List of Disclosures Requirements Applicable to NBFCs

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Srl No Particular Clause Reference Remarks
List of Disclosure in Annual Report – As per RBI Direction
1 NBFCs shall disclose in their annual reports the details of the auctions conducted during the financial year including the number of loan accounts, outstanding amounts, value fetched and whether any of its sister concerns participated in the auction. Para 27(4) (d)-Loans against security of single product – gold jewellery Applicable for Gold loan business
2
 Non-deposit taking NBFC with asset size of ₹ 500 crore and above issuing PDI, shall make suitable disclosures in their Annual Report about : Annex XVII
(i) Amount of funds raised through PDI during the year and outstanding at the close of the financial year;
(ii) Percentage of the amount of PDI of the amount of its Tier I Capital;
(iii) Mention the financial year in which interest on PDI has not been paid in accordance with clause 1(viii) above.		 Terms and Conditions Applicable to Perpetual Debt Instruments (PDI) for Being Eligible for Inclusion in Tier I capital Applicable for NBFCs issuing PDIs
2A Details of all material transactions with related parties shall be disclosed in the annual report along with policy on dealing with Annual Report Para 4.3 – Annex IV, Master Directions
2B (i) Remunerarion of Directors (Para 4.5)
(ii) a Management Discussion and Analysis report		 Para 4.3 – Annex IV, Master Directions
Disclosure in Financial Statements- as per RBI Direction
3
 Disclosure in the balance sheet
The provision towards standard assets need not be netted from gross advances but shall be shown separately as ‘Contingent Provisions against Standard Assets’ in the balance sheet. Master Directions Para 14
Every applicable NBFCshall separately disclose in its balance sheet the provisions made as per these Directions without netting them from the income or against the value of assets.

The provisions shall be distinctly indicated under separate heads of account as under:-
(i) provisions for bad and doubtful debts; and
(ii) provisions for depreciation in investments.

 Master Direction Para 17 (1) and (2)
In addition to the above every applicable NBFCshall disclose the following particulars in its Balance Sheet:
(i) Capital to Risk Assets Ratio (CRAR);
(ii) Exposure to real estate sector, both direct and indirect; and
(iii) Maturity pattern of assets and liabilities.		 Master Direction Para 17 (5)
4 Indicative List of Balance Sheet Disclosure for non-deposit taking NBFCs with Asset Size ₹500 Crore and Above and Deposit Taking NBFCs (hereinafter called as Applicable NBFCs) Annex XIV Please refer Annex XIV
5
 Disclosures to be made by the Originator in Notes to Annual Accounts Guidelines on Securitisation Transactions
The Notes to Annual Accounts of the originating NBFCs shall indicate the outstanding amount of securitised assets as per books of the SPVs sponsored by the NBFC and total amount of exposures retained by the NBFC as on the date of balance sheet to comply with the MRR. These figures shall be based on the information duly certified by the SPV’s auditors obtained by the originating NBFC from the SPV. These disclosures shall be made in the format given in Appendix 2.
6
 LRM Framework
An NBFC shall publicly disclose information (Appendix I) on a quarterly basis on the official website of the company and in the annual financial statement as notes to account that enables market participants to make an informed judgment about the soundness of its liquidity risk management framework and liquidity position. Guidelines on Liquidity Risk Management Please refer Appendix I
7
 LCR Disclosure Standards
NBFCs in their annual financial statements under Notes to Accounts, starting with the financial year ending March 31, 2021, shall disclose information on LCR for all the four quarters of the relevant financial year. The disclosure format is given in the Appendix I. Data must be presented as simple averages of monthly observations over the previous quarter (i.e., the average is calculated over a period of 90 days). However, with effect from the financial year ending March 31, 2022, the simple average shall be calculated on daily observations.
NBFCs should provide sufficient qualitative discussion (in their annual financial statements under Notes to Accounts) around the LCR to facilitate understanding of the results and data provided. Please refer Appendix I (Part B)
8
 Schedule to the balance sheet Master Direction Clause 19
Every applicable NBFC shall append to its balance sheet prescribed under the Companies Act, 2013, the particulars in the schedule as set out in Annex IV.
9
 Participation in Currency Options Master Direction Clause 83
Disclosures shall be made in the balance sheet regarding transactions undertaken, in accordance with the guidelines issued by SEBI.
10
 Participation in Currency Futures Master Direction Clause 94
Disclosures shall be made in the balance sheet relating to transactions undertaken in the currency futures market, in accordance with the guidelines issued by SEBI.
11
 Disclosure for Restructured Accounts Master Direction Annex VII
With effect from the financial year ending March 2014 NBFCs shall disclose in their published annual Balance Sheets, under “Notes on Accounts”, information relating to number and amount of advances restructured, and the amount of diminution in the fair value of the restructured advances as per the format given in Appendix – 4
12 Disclosures relating to fraud in terms of the notification issued by Reserve Bank of India
14
 Moratorium Circular
The lending institutions shall suitably disclose the following in the ‘Notes to Accounts’ while preparing their financial statements for the half year ending September 30, 2020 as well as the financial years 2019-20 and 2020-2021:

(i) Respective amounts in SMA/overdue categories, where the moratorium/deferment was extended, in terms of paragraph 2 and 3;

(ii) Respective amount where asset classification benefits is extended.

(iii) Provisions made during the Q4FY2020 and Q1FY2021 in terms of paragraph 5;

(iv) Provisions adjusted during the respective accounting periods against slippages and the residual provisions in terms of paragraph 6.

