IMPACT OF FAIR VALUE CHANGES ON RETAINED EARNINGS DURING FIRST TIME IND AS ADOPTION

By Beni Agarwal (beni@vinodkothari.com)

INTRODUCTION

A major change that has taken place in the corporate sector in the past couple of years has been the transition from the Indian GAAP accounting to Indian Accounting Standards (Ind AS) accounting. There is a paradigm shift in the way the accounting will have to be done henceforth as against what was being done all this while. While some of the companies have already moved into Ind AS, others are yet to move.

One of the significant requirements of adoption of Ind AS is fair valuation of assets and liabilities. The relevant Indian Accounting Standard which guides the transition from Indian GAAP is Ind AS 101. As per Ind AS 101, any difference arising due to fair valuation of assets and liabilities has to be adjusted against the retained earnings of the reporting entity. The difference due adjustments can either give rise to gains or losses. In this article, we intend to analyze whether these notional gains or losses, adjusted with the retained earnings, be considered while computing net-worth, free reserves for the purpose of Companies Act, 2013.

GUIDING STANDARD FOR IMPLEMENTATION OF IND AS FOR THE FIRST TIME

The Ind AS 101 requires every entity to recognize all assets and liabilities as per the Ind AS in its opening financial statements. Consequently, it leads to recasting of several account balances in the financial statements as per the Ind AS provisions.
For this we refer the relevant para of the Standard. Para 10 of Indian Accounting Standard 101(Ind AS 101) First-time adoption of Indian Accounting Standards, states that:

“10. Except as described in paragraphs 13–19 and Appendices B–D, an entity shall, in its opening Ind AS Balance Sheet:
(a) Recognize all assets and liabilities whose recognition is required by Ind ASs;
(b) Not recognize items as assets or liabilities if Ind ASs do not permit such recognition;
(c) reclassify items that it recognized in accordance with previous GAAP as one type of asset, liability or component of equity, but are a different type of asset, liability or component of equity in accordance with Ind ASs; and
(d) Apply Ind ASs in measuring all recognized assets and liabilities.”

Thus, the reporting entities shall not only have to recognize the assets and liabilities as per the Ind AS but also derecognize, reclassify and re measure the existing assets and liabilities, if so required.
As per para 11 as stated above, any adjustments arising out of the transition from previous GAAP to Ind AS financial statements shall have to be adjusted against the Retained Earnings.

MEANING OF “OTHER EQUITY” AS PER REVISED SCHEDULE III

Before we discuss further on implications of Ind AS 101, it becomes important to understand the revised structure of the Balance Sheet as per Division III of Schedule III of the Companies Act, 2013. Division III is a newly inserted division which deals with presentation of financial statements for NBFCs specifically on which Ind AS is applicable. The segment which is of immediate importance for us currently is the section on “Other Equity”.

“Other Equity” is a sub-head under the head “Equity”, which has yet another sub-classification called “Reserves and Surplus”. Reserves and Surplus includes various items like Statutory Reserves, Capital Reserves, Securities Premium, Other Reserves of specified nature which could be capital redemption reserve, debenture redemption reserve etc. There is a residuary class called “Retained Earnings”. Since, any reserve created for a specific purpose would get reported under Other Reserves of specified nature, Retained Earnings should include the debit or credit balance of profit and loss account, general reserves, etc.

Therefore, as per the newly inserted Division III, Retained Earnings represent reserves and surplus of generic nature like debit or credit balance of profit and loss account, general reserves, etc.

TRANSITION FROM GAAP TO IND AS- RETAINED EARNINGS

Para 11 of Ind AS 101 provides the treatment of adjustments arising on transition date as follows:
“11. The accounting policies that an entity uses in its opening Ind AS Balance Sheet may differ from those that it used for the same date using its previous GAAP. The resulting adjustments arise from events and transactions before the date of transition to Ind ASs. Therefore, an entity shall recognize those adjustments directly in retained earnings (or, if appropriate, another category of equity) at the date of transition to Ind ASs.”

Embarking on the discussion regarding implications and requirements of Ind AS 101, the Standard states, the adjustments arising during first time adoption of Ind AS due to transition from GAAP to Ind AS must be directly adjusted into the Retained Earnings. There is no definition of Retained Earnings in the Companies Act or in Ind AS but the format of the Schedule III lends a residuary meaning to it, as discussed above.
Therefore, this signifies that for the purpose of recasting the financial statements under Ind AS, if there are fair valuation changes, which could include both upward as well as downward revision in the value of the assets and liabilities, all the differences must be routed through Retained Earnings.

IS THE RETAINED EARNINGS A PART OF NET WORTH?

Our aim in this article is to examine whether the fair valuation changes carried out through Retained Earnings will be considered for the following purposes:
a. Computation of net worth;
b. Computation of Free Reserves;
c. Declaration of dividends; and
d. Issuance of bonus shares

WHAT DOES COMPANIES ACT SAY ABOUT NET WORTH?

