ICDS does not allow recognition of MTM losses/gains on forward contracts entering into for trading purposes. This would result in significant differences between the accounting profit and taxable income of banks. Additionally, this might require banks to maintain separate records for tax purposes which is actually against the spirit of ICDS. Given the volume of the transactions, maintaining separate records could involve substantial time
as well as cost. Spending resources on items of timing differences may not be worthwhile.
• Financial items of integral foreign operations are required to be translated using the same principles and procedures as if the transactions of foreign operations had been those of the person himself/herself, whereas assets and liabilities, both monetary and non-monetary of the non-integral foreign operations shall be recognised at the closing rate.
• AS 11 provides that exchange differences arising on translation of financial statements of non-integral foreign operations should be accumulated in the foreign currency translation reserve in the balance sheet and the cumulative difference should be brought to the statement of profit and loss, on disposal of the non-integral foreign operations (since that is the time the exchange difference is actually realised).
• In this regard, the transitional provisions are not clear as to whether the opening balance of the foreign currency translation reserve as on 1 April 2015 is taxable. On account of the depreciating rupee, offering an unrealised amount to tax may involve substantial tax outgo.
ICDS VIII - Securities• ICDS prescribes the guidelines
for valuation of securities held as stock-in-trade. The said ICDS are not applicable to banks.
• ICDS on inventories excludes shares, debentures and other financial instruments held as stock-in-trade dealt with ICDS on securities. Given that ICDS on securities is not applicable to banks, a question arises whether the securities held by banks are governed by ICDS on inventories or ICDS I. If such securities are governed by ICDS I, banks may not be applicable to claim depreciation on securities since the standard does not permit recognition of MTM losses. If ICDS on inventories is applicable to banks, it may add complications given that such ICDS require recognition at the net realisable value.
• Separately, no specific carve out is prescribed for NBFCs from the applicability of ICDS on securities. Accordingly, NBFCs would be required to value securities in
four categories – shares, debt securities, convertible securities and other securities. Given that these categories are different than the categories prescribed by the RBI, separate records and reconciliations are required to be maintained for tax purposes.
• Further, the said ICDS also provide that in case of unlisted securities or securities listed but not quoted on a recognised stock exchange with regularity, shall be valued at the actual cost initially recognised. Accordingly, investment in government securities such as G-secs, treasury bills, preference shares, etc. which are not listed would be required to be valued at cost and any depreciation on such securities would not be allowed for tax purposes. This may be a significant area of concern for primary dealers.
ICDS IX – Borrowing costs• ICDS on borrowing costs provides
for the manner of computation of borrowing costs for capitalisation of qualifying assets. ICDS requires to capitalise the general purpose borrowing cost on the basis of a formula. Given the banking business (wherein borrowing is a routine activity) and the fact that funds are fungible, capitalising borrowing costs as per ICDS may emerge as a major area of litigation.
ICDS X - Provisions, contingent liabilities and contingent assets• This ICDS does not apply to insurance
business from contract with policyholders.
• ICDS requires recognition of a provision when it is reasonably certain that an outflow of resources embodying economic benefits will be required to settle the obligation whereas accounting norms require such recognition when it is probable that an outflow of resources is required.
• Further, ICDS requires assessment of contingent assets continually and when it is reasonably certain that inflow of economic benefits will arise, the asset and its related income should be recognised whereas accounting norms require such recognition when the inflow of economic benefits is virtually certain.
• Accordingly, the criteria for recognition of a provision changes from ‘probable’ to ‘reasonable certain’ whereas criteria for recognition of an asset changes from ‘virtually certain’ to ‘reasonable certain’.
• This difference in method for recognising a provision/asset as per the accounting standard vis-à-vis ICDS may require the taxpayer to maintain multiple sets of records. Further, it may be another area of litigation in the absence of the definition of the term ‘reasonably certain’.
Way forwardWhile the stated objective of ICDS is to reduce alternatives as well as litigation and provide certainty, its overall theme seems to be preponing taxation of income and postponing the deductibility of expenses and thereby advancing payments of taxes. In essence, a lot of the issues dealt by the ICDS are nothing but timing differences.
In its current form, ICDS is extremely arduous and shall create an unwarranted administrative burden such as maintenance of separate records for tax purposes.
At a time when the Indian economy is accelerating, minimical changes such as ICDS may not be warranted. While the industry is grappling with new sets of regulations such as GST, Ind AS and the Companies Act, 2013, the introduction of ICDS may prove to be a deterrent towards the agenda of the ease of doing business.