 Para 10 COVID19 Regulatory Package – Asset Classification and Provisioning
15
 Disclosure under sector – Restructuring of Advances, Circular
NBFCs shall make appropriate disclosures in their financial statements, under ‘Notes on Accounts’, relating to the MSME accounts restructured under these instructions as per the following format:

No. of accounts restructured Amount (₹ in million)

 Micro, Small and Medium Enterprises (MSME) sector – Restructuring of Advances
16
 Lending institutions publishing quarterly statements shall, at the minimum, make disclosures as per the format prescribed in Format-A Para 52 of Resolution Framework for COVID-19-related Stress In the financial statements for the quarters ending March 31, 2021, June 30, 2021 and September 30, 2021
16A (i) registration/ licence/ authorisation, by whatever name called, obtained from other financial sector regulators;
(ii) ratings assigned by credit rating agencies and migration of ratings during the year;
(iii) penalties, if any, levied by any regulator;
(iv) information namely, area, country of operation and joint venture partners with regard to joint ventures and overseas subsidiaries and
(v) Asset-Liability profile, extent of financing of parent company products, NPAs and movement of NPAs, details of all off-balance sheet exposures, structured products issued by them as also securitization/ assignment transactions and other disclosures		 Para 73 – Master Directions (Ref. Annexure XIV)
Other Disclosure
17 Report on-line to stock exchanges on a quarterly basis, information on the shares pledged against LAS, in their favour, by borrowers for availing loans 22 of Master Directions In format as given in Annex V for Master Direction.
18 Quarterly statement to RBI on change of directors, and a certificate from the Managing Director of the applicable NBFC that fit and proper criteria in selection of the directors has been followed 72 of Master Direction The statement must be sent 15 days of the close of the respective quarter. The statement for the quarter ending March 31, shall be certified by the auditors
19 On a quarterly basis, NBFCs shall report “total exposure” in all cases where they have assumed exposures against borrowers in excess of the normal single / group exposure limits due to the credit protections obtained by them through CDS, guarantees or any other permitted instruments of credit risk transfer Para 8 of Guidelines for Credit Default Swaps – NBFCs as users
Website Disclosure
20
 Public disclosure
An NBFC shall publicly disclose information (Appendix I) on a quarterly basis on the official website of the company that enables market participants to make an informed judgment about the soundness of its liquidity risk management framework and liquidity position. Guidelines on Liquidity Risk Management Please refer Appendix I
21 NBFCs are required to disclose information on their LCR every quarter Para 6 LCR Framework To be made on website
Additional Disclosures w.r.t. COVID-19
22 Lending institutions publishing quarterly financial statements shall, at the minimum, shall make disclosures in their financial statements for the quarters ending September 30, 2021 and December 31, 2021. The resolution plans implemented in terms of Part A of this framework should also be included in the continuous disclosures required as per Format-B prescribed in the Resolution Framework – 1.0. As per format prescribed in Format-X
23 The number of borrower accounts where modifications were sanctioned and implemented in terms of Clause 22 above, and the aggregate exposure of the lending institution to such borrowers may also be disclosed on a quarterly basis,
24 The credit reporting by the lending institutions in respect of borrowers where the resolution plan is implemented under Part A of this window shall reflect the “restructured due to COVID-19” status of the account

Inter-se Ranking of Creditors – Not Equal, but Equitable

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-Megha Mittal, Associate and Prachi Bhatia, Legal Intern 

(resolution@vinodkothari.com)

Insolvency laws, globally, have propagated the principle of equitable distribution as the very essence of liquidation/ bankruptcy processes; and while, “equitable distribution” is often colloquially read as “equal distribution” the two terms hold significantly different connotations, more so in liquidation processes – an ‘equitable distribution’ simply means applying similar principles of distribution for similarly placed creditors.

Closer home in India, the preamble of the Insolvency and Bankruptcy Code, 2016 (‘Code’/ ‘IBC’) also upholds the principles of equitable distribution – thus balancing interests of all stakeholders under the insolvency framework. Judicial developments have also had a significant role in holding such equity upright[1]. However, in the recent order of the Hon’ble National Company Law Appellate Tribunal, in Technology Development Board v. Mr. Anil Goel[2], the Hon’ble NCLAT has refused to acknowledge the validity of inter-se rights of secured creditors once such security interest in relinquished in terms of section 52 of the Code.

In what may potentially jeopardize interests of a larger body of secured creditors, the Appellate Authority held that inter-se arrangements between the secured creditors, for instance, first charge and second charge over the same asset(s), would not hold relevance if such secured creditors choose to be a part of the liquidation process under the Code – thus placing all secured creditors at an equal footing. The authors humbly present that the instant order may not be in consonance with the established and time-tested principles of ‘equitable’ treatment of creditors. The authors opine that contractual priorities form the very basis of a creditor’s comfort in distress situations – as such, a law which tampers with such contractual priorities (which of course, are not otherwise hit by avoidance provisions) in those very times, will go on to defeat the commercial basis of such contracts and demotivate the parties. This, as obvious, cannot be a desired outcome of a law which otherwise delves on the objective of ‘promotion of entrepreneurship and availability of credit’. The authors have tried putting their perspective in this article.

Read more →

MCA circular on excess spent done by contribution to PM-Cares

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-raises more questions than it settles.

Nitu Poddar, Senior Associate ( corplaw@vinodkothari.com )

Setting off excess-spent on CSR

Pursuant to Rule 7(3) of the CSR Rules, 2014, a company is allowed to take benefit of the excess amount (more than the requirement under section 135(5) spent by it on CSR activities upto three succeeding financial years. This provision has come into effect from January 22, 2021.

Accordingly, the common view that has formed is that only amount that is spent in excess on and from January 22, 2021 can be set off against the CSR obligations of three succeeding year. However, the second view, and the more appropriate one is, even amount spent in excess before Jan 22, 2021 may also be set-off against the CSR obligations of a year, subject to such excess spent is done within three years of taking such set-off. That is to say, any excess spent done in FY 2019-20, 2018-19, 2017-18 could have been set-off in FY 2020-21.

The reason for the second view is that, all that the provisions of Rule 7(3) allows is “setting off “the excess spent, which is being done post January 22, 2021. 