Section 2 of the Companies Act, 2013 defines Net Worth:
“2(57) ―net worth means the aggregate value of the paid-up share capital and all reserves created out of the profits, securities premium account and debit or credit balance of profit and loss account, after deducting the aggregate value of the accumulated losses, deferred expenditure and miscellaneous expenditure not written off, as per the audited balance sheet, but does not include reserves created out of revaluation of assets, write back of depreciation and amalgamation.”

BREAKING UP THE DEFINITION

The net worth of a company includes the paid up share capital of company and the reserves created out of profits, securities premium and the debit and credit balance of profit and loss account after removing the accumulated losses, miscellaneous expenses not written off and deferred expenditure. It specifically excludes reserves created out of revaluation of assets, write back of depreciation and amalgamation. The debit and credit balance of profit and loss account has been added post the 2017 amendment of Companies Act.
Net worth should reflect the intrinsic value of a company. As per the definition of net worth, it includes “all reserves created out of profits” but excludes “reserves out of revaluation of assets”. In order to decide whether the changes in fair value adjusted through Retained Earnings should be a part of net worth or not, it would be prudent to determine the nature of the adjustment and whether these can be considered as revaluation reserves or not.

INTENT OF IND AS ALTERED NET WORTH

The intention of allowing the reporting entities to adjust the changes in the fair value at the time of transition is to ensure that the value of assets/liabilities that enter Ind AS financial statements are, as far as possible, consistent with Ind AS treatment. That is, while an entity cannot travel back in time before the previous year, it will at least adjust the opening value of assets and liabilities on the transition date. That is, had the entity been following the Ind AS provisions from the very inception, there is a likelihood that some assets or liabilities which were appearing in the financial statements as per GAAP would not have been there as per Ind AS and vice versa. Similarly, there also remains a possibility that the manner in which the assets and liabilities were valued under GAAP would be inconsistent with the provisions of Ind AS. Hence, the Ind AS allows the reporting entities to make these upfront changes, on the transition date itself by reclassifying, measuring and re measuring the assets and liabilities, and take the cumulative impact of these into retained earnings. The result of these adjustments is to ensure that the net worth that shows on the transition date is Ind AS-compliant net worth.

The changes in the carrying value of assets and liabilities on the transition date are not in the nature of revaluation of assets or liabilities. There may be several financial assets that may not be permitted to put off the balance sheet. There may be several derivatives-related assets or liabilities which may not have been recorded on the books during IGAAP financial statements, which may require to be brought into the books. Therefore, the act of adjusting asset and liability balances on the transition date is not one of revaluation, but one of right valuation, as per applicable principles of Ind ASes. The whole agenda or objective of re stating the net worth to show the true value of the company had it been following Ind AS for preparing and presenting its Financial Statements from the very beginning.

As the definition in section 2(57) of Companies Act 2013 clearly excludes reserves out of revaluation of assets, therefore, these changes shall not be treated as a part of net worth. However, the opening adjustment in assets/liabilities due to first time adoption of Ind AS cannot be regarded as a revaluation exercise, as already discussed. Hence, the adjustments arising out of Ind AS adoption in the first year of transition shall be part of net worth as it is not regarded as revaluation of assets. The same shall not hold true for any subsequent adjustments because whatever adjustments were required to be done during alignment of Financials with Ind AS have already been done in the first year itself. In the subsequent years, it shall be regarded as revaluation of assets.

FURTHER DISCUSSION ON NET WORTH

Having adopted Ind AS, another pertinent question will be, whether gains/losses sitting in the “Other Comprehensive Income” will be regarded as a part of net worth. Here it may be noted that Ind AS 109 allows reporting entities allow some of the financial instruments to be fair valued through Other Comprehensive Income (OCI). Any changes in the fair value of these instruments are effected through OCI, which is carried to the Balance Sheet as Other Equity.

It may be noted that the definition of net worth allows inclusion of only such profits which flow from the Profit and Loss. Unrealized OCI do not form part of the profits/ losses earned/ incurred by the reporting entity in a particular as the OCI are shown separately in the new format of Statement of Profit and Loss. As per the new format of Statement of Profit and Loss, after the Profit earned by a reporting entity is arrived at, the same is added with the OCI during the year to show the Total Comprehensive Income of the reporting entity.

Therefore, just because the OCI is shown in the Statement of Profit and Loss does not mean that the same must be considered as Profits earned by the reporting entity. Hence, for the purpose of computation of net worth, OCI cannot be considered as a part of the net worth.
However, as per Ind AS 109, once the unrealized profits trapped in the form of OCI gets realized due to sale of financial asset or otherwise, it gets transferred from Equity to Profit and Loss. In such a situation, the same must be considered as a part of net worth.