While a number of representations have been made by different stakeholders, there was an expectation that the Finance Minister in his Budget speech for the year 2016-17 may suggest that further work is ongoing in the case of ICDS and that its applicability might be deferred for a year (if not more). However, there was no such announcement in the Union Budget. Despite this, taxpayers are still hopeful of the Central Board of Direct Taxes (CBDT) would be clarifying certain crucial aspects by way of a circular.
It is imperative that the government clarifies various issues to provide certainty and transparency in respect of tax matters, after taking into consideration the views of the stakeholders.
India Inc. is looking forward to one of its biggest tax reforms i.e. the introduction of the Goods and Services Tax (GST). The Finance Minister in the Union Budget 2016 reinforced the commitment of the government towards passing of GST. The government is taking all possible efforts to get the GST Bill passed in the Rajya Sabha. Considering the steps taken, such as releasing the draft business processes, ongoing work for setting-up a GST Network (GSTN), determination of the revenue neutral rate, etc. there is growing anticipation across the country with respect to implementation of GST.
Global perspective
In a lot of developed countries, significant components of the financial services sector are outside the purview of GST. For example: GST is not leviable on credit card fees and penal charges in countries such as Australia, Singapore and the U.K. However, in India, several banking and financial services are exposed to the levy of service tax, except interest income. Accordingly, to bring India in line with other countries, representations are being made for granting an exemption to the financial services sector under GST.
The Select Committee of the Rajya Sabha, in its report on GST1, has also made the following recommendations on the financial services sector:• Banking services may be kept outside
GST purview• Alternatively, interest, trading in
securities and foreign exchange and services to retail customers should not be subject to GST
• The GST rate applicable should be internationally competitive.
However, looking at the present scenario, we may have to wait and see, if any or all of the recommendations are accepted.
The introduction of GST is expected to simplify the current tax regime. However, it might also bring with it, its own set of challenges which need to be addressed. Some of the major challenges for the financial services sector are discussed below.
Increase in tax rateThe financial services sector is currently subject to service tax at 14.5 per cent. Further, the Union Budget 2016 has proposed the levy of an additional 0.5 per cent tax, named as the Krishi Kalyan cess with effect from 1 June 20162.
However, under GST, considering the recommendations of the committee headed by the Chief Economic Advisor, the rate could be between 18 to 20 per cent3 which can increase the cost of these services. It is, however, expected that due to the liberal credit regime under GST, the overall tax cost could reduce.
Availability of CENVAT creditAt present, banking and financial institutions are required to mandatorily reverse CENVAT credit equal to 50 per cent of the CENVAT credit availed. The Union Budget 2016 provided an option of proportionate reversal of CENVAT credit to the financial services sector4.
Further, at present, there is a restriction based on the type of input services for availing CENVAT credit. In addition, Central Sales Tax (CST) and Value Added Tax (VAT) are also costs to be taken into account. In fact, banks are ineligible to obtain even Form C for their interstate procurements. Also, banks procure majority of the goods that they use from traders, wherein excise duty is built into the cost. Under GST, complete credit should be available for the taxes paid on all procurements. Thus, availability of cross credits under GST is expected to be a major relief for the sector, reducing its overall cost. However, for availing the said benefit, entities may need to modify their systems and accounting softwares to identify such credits.
It should be noted that the Select Committee of the Rajya Sabha has recommended to allow full credits even for activities which are not taxable under the financial services sector.
Situs of transactions and place of supplyGST will shift the situs of transactions from the origin based system to a destination based one. Thus, determination of the place of supply for different transactions can be crucial for determining the taxation of a transaction.
The financial services sector is expected to be faced with challenges in determining the situs and place of supply of numerous transactions, ranging from investment banking, broking, multi-city banking, lending for pan India businesses, credit cards, online banking, etc.
Additional compliances/burdenThe present service tax law provides a facility of centralised registration to service providers which considerably reduces their compliance complexity since banks and financial institutions have operations across India.
However, looking at the draft GST framework, it is clear that state-wise compliance shall be required and therefore, lead to additional costs and complications.
It may be noted that the Select Committee of the Rajya Sabha, has recommended to permit single registration coupled with the Integrated GST (IGST) provision for the financial services sector.