Clarification Circular by MCA:

MCA, on May 20, 2021, has issued a Circular, purportedly clarifying the following:

  1. Any amount spent in excess during FY 2019-20;
  2. On March 31, 2020;
  3. By contribution to the PM-Cares

may be set off against the CSR obligation for FY 2020-21 (only) subject to the following conditions:

  1. Unspent amount, if any, of the previous years, should have been factored;
  2. CFO and statutory auditor to certify that such amount was
    1. contributed on 31.03.2020;
    2. pursuant to the appeal by the MCA.
  3. Details of such contribution to be disclosed separately in the CSR Report and Board’s Report. 

Issues arising from the Circular

The MCA Circular rather raises several questions and leave then unanswered:

  1. What about the contribution done prior to 31.03.2020?;
  2. What about the excess spent done in any other activity as mentioned in schedule vii?;
  3. What about the excess spent done in FY 2018-19 and 2017-18?
  4. Why a certificate from statutory auditor? This is not required for any other excess spent done neither is this part of Rule 7(3).

The Circular seems to support the view of the ICSI, as mentioned in Q-47 of the FAQ released on April, 29, 2020, which says that only excess spent done after January, 22, 2021 may be allowed to set-off in subsequent years. However, taking such view would may not be the correct interpretation of the applicability of the provisions.

 

Our other resources on CSR can be accessed at : http://vinodkothari.com/csr/

‘Material Subsidiary’ under LODR Regulations: Understanding the metrics of materiality

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Barsha Dikshit | corplaw@vinodkothari.com

Himanshu Dubey | corplaw@vinodkothari.com

The term ‘subsidiary’ or ‘subsidiary company’ as defined under the Companies Act, 2013[1] (‘Act’) refer to a company in which a holding company controls the composition of the Board of directors or may exercise at least 51% of the total voting power either on  its own or together with one or more of its subsidiaries. A company may have a number of subsidiaries; however, all of them may or may not have a material impact on the holding company or on the group at a consolidated level. Therefore, regulations sometimes require identification of such subsidiaries which may have a material impact on the overall performance of the holding company/group.

Though SEBI (Listing Obligations and Disclosure Requirement) Regulations, 2015 (‘SEBI LODR’), define the term ‘Material Subsidiary’ as a subsidiary, whose income or net worth exceeds ten percent (10%) of the consolidated income or net worth, respectively, of the listed entity and its subsidiaries in the immediately preceding accounting year, however, there remains confusion w.r.t. the criteria provided for determining the materiality of a subsidiary. For instance, whether a subsidiary having negative net worth exceeding 10% of the consolidated net worth of the listed company will be qualified as a material subsidiary? Or say if the net worth at the group level is negative, however the net worth of the subsidiary is positive, will that subsidiary be treated as a material subsidiary, etc.

Through this article the author has made an attempt to decode some of these puzzling issues relating to determination of materiality of a subsidiary.

The Concept of ‘Material Subsidiary’

In present day corporate world, operating through a network of subsidiaries and associates is quite common. Sometimes, it is a matter of corporate structuring discretion, and sometimes, it is purely a product of regulation – for example, overseas direct investment can be made only through subsidiaries or joint venture entities. While the listed subsidiaries are always under the observation of SEBI, an appropriate level of review and oversight is required by the board of the listed entity over its unlisted subsidiaries for protection of interests of public shareholders. The board of directors of a holding company cannot take a tunnel view and limit their perspective only to the company on whose board they are sitting. After all, subsidiaries operate with the resources of the parent, and therefore, what happens at subsidiaries and associates is of immediate relevance to the holding company.  Accordingly, the obligation of the board of a listed entity with respect to its subsidiaries has been increased vide SEBI LODR Amendment Regulations, 2018 dated 9th May, 2018[2], thereby reducing the threshold for determining materiality of a subsidiary to 10% (as opposed to the previous limit of 20%) of the consolidated income or net worth respectively, of the listed entity and its subsidiaries, in the immediately preceding accounting year.

Since the material subsidiaries have a considerable role in the overall performance of the holding company or the group as a whole, it is important to arrive at the correct interpretation of the term in line with the intent and purpose of the definition as well as the compliance requirements following it.

In terms of the definition provided under Regulation 16(1)(c) of SEBI LODR the triggers for determining materiality of a subsidiary are- Net Worth [3]and Turnover. That is to say, the pre-requisites for determining materiality of a subsidiary are:

  1. It has to be a subsidiary, in terms of the definition provided under Act, 2013; and
  2. Its income/net worth in the immediately preceding financial year exceeds 10% of the consolidated net worth of the listed company.

It is pertinent to note that the definition of material subsidiary currently provides for 10% or more impact on the consolidated turnover or net worth of the listed company/group, however, it does not specify whether the said impact has to be in positive or negative. It just says that the impact has to be 10% of the overall income/net worth. Since the turnover of a company cannot be negative, the focus has to be made on the later.

A parent company is required to prepare consolidated financial statement taking into account the performance of its subsidiaries. While a subsidiary, with a good performance and positive net worth/income can add on the overall growth of the group, the same can affect the overall performance of the group with its negative net worth, and if the said impact exceeds 10% of the income/net worth of the consolidated performance of the group, the said subsidiary will become material and shall require special attention of the parent company. Therefore, for the purpose of determining the ‘materiality’, one has to drop the minus sign of the net worth of the subsidiary or group and has to see the absolute term and the overall impact it has on the group. In other words, if a subsidiary is big enough to shake the performance of its holding company, it shall be qualified as a ‘material subsidiary’.

Let us take some illustrations to understand the definition provided under Reg. 16 (1) (c) of SEBI LODR:

Illustration 1:

XYZ Limited is a subsidiary of ABC Limited. In the FY 2019-20, the net worth of XYZ Limited was Rs. 50 Crs. and the consolidated net worth of ABC Limited company was Rs. 400 Crs., Whether XYZ Limited be considered as a material subsidiary of ABC Limited?

Yes. The contribution of XYZ Limited towards the consolidated net worth of ABC Limited is more than 10%, therefore XYZ Limited shall be consolidated as a ‘material subsidiary’ of ABC Limited.

Illustration 2:

Net worth of XYZ Limited in FY 2019-20 was Rs. (50) Crs., however, the consolidated net worth of ABC Limited was Rs. 400 Crs, will XYZ Ltd. be considered as a material subsidiary of ABC Ltd?