SHOULD THE RETAINED EARNINGS BE CONSIDERED FREE RESERVE?

Section 2 of the Companies Act, 2013 defines Free Reserves:
“2(43) ―free reserves means such reserves which, as per the latest audited balance sheet of a company, are available for distribution as dividend: Provided that—
(i) any amount representing unrealized gains, notional gains or revaluation of assets, whether shown as a reserve or otherwise, or
(ii) any change in carrying amount of an asset or of a liability recognized in equity, including surplus in profit and loss account on measurement of the asset or the liability at fair value, shall not be treated as free reserves.”

The definition of Free Reserves says that the reserves should be available for dividend distribution as per latest audited balance sheet. It specifically excludes notional or unrealized gains and gains on revaluation of assets. It also states that change in carrying amount of asset or liability recognized in equity and surplus in profit and loss account due to restatement of asset or liability at fair value shall not be included in free reserves.

The definition does not include the unrealized part of the gains. It also excludes the surplus arising on restatement of asset or liability fair value restatement. Hence, the retained earnings which is adjusted for any differences in fair value measurement of assets and liabilities during first time Ind AS adoption cannot be considered as free as these are not realized in nature. The definition of net worth does not distinguish between realized and unrealized gains but the definition of Free Reserves does. Hence although it is a part of Net Worth as explained above, it cannot be a part of free reserves as it excludes unrealized and notional gains.
Hence the amount transferred to Retained Earnings as adjustments during transition of Financial Statements from GAAP to IND AS cannot be considered as Free Reserves.

USE OF THE FREE RESERVES FOR ISSUE OF BONUS SHARES AND DECLARATION OF DIVIDEND

Free Reserves is of immense significance because it is used for the purpose of issue of bonus shares and declaration of dividend. With the changes brought in it post Ind AS adoption, its corresponding effect on bonus shares and dividend declaration is also required to be addressed. Relevant excerpts for bonus issue and dividend declaration from Companies Act 2013 are discussed below.

Issuance of Bonus Shares

“63(1). A company may issue fully paid-up bonus shares to its members, in any manner whatsoever, out of—

(i) Its free reserves;

(ii) The securities premium account; or

(iii) The capital redemption reserve account:

Provided that no issue of bonus shares shall be made by capitalizing reserves created by the revaluation of assets.”

It may be noted that bonus issue can be done only out of the sources mentioned in section 63(1) and no other source can be used in this regard.

Declaration of Dividend:

“123(1). No dividend shall be declared or paid by a company for any financial year except—

(a) out of the profits of the company for that year arrived at after providing for depreciation in accordance with the provisions of sub-section (2), or out of the profits of the company for any previous financial year or years arrived at after providing for depreciation in accordance with the provisions of that sub-section and remaining undistributed, or out of both; or

(b) out of money provided by the Central Government or a State Government for the payment of dividend by the company in pursuance of a guarantee given by that Government: Provided that a company may, before the declaration of any dividend in any financial year, transfer such percentage of its profits for that financial year as it may consider appropriate to the reserves of the company:

Provided further that where, owing to inadequacy or absence of profits in any financial year, any company proposes to declare dividend out of the accumulated profits earned by it in previous years and transferred by the company to the reserves, such declaration of dividend shall not be made except in accordance with such rules as may be prescribed in this behalf: Provided also that no dividend shall be declared or paid by a company from its reserves other than free reserves.”

As is clearly provided in the Companies Act 2013, regarding issuance of bonus shares and declaration of dividend, only Free Reserves can be utilized. Drawing from the discussion above, the adjustments arising due to transition of assets and liabilities from GAAP to Ind AS cannot be part of first time Ind AS adopted Free Reserves. Hence, this cannot be used for declaration of dividend and issuance of bonus shares.

CONCLUSION

Summing up the entire discussion above, when a company is moving to Ind AS way of preparing Financial Statements, it may be required to recognize some assets and liabilities on its Balance Sheet and may be required to put other assets and liabilities off balance sheet. Also, some assets and liabilities may be required to be reclassified or re measured. This is brought about by adjusting the Retained Earnings. However, the question is whether such an Ind AS adjusted Retained Earnings be a part of net worth, free reserves and whether it can be used for issuing bonus shares and declaring dividend? The answer is based on the above discussion. Retained Earnings representing the adjustments arising out of restating the assets and liabilities at its fair value due to its first time Ind AS adoption shall be a part of Net Worth as the amount is attributable to the right valuation of assets and liabilities and not revaluation of the same. The adjustments arising out of first time Ind AS adoption reflected in Retained Earnings shall not be a part of Free Reserves as per definition of Companies Act. These adjustments cannot be considered as free reserves as they are unrealized in nature. Hence, it cannot be used for declaration of dividend and issuance of bonus shares. However, upon their subsequent disposal, the positive or negative surplus shall be realized in nature and then shall form part of Free Reserves.


 

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