In addition to above, the concept of an Input Service Distributor (ISD) needs to be retained under GST so as to enable maximum availability of CENVAT credit and avoid a situation of blockage of credit in one state and cash payment in another.
Addressing the present challengesThe financial services sector, at present, has many open issues such as a dual levy of service tax and VAT on leasing transactions, taxation of repossessed assets, taxation of damages, etc. Thus, it is important to address these present issues for a smooth transition to GST.
Taxation of services rendered in the state of Jammu and KashmirAt present, there is no service tax on services rendered in the state of Jammu and Kashmir; though, certain services are taxed under the Jammu and Kashmir General Sales Tax Act, 1962. Under GST, it is expected that the law will be applicable PAN India, including Jammu and Kashmir and that no separate legislation shall continue.
1. Report of the Select Committee on The Constitution (One hundred & twenty-second amendment) Bill, 2014 presented to the Rajya Sabha on 22 July 2015
2. Chapter VI/Clause 158 of the Finance Bill, 2016
3. Report on the Revenue Neutral Rate and Structure of Rates for the Goods and Services Tax dated 4 December 2015
4. Notification No 13/2016 - Central Excise - (N.T) dated 1 March 2016 announced in Union Budget 2016-17
41
Transition related issues from the current regime to GSTIn order to ensure smooth transition to GST, it is important that the government issues provisions for bringing about ease in the transition phase. Key issues which may arise during the transition period are taxation of existing loans, deposits or advances post introduction of GST, taxation of advance payments covering the pre and post GST period, treatment of unutilised closing credits, etc.
To address the above challenges, there exists a need for a transition period wherein the financial services sector carries out necessary changes in the systems, transactions and processes for smooth transition to GST and that the policymakers consider the current issues and challenges that may be faced while framing the GST law.
Regulatory updatesCompanies (Filing of documents and forms in Extensible Business Reporting Language (XBRL)) Amendment Rules, 2016Background
The XBRL Rules 2015 prescribe the class of companies which are required to file their financial statements and other documents under Section 137 of the Companies Act, 2013, (2013 Act) with the Registrar of Companies in e-form AOC-4 XBRL. The Rules prescribe the manner in which such financial statements are filed.
New development
The Ministry of Corporate Affairs (MCA) through its notification dated 4 April 2016 issued the Companies (Filing of documents and forms in XBRL) Amendment Rules, 2016. The amended rules aim to amend the Companies (Filing of documents and forms in XBRL) Rules, 2015. The amended rules provide that companies in the banking, insurance, power sector, Non-Banking Financial Companies (NBFCs) and housing finance companies need not file financial statements under these Rules.
The amendment is in force since the date of its publication in the Official Gazette i.e. 5 April 2016.(Source: MCA notification Companies (Filing of Documents and Forms in Extensible Business Reporting Language) Amendment Rules, 2016 dated 4 April 2016)
Modifications to IRDA (Preparation of financial statements and auditors’ report of insurance companies) Regulations, 2002The Insurance Regulatory and Development Authority of India (IRDA) through its circular dated 4 April 2016 modified IRDA (Preparation of financial statements and auditors’ report of insurance companies) Regulations, 2002. The IRDA issued these modifications consequent to amendments in Section 10 and 11 of the Insurance Laws Act.
Key modifications prescribed in the IRDA (Preparation of financial statements and auditors report of insurance companies) Regulations, 2002 are as following:• Separate funds for policyholders
and shareholders for insurers carrying on general insurance, health and reinsurance business.
• Insurers are required to file a certificate from one of the statutory auditors to this effect within the prescribed time.
• Insurers should ensure that policyholders’ fund are fully supported by the policyholders’ investments.
• Prescribed the procedure for accounting of the branch office of a foreign insurer which is permitted to operate in India.
The circular is applicable from 1 April 2016, however, the circular prescribes various timelines to achieve the above modifications.(Source: IRDA/F&A/CIR/CPM/056/03/2016 dated 4 April 2016 issued by IRDA)
FEMA regulationsThe Reserve Bank of India (RBI) through its notification issued following regulations under the Foreign Exchange Management Act, 1999 (FEMA).
• Foreign Exchange Management (Transfer or issue of security by a person resident outside India) (Fifth Amendment) Regulations, 2016: The RBI through its notification dated 30 March 2016 issued the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) (Fifth Amendment) Regulations, 2016 which, inter-alia, has increased the limit of Foreign Direct Investment (FDI) in the insurance sector from 26 per cent to 49 per cent.