Yes. Irrespective of having a negative net worth, since XYZ Limited contributes more than 10% of the consolidated net worth of ABC Limited, XYZ Limited shall be considered as a ‘material subsidiary’ of ABC limited.

Illustration 3:

Net worth of XYZ Limited in FY 2019-20 was Rs. (50) crores, and the consolidated net worth of ABC Limited was Rs. (400) Crs., will XYZ Limited be considered as a material subsidiary of ABC Limited?

Yes. Even if the net worth at the subsidiary level and the consolidated level are negative, however, one has to see as to how much contribution the subsidiary has in the consolidated net worth of the holding company. Therefore, irrespective of having negative net worth, XYZ Limited shall be considered as a ‘material subsidiary’ of ABC limited.

Illustration 4:

Net worth of XYZ Limited in FY 2019-20 was Rs. 50 crores and the consolidated net worth of ABC Limited was Rs. (400) Crs., will that subsidiary be considered as a material subsidiary of ABC Limited?

Yes. In the given case, because of the positive net worth of the subsidiary the net worth of the holding company has contributed to reduce the negative net worth of the holding company by more than 10%. Therefore, the subsidiary, viz. XYZ Limited shall be considered as a material subsidiary of ABC Limited.

Illustration 5:

Net worth of XYZ Limited in FY 2019-20 was Rs. 30 Crs. and the consolidated net worth of ABC Limited was  Rs. (400) Crs., will that subsidiary be considered as a material subsidiary of ABC Limited?

No. Even though the positive net worth of the subsidiary is contributing to reduce the negative consolidated net worth of the holding company, however, that contribution is less than 10%, therefore in this case, XYZ Limited shall not be considered as a ‘material subsidiary’ of ABC Limited.

Thus, for determining ‘materiality’ of a subsidiary, the emphasis should not be on whether net worth is positive or negative, rather the impact of its net worth or income on the overall consolidated performance of the listed entity is to be seen.

Special Situation in case of Regulation 24 (1)

 In the SEBI LODR, the term ‘Material Subsidiary’ has been defined twice, i.e under regulation 16 (1)(c) and under regulation 24 (1). While the threshold for determining ‘materiality’ provided under regulation 16 (1) (c) is 10%, the one provided under reg. 24 (1) is 20%. The reason behind the said increase in the threshold is the higher level of impact the said subsidiary can make on the performance of the listed company/group. That is to say, when a subsidiary is ‘material’ it requires attention of the parent company, however when it becomes significantly material, such that it can give shock to the parent company with its performance, it requires higher attention. Therefore regulation 24 (1) requires those significantly material subsidiaries to have on independent director of the parent company in its board.

The need for an independent director can be established by the fact that they are expected to be ‘independent’ from the management and act as the fiduciary of shareholders. This implies that they are obligated to be fully aware of the conduct which is going on in the organizations and also to take a stand as and when necessary, on relevant issues.

The requirement of appointing independent director is applicable only in case of significantly material subsidiary (unlisted), whether incorporated in India or not, and not in case of material subsidiary. 

Obligation of the Listed Entity with respect to its Material Subsidiary(ies)

Other than the obligations provided under Reg. 24 of SEBI LODR for the listed companies w.r.t. their subsidiaries, the following additional obligations are applicable in case of material subsidiaries:

  • Formulating Policy– The listed entity is required to formulate a policy for determining materiality of its subsidiaries, and shall disseminate the same on its website.
  • Appointment of Independent Director– Pursuant to Regulation 24(1) of the LODR, at least one (1) independent director of the listed entity is required to be a director on the board of an unlisted material subsidiary (with respect to this provision, material subsidiary has been defined with a threshold of 20% of the consolidated income or net worth).
  • Disposing of shares in Material Subsidiary – A listed company shall not dispose of shares in its material subsidiary resulting in reduction of its overall shareholding to less than 50% or cease to exercise control over subsidiary without passing special resolution in general meeting except in case where such divestment is made under a scheme of arrangement (duly approved by the Tribunal/ Court) or in case of resolution plan duly approved in terms of section 31 of IBC, 2016.
  • Selling, disposing and leasing of assets – Pursuant to Regulation 24(6) of the LODR, the sale or disposal or leasing of assets amounting to more than 20% of the assets of a material subsidiary (on an aggregate basis during a financial year), subject to certain exceptions, requires prior approval of the shareholders of the listed holding company by way of a special resolution.
  • Secretarial Audit: Pursuant to Regulation 24A of the LODR, all listed entities and their Indian unlisted   material   subsidiaries   are   required   to   undertake   a secretarial audit and annex such reports to the annual report of the listed entity.

The discussion above can be summarised in the presentation below:

Role of Policy on determining Materiality of Subsidiary

The definition of ‘material subsidiary’ under regulation 16(1)(c) defines a subsidiary that is material to the listed entity and the explanation to the aforesaid provision allows the listed entity to formulate a policy for the same, i.e., a listed entity can develop criteria that is stricter than what has been provided in the Regulations. However, nothing has been provided regarding the contents of the Policy in the SEBI LODR. Therefore, the Policy is nothing but a replica of what has already been provided in the law, as in order to ensure compliance of the law, listed entities frames policy for determining materiality of subsidiaries based on the contents of the regulations. Thus, the requirement of the policy is limited to ensure compliance of the law.

Can a section 8 company be treated as ‘Material Subsidiary’?

Section 8 Company, as defines in the Act, 2013 are companies that are formed with an object of promoting commerce, art, science, sports, education, research, social welfare, religion, charity, protection of environment or any such other object. These companies are required to apply their profit, if any or other income in promoting their objects and are prohibited from payment of any dividend to its members. Whereas, the benchmark for satisfying the definition of ‘material subsidiary’ is contribution towards consolidated income or net worth of the holding company.

