Each such byte focuses on a functional issue startups need to solve as they build their company, from idea to scale. In this edition, we speak about the Indian accounting standards.
In the past couple of decades, we have witnessed innovative business models and growing outreach of Indian companies in the global arena. If your company has tried to access capital from any foreign investors, you might have also been asked to present your financial statements in line with global standards.
To facilitate capital raising and increase in foreign investments for domestic companies our government in February 2015 issued the Companies (Indian Accounting Standards [Ind AS]) Rules. Ind AS are in convergence with International Financial Reporting Standards (IFRS). Ind AS will enable your investors to compare investments across countries, as financial statements are prepared using the same set of global standards. If your company has a foreign subsidiary, adopting Ind AS can help by reducing regulatory compliance and costs. Implementation of Ind AS is expected to reduce the cost of capital since capital would be more accessible and easily available.
In our view, Indian regulators have done a laudable job by taking a giant leap to converge with IFRS. However, due to minor carve-outs and deviations between the two standards, Indian companies will not be able to state dual compliance with IFRS.
Phases of Adoption of Indian Accounting Standards
As per the notification, MCA necessitated Ind AS to be implemented in a phase-wise manner based on their net worth and listing status.
So, if your company is a listed entity or an unlisted company with a net worth of more than INR 250 crores you would have already adopted Ind AS.
- Apart from these mandates, all companies were also allowed to adopt Ind AS voluntarily from 1st April 2015 or thereafter except for banks, NBFCs, and Insurance companies. There is no voluntary diving into the Ind AS pool for financial institutions yet!
- Remember, you are not allowed to revert to the old accounting standards if a company starts following the Ind AS. Think, before diving!
- Moreover, if Ind AS becomes applicable to a company, then it shall also be applied to the holding, subsidiary, joint venture, or associate companies of that company. Scope, when you decide to dive!
- The RBI and IRDAI have deferred Ind AS implementation until further notice for commercial banks and insurance companies, respectively. Breathe easy, until then!
It is important to note that Ind AS is not just a change in the way companies present their financial numbers; its implementation can have a significant impact on the reported earnings and net worth of your company. Some of these critical differences with Indian GAAP have been highlighted below: –
A. Revenue recognition
Ind AS 115, Revenue from contracts with customers, introduces a new single five-step revenue recognition model to ascertain the timing and amount of revenue to be recognized.
- 1. Identify the contract with the customer.
- 2. Identify the separate performance obligation in the contract.
- 3. Determine the transaction price.
- 4. Allocate the transaction price to separate performance obligations.
- 5. Recognize revenue when (or as) each performance obligation is satisfied.
Performance Obligation – The Finance team of your company needs to ascertain if there are multiple promises in a contract and whether those promises are distinct. Moreover, if a transaction contains separately identifiable components (such as a bundled software contract along with necessary hardware components) Ind AS requires us to allocate revenues based on the fair value of each component.
- Under the new regime, revenue is to be recognized when the transfer of control takes place as opposed to the transfer of risk and rewards under existing Indian GAAP. Your customer is considered to obtain control when they can direct the use and obtain the benefits of the goods and services delivered by you. Sometimes the difference between these two concepts might be subtle and other times be stark, requiring us to take assistance from our financial advisors and auditors.
- Revenue will be recorded after netting off incentives and discounts given to the customer; earlier, these were accounted under cost line items like advertising, sales promotion, and marketing expenses, contributing to a perceived enhanced scale of operations.
- Fair value, i.e. the time value of money of each deliverable component, must be accounted for under Ind AS. This essentially means that revenue earned by your company will be measured at the fair value of the consideration received or receivable. If consideration is deferred it should be appropriately discounted to the present value for revenue recognition.
- Extensive disclosures of qualitative and quantitative information used while making judgments, and changes in these judgments while recording revenue, needs to be provided by the management.
B. Goodwill and Intangible assets
Goodwill generated as part of a business combination has typically been amortized over a period under Indian GAAP as it is considered to have a definite life. Ind AS considers such goodwill to have indefinite life (mark the usage of the word ‘indefinite’, which is different from ‘infinite’), and hence no amortization is needed. Goodwill is tested annually for impairment. An impairment loss must be recognized if the carrying amount exceeds the amount to be recovered through the use or sale of goodwill. Similarly, all intangible assets with indefinite useful life will be tested annually for impairment loss if any.
C. Property, plant, and equipment
Ind AS 116 on leases has removed the concept of operating lease. Now a single lease accounting model like financial leases is permitted for most categories of leases, under which they will have to be recognized on the balance sheet as a right-of-use asset. Operating lease allowed companies to just record rental expenses for leased assets without including the leased assets in their balance sheet. A financial lease, on the other hand, inflates the balance sheet by including right-of-use asset and a corresponding lease liability on the companies’ balance sheet. Depreciation of right-of-use asset and interest expense on lease liability is recorded annually in the profit and loss account instead of cash rental expense under an operating lease. Some implications:
- Companies with existing operating leases will appear to be more asset-rich and heavily indebted when they move to Ind AS.
- Companies will report greater lease expenses in the initial years of the financial lease even when actual cash rental payments are constant. This front-loading in lease expenses is a result of higher interest payments on the declining balance of lease liability in the initial years.