• Foreign Exchange Management (Establishment in India of a branch office or a liaison office or a project office or any other place of business) Regulations, 2016: The RBI through its notification FEMA 22(R)/RB-2016 dated 1 April 2016 issued the Foreign Exchange Management (Establishment in India of a branch office or a liaison office or a project office or any other place of business) Regulations, 2016. These regulations are issued to prohibit, restrict and regulate establishment in India of a branch office or a liaison office or a project office or any other place of business by a person resident outside India. These regulations are applicable from 31 March 2016.
• Foreign Exchange Management (Deposit) Regulations, 2016: The RBI through its notification FEMA 5(R)/2016-RB dated 1 April 2016 issued the Foreign Exchange Management (Deposit) Regulations, 2016 under the FEMA Act, 1999. These regulations provide guidance relating to deposits between a person resident in India and a person resident outside India. These regulations are effective from 1 April 2016.
Further, RBI through its circular RBI/2015-16/371 A.P. (DIR Series) Circular No.59 dated 13 April 2016 issued a clarification under Regulation 3 of the Foreign Exchange Management (Deposit) Regulations, 2016 in the case ‘acceptance of deposits by Indian companies from a person resident outside India for nomination as a director’. The RBI
clarified that keeping deposits with an Indian company by persons resident outside India, in accordance with Section 160 of the 2013 Act, is a current account (payment) transaction and, as such, does not require any approval from the RBI. All refunds of such deposits, arising in the event of selection of the person as a director or getting more than 25 per cent votes, shall be treated similarly.
• Foreign Exchange Management (Remittance of Assets) Regulations, 2016: The RBI issued notification on FEMA 13 (R)/2016-RB on 1 April 2016. These regulations provide guidance in respect of remittance outside India by a person whether resident in India or not, of assets in India. These regulations are effective from 1 April 2016.
(Source: RBI notification dated 31 March 2016, 1 April 2016 and 13 April 2016)
Companies (Share Capital and Debentures) Second Amendment Rules, 2016The Companies (Share Capital and Debentures) Rules, 2014 relating to buy-back of shares and securities by private companies and unlisted public companies provide that the audited accounts on the basis of which calculation with reference to buy-back is done should not be more than six months old from the date of the offer document.
On 10 March 2016, MCA issued the Companies (Share Capital and Debentures) Amendment Rules, 2016 to amend the regulations. The amended regulations provide a clarification that where the audited accounts are more than six months old, the calculations with reference to buy-back should be on the basis of unaudited accounts not older than six months from the date of the offer document which are subjected to limited review by the auditors of the company.
Further on 29 March 2016, MCA issued the Companies (Share Capital and Debentures) Second Amendment Rules, 2016. The recent amendment provides that where all members of a company agree, the offer for buy-back may remain open for a period of less than 15 days.(Source: MCA notification dated 10 March 2016 and 29 March 2016)
Guidance Note on insider tradingThe Securities and Exchange Board of India (SEBI) on 24 August 2015, issued a guidance note to remove difficulties in the interpretation or application of Securities Exchange Board of India (SEBI) (Prohibition of Insider Trading) Regulations, 2015 (PIT Regulations). The guidance note, inter-alia, clarifies that exercise of Employee Stock Options (ESOPs) is not considered as ‘trading’ for the purpose of the above Regulations, except for provisions relating to disclosures.
Subsequently, the SEBI Issue of Capital and Disclosure Requirements (ICDR) Regulations, 2009 were amended with effect from 17 February 2016 to provide for an exit opportunity to dissenting shareholders in terms of Sections 13 and 27 of the 2013 Act.
Consequently, the Guidance Note on SEBI PIT Regulations, 2015 has been amended with effect from 17 February 2016 to clarify that the exit offer is also exempted from the restriction on contra trade under the PIT Regulations.(Source: Guidance Note on SEBI (Prohibition of Insider Trading) Regulations, 2015 dated 12 April 2016)
Ind AS updatesBackground
Post the Finance Minister’s announcement in his Union Budget speech in July 2014 with respect to convergence with the International Financial Reporting Standards (IFRS), regulators in India have in the past two years announced specific Ind AS implementation road maps across all sectors in India. The MCA, through its notification dated 16 February 2015, issued 39 Indian Accounting Standards (Ind AS) which have been converged with IFRS.
New development
With the implementation of Ind AS approaching, MCA has issued various notification to facilitate implementation of Ind AS in India. The below section summaries the notifications issued by MCA.