When we consolidate the holding company with a Section 8 company, it will however depict a wrong picture of the wealth of the holding company, as the holding company can never claim any right over the profits of a Section 8 Company. Therefore, the question of consolidation of section 8 with that the holding company does not arise.

Given that the income of a section 8 company cannot be consolidated with that of the listed company or can say that since the performance of a section 8 company has no role to play on the overall performance of the listed company, a section 8 company cannot be treated as a ‘material subsidiary’. 

Concluding Remarks

The term “material subsidiary” has been prioritized over the years because of the impact it may have over the consolidated performance of the listed entity. The principle behind emphasizing absolute numbers of the net worth is the impact of the same on the consolidated figures. Any changes in the income/net worth of these material subsidiaries will be reflected proportionally on the listed entity since the net worth derived from the said material subsidiaries constitutes an integral part of the consolidated net worth of the listed entity. Accordingly, the listed entities should determine the materiality of its subsidiaries wisely and comply with the requirements of SEBI LODR as are applicable on the material subsidiaries.

Our other videos and write-ups may be accessed below:

YouTube:

https://www.youtube.com/channel/UCgzB-ZviIMcuA_1uv6jATbg

Other write-up relating to corporate laws:

http://vinodkothari.com/category/corporate-laws/

Our article on similar topics –

  1. http://vinodkothari.com/wp-content/uploads/2019/04/Final_PPT_on_SEBI_LODR_Amendment_Regulations_2018.pdf
  2. http://vinodkothari.com/2019/02/decoding-large-number-in-case-of-group-governance-policy-under-lodr/

 

[1] Section 2 (87) of the Act

[2] https://www.sebi.gov.in/legal/regulations/may-2018/sebi-listing-obligations-and-disclosure-requirement-amendment-regulations-2018_38898.html

[3] Section 2 (57) of the Act defines net worth as:

“Net worth” means aggregate value of the paid up share capital and all reserves created out of the profits and securities premium 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

 

 

Impairment in case of Lease Transactions

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– Abhirup Ghosh (abhirup@vinodkothari.com)

Background

Like all assets, leased assets also undergo impairment. IAS 36 is the relevant standard for impairment of assets, however, IFRS 9 deals with impairment of financial assets, as well as lease receivables.

Therefore, even though lease transactions are governed by IFRS 16, for impairment of leased assets, one has to refer either of aforesaid standards.

In this article, we will focus on the manner in which leased assets are impaired, especially the way expected credit losses (ECL) could be calculated for lease transactions.

Approach

In the books of the Lessor

The approach of impairment differs with the nature of lease. In case of an operating lease, the lessor recognizes the asset under Property, Plant and Equipment. Therefore, the lease asset capitalized in the books of the lessor has to undergo impairment testing under IAS 36. In addition to that, the lease receivables that fall under the purview of IFRS 9 also have to be tested for impairment. In case of operating leases, only those rentals which are overdue shall undergo impairment testing under IFRS 9.

In case of financial leases, the lessor recognizes only lease receivables in its books. Therefore, there is no question of assessing impairment on the fixed asset in such case; only ECL has to be provided on the lease rentals.

In the books of the Lessee

Unlike the erstwhile standards on leasing, IFRS 16 provides for recognition of Right of Use (ROU) Asset in the books of the lessee, and a corresponding lease liability.

The ROU asset will also have to undergo impairment testing under IAS 36.

Impairment under IAS 36

The requirement to impair an asset under IAS 36 gets triggered only when any of the following indicators are noticed:

a.) External indicators:

  1. Significant decline in market value
  2. Change in technology, market, economic or legal environment
  3. Change in interest rate.
  4. Where the carrying amount is more than the market capitalization

b.) Internal indicators:

  1. Asset’s performance is declining
  2. Discontinuance or restructuring plan
  3. Evidence of physical obsolescence

The standard looks at assets Cash Generating Units, in case of lease transactions, each asset on lease would be treated as CGU for the purpose of this standard.

The impairment loss is calculated based on the carrying value of the asset and the recoverable value.

Recoverable value is the higher of the following:

a.) Fair value of the asset, less cost of disposal

b.) Value in use

Fair value of the asset is arrived at based on the valuation of the asset using appropriate valuation methodologies. From the fair value, cost of disposal has to be reduced, which includes:

  1. Legal costs
  2. Stamp duty and similar taxes
  3. Costs of removing the assets
  4. Incremental costs for bringing the assets into the conditions for its sale
  5. Other costs

The value in use computed based on the present value of all the future cash flows from the asset, discounted at rate which truly reflects the time value of money and the risks specific to the asset. To compute value in use, a risk weighted cash flows approach must be adopted.

There are two ways in which this approach can be adopted – a) by adjusting the cashflows, b) by adjusting the discounting rate.

In the first one, the future cash expected cash flows must be assigned different probabilities of recovery which would corroborate with the risk associated with the asset, and then discount the cash flows at the agreed yield of the transaction.

Alternatively, the instead of assigning probabilities of recovery on the cash flows, the original expected cash flows may be considered, however, the discounting rate may be adjusted to corroborate with the risks associated with the assets.

If the recoverable value of the asset is lower than the carrying amount, then the difference has to be booked as an impairment loss and the carrying amount has to be brought down to that extent.

Impairment under IFRS 9

There are two approaches for computing ECL:

  1. General Approach
  2. Simplified Approach

In the general approach, ECL is computed based on 12-months losses for instruments not showing significant increase in credit risk, and lifetime losses for instruments showing significant increase in credit risk.

In the simplified approach, ECL is computed based on lifetime losses on financial instruments, irrespective of whether it is showing significant increase in credit risk or not. This approach is mandatory for trade receivables not having a significant financing component. This approach is option for lease receivables and trade receivables having a significant financing component.

Therefore, for lease transactions, a reporting entity can opt for either of the two approaches.