D. Consolidation and Business combinations
Under Indian GAAP control is assessed based on majority voting rights and composition of the board of directors. Ind AS introduces a new definition of controlling rights under which investor (someone like Caspian) controls an investee (your company) if it satisfies all the following conditions: –
- The investor has existing rights making them able to direct relevant activities of the company to influence the overall returns of the company. Such as parent company might have the right to decide on issues such as royalty payments, repatriation of additional funds, act as a key supplier/ customer of the company, etc.
- Exposure, or rights, of the investor to receive variable returns (such as dividend pay-outs, rights issue, etc.) from the investee.
- Investor’s ability to use their power over the company to influence investor’s returns.
This implies that an entity which might have 0% equity stake, but has controlling rights owing to contractual obligations such as a lender relationship with rights of board membership (not triggered by an event of default), or can influence company as well as its returns (E.g.-Convertible debt holders of a company with additional controlling rights), might see a subsidiary relationship getting established!
E. Equity and Liability instruments
Ind AS 32 Financial Instruments: Presentation requires financial instruments to be classified based on the substance of the contractual agreement rather than its legal form. Some of the key accounting differences because of this are that redeemable preference shares now get classified as a liability and the ‘dividend’ on such instruments are now recognized as interest expense (with obvious implications on reported profit). Another aspect of change is that compulsory convertible debenture would now be split into their liability and equity components while reporting, with the fair value of the estimated interest pay-out becoming the liability component. Combine this with the effect of changes caused by the revenue recognition policy under Ind AS, and anyone can guess the leverage your entity would reportedly be riding on!
Changes peculiar to financial institutions:
The financial services industry has been significantly impacted by the implementation of Ind AS, more so around points like:
- Loans and advances are to be measured at amortized cost using the Effective Interest Rate (EIR). This implies that the loan processing fee which was recorded upfront in the profit and loss statement under GAAP will now be credited to the profit and loss statement based on the EIR method, and any unamortized portion of loan processing fees will be adjusted from the loan portfolio.
- Expected Credit Loss (ECL) model is introduced to calculate the impairment allowance of financial assets under Ind AS. This is an elaborate, management-driven process utilizing statistical models on historical delinquencies to arrive at probable values of impairment.
Under GAAP, this allowance though based on the percentage decided by the management retained the RBI’s prudential norms on Income Recognition, Asset Classification, and Provisioning (IRACP) as a benchmark. Does it mean, the impairment allowance decision would now be completely management-decided? Not quite. The RBI has recently clarified that NBFCs moving to Ind AS reporting would be required to calculate allowances under both methods (i.e., as per ECL and also as per the prudential norms on IRACP), with an additional P&L charge having to take place if the former turns out lower than as prescribed by the RBI! Double whammy, anyone?
- NBFCs sometimes sell loans made by them to another financial institution through the direct assignment route or by converting them into marketable securities (the securitization route). These transactions allow the institutions – typically banks – to meet their priority sector lending targets by taking exposure in such securities. Such off-loading of loan assets by NBFCs and mortgage lenders is also important as it allows them to raise funds in risk-averse credit markets or when avenues for further leverage have been fully tapped. Under GAAP, such transactions were derecognized from the financial statements of the NBFCs based on the RBI guidelines. Ind AS retains its principle of ‘control’ or ‘true sale’ even here: Securitization transactions in particular will now be considered on-balance sheet arrangements as they do not meet the criteria of complete transfer of risk and rewards for derecognition from financial instruments! Direct assignment transactions by their very nature continue to remain eligible for de-recognition. What side are you tilted on, in this new schema? Would securitization interest you any longer?
In conclusion, Ind AS gives a lot of emphasis on clear disclosures to investors and other stakeholders. Keeping the spirit of these principles intact while reporting under Ind AS (as opposed to adhering to guidelines in the erstwhile GAAP) will aid your company in its pursuit of growth funds too, as it complements the transparency metric key to many funders’ decisions. However, it is imperative for the companies to work closely with their auditors – at all stages – to ensure a comprehensive
https://m.rbi.org.in/scripts/BS_CircularIndexDisplay.aspx?Id=11818
conveying of business realities and computation methods in the disclosures. Ind AS requires segment reporting to be in line with the ones used by the management to make decisions, and the disclosure of judgments and assumptions used by the management. Disclosures of various risks impacting the company and corresponding sensitivity analyses also need to be provided for in the notes to financial statements. While the engagement with the auditors is going to increase (causing higher monetary & time costs), Ind AS inherently gives greater flexibility for the management to customize their accounts based on their unique business models & assumptions of growth – thus, driving more realistic financial reporting, a key need for entrepreneurs.
Please refer to these guidance documents by top accounting and advisory organizations to seek clarity on the various facets of Ind AS.
https://www.pwc.in/assets/pdfs/publications/2016/ind-as-pocket-guide-2016.pdf
https://www2.deloitte.com/content/dam/Deloitte/in/Documents/audit/in-audit-the-path-to-indas-conversion.pdf
http://gtw3.grantthornton.in/assets/Ind-AS/IND_AS.pdf
Let us know if you have questions or feedback. Reach out to us on info@caspian.in.