A. Notification on revenue standards: Ind AS 11 and Ind AS 18
Amongst those notified by MCA is Ind AS 115, Revenue from Contracts with Customers, which is based on IFRS 15, Revenue from Contracts with Customers. IFRS 15 was issued in May 2014 as a result of a joint project of the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB). Post the issue of IFRS 15, IASB received many representations for the deferral of IFRS 15 and accordingly, on 22 July 2015, the IASB confirmed a one year deferral of the effective date of IFRS 15 to 2018.
The initial plan of the regulators in India such as MCA and the Institute of Chartered Accountants of India (ICAI) was to implement the new revenue standard ahead of its global roll-out. However, post the deferral of IFRS 15 to 2018, the ICAI in October 2015 proposed a deferral of Ind AS 115. This has been confirmed by MCA through its notification issued on 30 March 2016. Consequently, MCA has issued the following Ind AS:
• Ind AS 11, Constructions Contracts along with the appendices corresponding to IFRIC 12, Service Concession Arrangements, SIC- 29, Service Concession Arrangements: Disclosures (collectively called ‘Ind AS on construction contract’)
• Ind AS 18, Revenue, along with the appendices corresponding to IFRIC 13, Customer Loyalty Programmes, IFRIC 18, Transfers of Assets from Customers, SIC-31, Revenue- Barter Transactions Involving Advertising Services (collectively called ‘Ind AS on revenue’) and
• Consequential amendments.
IFRS guidance (IFRIC 15) relating to revenue recognition from sale of real estate will not be applicable under Ind AS. A guidance note on accounting of real estate transactions is expected to be issued by the ICAI.
Some key impact areas are as follows:• Under Ind AS 18, revenue would
be measured at the fair value of the consideration received or receivable, taking into account any trade or volume discounts or cash rebate.
• Revenue would include excise duty. • If a transaction includes a financing
element, then revenue is measured by discounting all future cash receipts at an imputed rate of interest.
• When an arrangement includes more than one component, it is necessary to account for the revenue attributable to each component separately (including customer loyalty programmes).
• Additionally, the standard also requires linking of transactions when individual transactions have no commercial meaning in isolation, and occurrence of one is dependent on the occurrence of another. In such cases, the transactions would be evaluated on a combined basis.
• The standard provides guidance for barter transactions, transfers of assets from customers, and service concession arrangements.
• Revenue from service contracts would be recognised with reference to the stage of completion method. The completed contract method would not be allowed.
B. Road map for Ind AS implementation by NBFCs and provides clarifications on the same for banks and insurance companies
On 29 September 2015, RBI recommended a road map to MCA for implementation of Ind AS from FY 2018-19 onwards for banks and NBFCs. The RBI then issued a circular on 11 February 2016 confirming the Ind AS implementation date for scheduled commercial banks.
Recently, on 30 March 2016, MCA notified the Companies (Indian Accounting Standards) (Amendment) Rules, 2016, which includes a road map for implementation of Ind AS by NBFCs.
NBFCs will be required to comply with Ind AS in a phased manner, from accounting periods beginning on or after 1 April 2018 for the first phase and 1 April 2019 for the second phase. This circular confirms the timeline for Ind AS implementation by NBFCs that was specified by MCA in its press release dated 18 January 2016.
C. Amendments to existing Ind ASsThe MCA through its notification dated 30 March 2016 issued certain revisions to some of the existing Ind AS(s). These amendments shall come into force from the date of their publication in the Official Gazette i.e. 30 March 2016.
The following Ind AS(s) have been revised, based on the improvements incorporated in IFRS applicable for
accounting periods on or after 1 January 2016.• Ind AS 105, Non-current Assets Held
for Sale and Discontinued Operations• Ind AS 107, Financial Instruments:
Disclosures• Ind AS 110, Consolidated Financial
Statements• Ind AS 112, Disclosure of Interests in
Other Entities• Ind AS 1, Presentation of Financial
Statements• Ind AS 2, Inventories• Ind AS 19, Employee Benefits• Ind AS 28, Investments in Associates
and Joint Ventures• Ind AS 34, Interim Financial Reporting.