General approach

Staging of financial instruments based on different risk categories is one of the key aspects of the general approach. There are three stages:

a) Stage 1 – A financial instrument is classified under Stage 1 at the inception of the transaction, unless the asset is credit impaired at the time of purchase. Subsequently, if the assets do not show significant increase in credit risk, they are classified under Stage 1.

b) Stage 2 – A financial instrument is classified under Stage 2, when it shows significant increase in credit risk. The credit risk on the reporting date is compared with the credit risk at the time of initial recognition.

c) Stage 3 – Lastly, if the financial asset shows objective evidence of impairment, the asset is credit impaired and classified as Stage 3.

For the purpose staging, the following considerations may be taken care of:

  1. Transition – In natural course, before a financial instrument becomes credit impaired or an actual default occurs, it should first show signs of significant increase in credit risk.
  2. Time to maturity – Time to maturity is an important indication of credit risk. For instance, a AAA bond has far more credit risk if the maturity is 10 years as compared 5 years. Therefore, while assessing the credit risk, the shortened remaining time to maturity must be considered. This logic however, may not hold good in case of transactions involving a balloon payment structure or a bullet payment structure, where the major part of the cashflows is concentrated towards the end of the tenure.
  3. What constitutes to be significant increase in credit risk – Usually the assessment of credit risk is left on the risk management division of the reporting entity, however, the standard states that if reasonable and supportable forward-looking information is available without undue cost or effort, an entity cannot rely solely on past due information when determining the credit risk. However, when information that is more forward-looking than past due status is not available without undue cost or effort, an entity may use past due information to determine the credit risk. There is a rebuttable presumption that the credit risk on a financial asset has increased significantly since initial recognition when contractual payments are more than 30 days past due.

An entity can rebut this presumption if it has reasonable and supportable information that is available without undue cost or effort, that demonstrates that the credit risk has not increased significantly since initial recognition even though the contractual payments are more than 30 days past due. However, the Reserve Bank of India in its notification on Implementation of Indian Accounting Standards for NBFCs[1], has stated that in case, the reporting entity wishes to rebut the presumption, then clear justification must be documented, and such shall be placed before the Audit Committee of the Board. However, in any event the recognition of significant increase in credit risk should not be deferred beyond 60 days past due.

Further, when an entity determines that there have been significant increases in credit risk before contractual payments are more than 30 days past due, the rebuttable presumption does not apply.

Once the staging is complete the expected credit losses on the assets depending on their stage.

In case of Stage 1 assets, 12-months credit losses are provided. In case of Stage 2 and Stage 3 assets, lifetime credit losses are provided.

The difference between a Stage 2 and Stage 3 asset is that for the latter, the asset has to be impaired to the extent of the expected credit losses and the showed at net amount.

The graphic below summarises the general approach of ECL.

Simplified approach

In the simplified approach, the concept of staging does not apply. There is no requirement of assessment of significant increase in credit risk. Lifetime credit losses have to be provided.

This is optional for lease transactions, however, if the reporting entity wishes to adopt this approach, it has to be implemented separately on operating and financial leases.

Method of computing ECL on lease transactions

While computing ECL, operating lease and financial leases must be considered separately. While financial leases are financial transactions, hence, akin to loan transactions, operating leases are operating/ rental contracts. However, ECL, in the both cases, are done based on the future expected cash flows from the contract, that is the lease rentals.

The most appropriate approach of computing ECL in case of lease transactions in the “Loss Rate Approach”. In this approach, the ECL is computed based on the Probability of Defaults and Loss Given Defaults. The PD and LGD rates are applied on the Exposure at Default, and subsequently, discounted at the effective interest rate or the yield of the transaction.

Probability of Default

One of the most important components of computing ECL. For entities which follow Internal Risk Based Approach, this is usually an outcome of the IRB. However, where the reporting entity does not follow an IRB approach, a scorecard approach may be adopted for the same.

In a scorecard approach, various factors specific to the asset and the borrower are weighted to assess the credit risk and produce a PD level.

In case of lease transactions, besides the borrower specific factors, the experience in the asset class also must be given sufficient weightage. For example, personal use assets like cars, two-wheelers etc. may be assigned to a lower risk weight, whereas, for assets such as construction equipments, farming equipments, etc. where repayment of rentals depend on the generation of cash flows from the asset, may be assigned a higher risk weight.

Once the credit risk is assessed, the PD level has to be produced through:

  1. Vintage analysis of the assets to understand how default rates change over a period of time;
  2. Extrapolation of the trends, where the default information is not available for the maximum tenure of the exposure.

Usually, PD levels are representation of the performance of similar assets in the past, however, for ECL, a forward-looking approach has to be adopted, and accordingly the PD levels have to be calibrated to give a forward-looking effect.

Alternatively, a simpler approach may be adopted where the reporting entities may rely on internal benchmarking and external ratings to predict a PD level.

Loss Given Default

The loss given default signifies what proportion of the exposure, will actually be lost, should there be a default. The LGD rate is a function of the past trends of recovery of cash flows organically, and also the recovery from the underlying asset.

Therefore, LGD can be denoted as 1 – Recovery Rate.

For determining the LGD of a lease, the following may be considered:

  1. Forecasts of future cash flow recoveries,
  2. Forecasts of future valuation of the leased asset,
  3. Time to realization of the leased asset,
  4. Cure rates,
  5. External costs of realization of the leased asset.

The estimation of the aforementioned may be influenced by several factors, namely, the sector in which the asset is deployed, the geography, nature of asset etc.

Macroeconomic factors and the dependence of the aforesaid factors on the same must also be considered. For examples, situations like flood or drought would impact the recoverability of tractors. Similarly, situations like the pandemic COVID-19, would impact all of the aforesaid factors.

Exposure at Default

This reflects the exposure outstanding periodically for the entire tenure of the loan.

Discounting Rate

Usually, the effective interest rate of the transaction is used for discounting the cash flows and the credit losses.

Period

This refers to the contractual tenure of the facility. While determining the period, the ability of the customer to cancel or prepay, or the lessor’s ability to call the facility must also be considered.