For a detailed overview of these amendments, please refer to KPMG in India’s IFRS Notes dated 1 April 2016.(Source: MCA notification dated 30 March 2016 and KPMG IFRS Notes dated 1 April 2016)
Applicability of Ind AS in offer documentsThe SEBI ICDR Regulations, 2009 require issuer companies to disclose financial information for each of the five financial years immediately preceding the filing of their offer document, while following uniform accounting policies for each of the financial years. Therefore, there was uncertainty with respect to the accounting framework to be applied by companies that are transitioning to reporting under Ind AS. This circular seeks to provide clarity on the same.
On 31 March 2016, SEBI issued a circular (reference no. SEBI/HO/CFD/DIL/CIR/P/2016/47) clarifying the applicability of Ind AS to the financial information disclosed by issuer companies in their offer document.
This circular specifies the accounting framework to be applied while disclosing financial information for each of the five financial years immediately preceding the filing of the offer document, based on the period in which it is filed.
This circular is applicable to companies that are covered in either of the phases of the corporate road map for Ind AS implementation, and file their offer document with SEBI on or after 1 April 2016.
SEBI has also permitted companies to voluntarily present financial information for all five financial years preceding the filing, in accordance with the Ind AS framework. All the financial information disclosed in the offer document for any particular year should be in accordance with consistent accounting policies (either Ind AS or Indian GAAP).
All other requirements for disclosure of financial information in the offer document, including the audit requirements shall remain the same.
Disclosure of interim financial information
Disclosures of the interim period in the offer document, if any, shall be made in line with the accounting policies followed in the latest financial year.
Additional disclosures
Once an issuer company transitions to reporting under Ind AS, it is required to clearly disclose the fact that the financial information disclosed is in accordance with Ind AS, while suitably explaining the difference between Ind AS and the previously applicable accounting standards along with its impact on transition. SEBI has prescribed the requirements in compliance with the requirements of Ind AS 101 for this purpose.
For a detailed overview of these amendments, please refer to KPMG in India’s IFRS Notes dated 1 April 2016.(Source: SEBI circular dated 31 March 2016 and KPMG IFRS Notes dated 11 April 2016)
Schedule III for financial statements as per Ind ASBackground
The Schedule III to the 2013 Act provides general instructions for preparation of the balance sheet and the statement of profit and loss of a company.
The MCA issued a road map for implementation of the Ind AS converged with the IFRS:• On 16 February 2015 by companies
other than insurance companies, banking companies and Non-Banking Financial Companies (NBFCs) (corporate road map) in a phased manner commencing from accounting periods beginning on or after 1 April 2016
• On 30 March 2016 by banking companies, insurance companies and NBFCs in a phased manner commencing from accounting periods beginning on or after 1 April 2018
New development
The MCA on 6 April 2016, amended Schedule III to include general instructions for preparation of financial statements of a company whose financial statements are required to comply with Ind AS. The amendment divides Schedule III into two parts i.e. Division I and II.• Division I is applicable to a company
whose financial statements are required to comply with the current accounting standards
• Division II is applicable to a company whose financial statements are drawn up in compliance with Ind AS
Overview of the revised Schedule III – Division II
Division II of the Schedule III provides instructions for preparation of financial statements and additional disclosure requirements for companies required to comply with Ind AS. The following is an overview of the Division II of the Schedule III:
Applicability
• It is applicable to every company to which Ind AS apply in preparation of its financial statements.
• The provisions of Schedule III also apply when a company is required to prepare consolidated financial statements, in addition to the disclosure requirements specified under Ind AS.
Balance sheet
• Schedule III provides a format of the balance sheet and sets out the minimum requirements of disclosure on the face of the balance sheet.
• Items presented in the balance sheet are to be classified as current and non-current.
• Schedule III does not permit companies to avail of the option of presenting assets and liabilities in the order of liquidity, as provided by Ind AS 1, Presentation of Financial Statements.
Statement of profit and loss
• Schedule III provides a format of the statement of profit and loss and sets out the minimum requirements of disclosure on the face of the statement of profit and loss.
• The statement of profit and loss is to be presented in accordance with the nature of expenses and would include profit or loss for the period and other comprehensive income for the period.
Statement of changes in equity
• This is a new component for preparers of financial statements that have historically prepared financial statements under Indian GAAP.
• The Statement of changes in equity would reconcile opening to closing amounts for each component of equity including reserves and surplus and items of other comprehensive income.
• The format also includes disclosure of the equity component of compound financial instruments in ‘other equity’, which is in accordance with Ind AS 32, Financial Instruments: Presentation.
Statement of cash flows
• The Statement of cash flows would be presented when required in accordance with Ind AS 7, Statement of Cash Flows.