The utilization of each of the factors for computation of ECL has been illustrated with the following numerical example:

Scheduled Cashflows Amort Schedule
Period Cash flows Interest Principal Closing POS
0  ₹ -1,00,000.00  ₹                       –  ₹                –  ₹ -1,00,000.00
1  ₹      25,000.00  ₹           7,930.83  ₹ 17,069.17  ₹     -82,930.83
2  ₹      25,000.00  ₹           6,577.10  ₹ 18,422.90  ₹     -64,507.93
3  ₹      25,000.00  ₹           5,116.01  ₹ 19,883.99  ₹     -44,623.94
4  ₹      25,000.00  ₹           3,539.05  ₹ 21,460.95  ₹     -23,162.98
5  ₹      25,000.00  ₹           1,837.02  ₹ 23,162.98  ₹                0.00
EIR 8%
Computation of ECL
Period EAD PD (Marginal) PD (Cumulative) LGD EIR Marginal ECL
0
1  ₹   1,00,000.00 3% 3% 20% 8%  ₹        555.91
2  ₹      82,930.83 3% 6% 20% 8%  ₹        427.15
3  ₹      64,507.93 3% 9% 20% 8%  ₹        307.84
4  ₹      44,623.94 4% 13% 20% 8%  ₹        263.07
5  ₹      23,162.98 4% 17% 20% 8%  ₹        126.52
12 Month’s ECL  ₹             555.91
Lifetime ECL  ₹          1,680.49

 

EIR Computed using IRR formula
PD and LGD Assumed numbers
Marginal ECL (PD*LGD*EAD)/(1+EIR)^Period

Conclusion

This article only tries to discuss one of the most commonly adopted approach for ECL computation. There could be several variations made to the aforementioned, or different approaches may be adopted. Ultimately, it is the management’s call to decide the approach which best suits the nature of the assets and the customers the entity is the dealing with.

Related articles on the Topic:

  1. Accounting for Lease Transactions
  2. New lease accounting standard kicks off from 1st April, 2019
  3. IMPLEMENTATION OF IFRS-16 IN VARIOUS COUNTRIES
  4. Lease accounting: Operating & Financial Lease distinction set to go from financial year 2019-20
  5. Comparative Analysis of changes in Standards on Leasing over time
  6. FAQs on Ind AS 116: The New Lease Accounting Standard

References:

  1. IFRS 9
  2. IFRS 16
  3. IAS 36
  4. Potential Impairments of Leased Assets and the Right-of-Use Asset under ASC 842 and IFRS 16
  5. Have lease assets become impaired?
  6. Leased Assets: Ongoing impairment considerations
  7. How does impairment look under IFRS 16?

[1] https://www.rbi.org.in/scripts/FS_Notification.aspx?Id=11818&fn=14&Mode=0

AIF Second Amendment Regulations, 2021 – Regulated Steps towards Liberalised Investment

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-Megha Mittal  (mittal@vinodkothari.com)

Amidst the various concerns addressed in the Board Meeting dated 25th March, 2021,[1] the Securities and Exchange of Board of India (‘SEBI’) extensively dealt with several issues identified with respect to Alternative Investment Funds (‘AIFs’), inter-alia a green signal to AIFs for investing in units of other AIFs; ambiguity regarding the scope of the term ‘start-up’; and the need for a code of conduct laying down guiding principles on accountability of AIFs, their managers and personnel, towards the various stakeholders including investors, investee companies and regulators.

Thus, with a view to target the issues in consideration, the Board proposed that the following amendments be introduced in the SEBI (Alternative Investment Funds) Regulation, 2012 (‘AIF Regulations’/ ‘Principal Regulations’)[2] –

  • provide a framework for Alternative Investment Funds (AIFs) to invest simultaneously in units of other AIFs and directly in securities of investee companies;
  • provide a definition of ‘start-up’ as provided by Government of India and to clarify the criteria for investment by Angel Funds in start-ups
  • prescribe a Code of Conduct for AIFs, key management personnel of AIFs, trustee, trustee company, directors of the trustee company, designated partners or directors of AIFs, as the case may be, Managers of AIFs and their key management personnel and members of Investment Committees and bring clarity in the responsibilities cast on members of Investment Committees; and
  • remove the negative list from the definition of venture capital undertaking.

 The aforesaid proposals, put to the fore in view of the suggestions and requests received from several stakeholder groups like the domestic AIFs, global investors, and the regulatory bodies, have now been notified vide notification dated 5th May, 2021, via the SEBI (Alternative Investment Funds) (Second Amendment) Regulations, 2021[3] (‘Amendment Regulations’). A key takeaway from the Amendment Regulations is the flexibility granted w.r.t. indirect investments by AIFs for investment in units of another AIF, however with some riders and possible gaps, as discussed below.

Below we summarise and discuss the amendments introduced vide the Amendment Regulations, and analyse its impact

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Failed Redemption of Preference Shares: Whether a Contractual Debt?

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– Sikha Bansal, Partner and Megha Mittal, Associate (resolution@vinodkothari.com)

Preference shares, as the nomenclature suggests, represent that part of a Company’s capital which carries ‘preference´ vis-à-vis equity shares, with respect to payment of dividend and repayment of capital in case of winding up. However, the real position of preference shares may be quite baffling, given that the instrument, by its very nature, is sandwiched between equity capital and debt instruments.  Although envisaged as a superior class of shares, preference shareholders enjoy neither the voting powers vested with the equity shareholders (true shareholders) nor the advantages vested with debenture-holders (true creditors). As such, the preference shareholders find themselves suspended midway between true creditors and true shareholders – hence facing the worst of both worlds[1].

The ambivalence associated with preference shares is adequately reflected in the manner various laws deal with such shares – a preference share is a part of ‘share-capital’ by legal classification[2], but can be a ‘debt’ as per accounting classification[3]; similarly, while a compulsorily convertible preference share is classified as an ‘equity instrument’[4], any other preference share constitutes external commercial borrowing[5] under foreign exchange laws. Needless to say, the divergent treatment is owed to the objective which each legislation assumes.