Notes
• Notes containing information in addition to that which is presented in the financial statements would be provided, including, where required, narrative descriptions or disaggregation of items recognised in the financial statements and information about items that do not qualify for such recognition.
Compliance with Ind AS and 2013 Act
• In situations where compliance with the requirements of the 2013 Act including Ind AS requires any change in treatment or disclosure (including addition, amendment, substitution or deletion in the head/sub-head or any changes in the financial statements or statements forming part thereof) in the formats given in Schedule III, then Schedule III permits such changes to be made and the requirements of Schedule III would stand modified accordingly.
• It further mentions that disclosure requirements specified in Schedule III would be in addition to and not in substitution of the disclosure requirements specified in Ind AS. Companies would be required to make additional disclosures specified in Ind AS either in the notes or by way of additional statement(s) unless required to be disclosed on the face of financial statements. Similarly, all other disclosures as required by the 2013 Act should be made in the notes in addition to the requirements of Schedule III.
Materiality
• It requires financial statements to disclose all ‘material’ items, i.e., the items if they could, individually or collectively, influence the economic decisions that users make on the basis of financial statements. Materiality depends on the size and nature of the item judged in particular circumstances. The definition of what is material is similar to that given in Ind AS 8, Accounting Policies, Changes in Accounting Estimates and Errors. However, while preparing the statement of profit and loss, it specifies that a company should disclose a note for any item of income or expenditure which exceeds 1 per
cent of the revenue from operations or INR10,00,000, whichever is higher, in addition to the consideration of materiality.
Other key points
• It does not permit disclosure of extraordinary items (in line with Ind AS). However, the format for the statement of profit and loss does provide for separate disclosure of exceptional items, if any.
• It requires a separate disclosure of the Earning Per Share (EPS) for continuing and discontinued operations.
(Source: MCA notification dated 6 April 2016 and KPMG IFRS Notes dated 18 April 2016)
Companies (Accounting Standards) Rules, 2016The MCA is in the process of revising the existing Accounting Standards (AS(s)), as it intends to upgrade the AS(s) as notified under the Companies (Accounting Standards) Rules, 2006 and seek alignment with the Indian Accounting Standards. Accordingly, the MCA on 30 March 2016 issued the Companies (Accounting Standards) Rules, 2016 to upgrade the following standards:
The ICAI vide its announcement dated 26 April 2016, clarified that the amended Accounting Standards should be followed for accounting periods commencing on or after the date of publication of the notification in the Official Gazette.(Source: MCA notification dated 30 March 2016)
Name of the AS Key revision
AS 2, Valuation of Inventories • Aligned spare parts accounting with revised AS 10, Property, Plant and Equipment
AS 4, Contingencies and Events Occurring After the Balance Sheet Date
• Dividend declared after the balance sheet would be a non-adjusting item
AS 6, Depreciation Accounting • Replaced by AS 10
AS 10, Property, Plant and Equipment • The standard is in line with Ind AS 16, Property, Plant and Equipment• Component accounting is mandatory (as required under Schedule II to the
2013 Act)
• Clarity on spare parts accounting
• Decommissioning liability on a discounted basis
AS 13, Accounting for Investments • Accounting for investment property would be in accordance with the cost model as prescribed in the revised AS 10
AS 14, Accounting for Amalgamations • Limited revision to include a reference to the 2013 Act
AS 21, Consolidated Financial Statements • A company which does not have an investment in a subsidiary but has investments in the associates and joint ventures would be required to prepare consolidated financial statements
AS 29, Provisions, Contingent Liabilities and Contingent Asset
• Decommissioning the liability provision would be discounted to its present value.
Section 143(11) of the 2013 Act requires that the auditor’s report for a specified class of companies should include a statement on the prescribed matters. These reporting requirements have been prescribed under the Companies (Auditor’s Report) Order, 2015 (CARO 2015) issued by MCA on 10 April 2015. Further on 9 February 2016, with an aim to revise the CARO, MCA issued the draft Companies (Auditor’s Report) Order, 2016 (CARO 2016).
New development
Based on the recommendations and suggestions received from the committee set-up for this purpose as well as the stakeholders, MCA on 30 March 2016 issued CARO 2016. The MCA has relaxed the scope/application of CARO on private companies, by increasing the applicability thresholds. Thus, it would be applicable to fewer private companies. Further, CARO 2016 would not be applicable to the auditor’s report on the consolidated financial statements.
CARO 2016 enhances the reporting requirements and thereby, would
increase the reporting responsibility of the auditors relating to the following important clauses:• Utilisation of loans/initial public
offer/further public offer term loans (including, debt instruments)
• Compliance with Section 42 of the 2013 Act (offer or invitation for subscription of securities on private placement)
• Report in relation to default in payment of loans and borrowings to the government. It also requires to provide lender-wise details in case of default of payment of dues to banks, financial institutions and the government.
• Additional requirement to report in case of loans granted to Limited Liability Partnerships (LLPs) covered under Section 189 of the 2013 Act (i.e. section on register of contracts or arrangements in which directors are interested).
• Report whether the terms and conditions are prejudicial to the company’s interest and limit of overdue for more than 90 days instead of reporting of overdue of more than the threshold of INR1 lakh
• Related party transactions (all transactions) under Section 188 and 177 of the 2013 Act
• Loans, investments and guarantees comply with Section 185 and 186 of the 2013 Act
• Nature and amount of frauds by officers and employees
• Non-cash transactions with directors or persons connected with him/her under Section 192 of the 2013 Act
• Managerial remuneration has been paid/provided for in accordance with the requisite approvals mandated by the provisions of Section 197 read with Schedule V to the 2013 Act
• Requirement to report in relation to registration of NBFCs
• Whether the Nidhi company has complied with the net owned fund in the ratio of 1:20 to meet the liability and whether it is maintaining 10 per cent liquid assets to meet out the unencumbered liability.
Obligations removed: The MCA has excused the auditor from an obligation to report on timely transfer of amounts to the IEPF, whereas Rule 11(c) of the Companies (Audit and Auditors) Rules, 2014 requires reporting of delays by auditors. Additionally, an auditor is not required to report under CARO with respect to third party frauds in relation to the company.(Source: MCA order dated 30 March 2016)
KPMG in India’s IFRS institute KPMG in India is pleased to re-launch its IFRS institute - a web-based platform, which seeks to act as a wide-ranging site for information and updates on IFRS implementation in India.The website provides information and resources to help board and audit committee members, executives, management, stakeholders and government representatives gain insight and access to thought leadership publications that are based on the evolving global financial reporting framework.
The proposed Companies (Amendment) Bill 2016
31 March 2016
Based on the recommendations of the CLC report, on 16 March 2016, the government proposed the Companies (Amendment) Bill 2016, (the Bill) on issues arising on account of implementation of the Companies Act, 2013 (2013
Act) in the Lok Sabha to amend the 2013 Act. The Bill considered the suggestions made by the CLC as well as the comments received from the stakeholders and ministries/departments.
The recommendations cover significant areas of the 2013 Act, including definitions, raising of capital, accounts and audit, Corporate Social Responsibility (CSR), managerial remuneration, companies incorporated outside India and offences/penalties.
Our issue of First Notes summarises key recommendations of the Bill.
KPMG in India is pleased to present Voices on Reporting – a monthly series of knowledge sharing calls to discuss current and emerging
issues relating to financial reporting
In our recent call, on 5 April 2016, we covered key financial reporting and regulatory matters that are expected to be relevant for stakeholders as they approach the quarter ending 31 March 2016.
Our call included updates from the Ministry of Corporate Affairs (MCA), the Securities and Exchange Board of India (SEBI), the Reserve Bank of India (RBI), the Institute of Chartered Accountants of India (ICAI), the Insurance Regulatory and Development Authority of India (IRDA).
Missed an issue of Accounting and Auditing Update or First Notes?
IFRS NotesFirst Impressions: Revised IFRS 15, Revenue from Contracts with Customers
20 April 2016
The International Accounting Standards Board (IASB) issued amendments to IFRS 15, Revenue from Contracts with Customers on 12 April 2016, to clarify some requirements and provide additional transitional relief to companies
that are implementing IFRS 15.
The amendments do not change the underlying principles of IFRS 15 but clarify how these principles are to be applied. This was a result of the discussions of the Transition Resource Group (TRG) which was set up jointly by the IASB and the U.S. Financial Accounting Standards Board (FASB).
Our IFRS Notes provides overview of the guidance.
KPMG IFRG Limited also released its publication First Impressions: IFRS 15 Revenue in April 2016. This publication has been fully revised and updated to provide a digestible introduction to the clarified version of IFRS 15.
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The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation.