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A Guide to Accounting of Collateral and Repossessed Assets

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-Financial Services Team ( finserv@vinodkothari.com )

The purpose of reporting in accordance with International Financial Reporting Standards (IFRS) is to provide financial information about the reporting entity that is useful to various stakeholders in making decisions about providing resources to the entity.

To satisfy the objective of IFRS/Ind AS reporting, to a large extent, based on estimates, judgements and models rather than exact depictions. In other words, the use of reasonable estimates is an essential part of the preparation of financial statements and does not undermine their reliability.

Understanding Collateral

Collateral is one or more assets that a borrower offers to a lender as security for a loan, with the intent that if the borrower defaults in making the promised loan payments, the lender has the right to seize the collateral, sell the same and realise the amounts due. Since collateral offers   a security to the lender should the borrower default, loans that are secured by collateral typically carry lower interest rates than unsecured loans.

Needless to say, secured lending forms a very important segment of the world of finance.

Although the legal rights that flow from collateral are typically specified in the loan agreement, law in some jurisdictions might specify particular overriding rights, obligations, restrictions, etc. In some cases, at the commencement of the loan, collateral is physically transferred from the borrower to the lender. These security interests are called possessory security interests – a pledge is an example of a possessory security interest. There are other types of security interests which are non-possessory, which are known as hypothecation, lien or charge in different jurisdictions. A mortgage in English and Indian law has a different connotation – it creates a property right in favour of the lender to secure the loan; hence, it results into transfer of specific title[1].

Irrespective of the form of collateral, it is clear that collateral is merely security interest, and not property interest. While covenants of security documentation may differ, the most common security document allows the lender to sell or cause the sale of the collateral upon default of the borrower.

Accounting of Collateral

Secured Loans:

When a financial institution (FI) extends a secured facility, it recognises  loan as its asset, as the benefits accruing to the entity would be on account of loan provided. The security would only act as backstop measure in case the performance of the loan deteriorates.  Further, the entity’s interest lies in the loan not in the charged asset.

However, this does not imply that security on a loan would go unnoticed while accounting for the loan asset. Collateral and other credit risk mitigants are important factors in an entity’s estimate of Expected credit losses (ECL).

Consequently, IFRS 7 Financial Instruments: Disclosures specifies that an entity must disclose information that enables users of its financial statements to evaluate the nature and extent of risks arising from financial instruments to which the entity is exposed at the end of the reporting period and how those risks have been managed by the entity (paragraphs 31 and 32). When relevant, an entity’s risk management disclosure would include its policies and procedures for taking collateral and for monitoring the continuing effectiveness of collateral in mitigating counterparty credit risk. Paragraph 35K of IFRS 7 requires information that will enable users of financial statements to understand the effect of collateral and other credit enhancements on the amount of expected credit losses.

The Division III of Schedule III to the Companies Act, 2013 prescribes a separate disclosure for secured and unsecured advances. Further the impairment loss allowance for both asset categories is also presented along with the specific asset  .

In short, disclosure of the collateral and credit enhancements is an important disclosure. The existence of the collateral itself may not change the carrying value of the loan, but it may have repercussions on the value of the ECL, as also, in case of fair-valued loans, on the risk-adjusted value by impacting the credit spread that is deployed as a part of the discounting rate.

Collateral and SPPI test

Simply payment of principal and interest (SPPI) test is one of the two tests that are required to be passed for a financial asset to be classified either as subsequently measured at Amortised Cost or at FVOCI. The test says that the contractual cash flows from the asset, on specified dates, should comprise only of principal payments and interest payments on the principal amount outstanding.

Paragraph BC4.206(b) of the Basis for Conclusions on IFRS 9 explains the IASB’s view that financial assets can still      meeting the SPPI test, i.e., the contractual cash flows may consist solely payments of principal and interest, even though they are collateralised by assets.     . Consequently, in performing the SPPI test an entity disregards the possibility that the collateral might be foreclosed in the future unless the entity acquired the instrument with the intention of controlling the collateral.

Accounting of Repossessed Assets

Assume the following facts: FI had a loan of Rs 1000 outstanding, which was in default. FI forecloses and repossesses the collateral, say a machinery, which is valued Rs 700 on the date of repossession. FI keeps the machinery pending disposal, and on the reporting date, the machinery is still in stock. Eventually, in the next reporting period, the machinery is sold, say for a net realisation of Rs 600.

Several questions arise – on the date of repossession, can FI remove loan to the extent of Rs 700 and debit it to machinery held for sale? What happens to the loss of Rs 100 on the sale – is it loss related to the loan, or loss related to disposal of machinery?

Questions like this are faced by financial institutions all the time.

Though accounting standards provide ample guidance on taking cognizance of collateral, specifically for credit risk assessment and asset recognition, the clarity is lost at the issue of accounting for repossessed assets. Accounting standards do not provide a clear view on how an asset should be treated when the entity enforces its right to foreclose and repossess the asset, and the asset is pending disposal. If the disposal of the asset has already been done, then the question of any accounting for collateral does not arise, as the collateral has already      been disposed off. However, the accounting for the collateral itself, as discussed below, will affect the accounting for the disposal as well.

As regards accounting for the repossession of the collateral, some guidance comes from the Para B5.5.55 of IFRS 9/Ind AS 109 :

“…….Any collateral obtained as a result of foreclosure is not recognised as an asset that is separate from the collateralised financial instrument unless it meets the relevant recognition criteria for an asset in this or other Standards.”

The extract clarifies that mere fact that the asset is repossessed would not make it eligible for being recognised as an asset on the books, as the entity’s interest still lies in recovery loan, the entity would have no interest in the asset if not for dues under the loan.

Further, Para 7 of IAS 16 / Ind AS 16 states that

“The cost of an item of property, plant and equipment shall be recognised as an asset if, and only if:

(a) it is probable that future economic benefits associated with the item will flow to the entity; and

(b) the cost of the item can be measured reliably”

Hence, the FI can capitalise and record only such assets whose future economic benefits would accrure to the financial institution in question, that is, the lender. PPE classification is possible  It may also be possible for an entity to hold the asset as an investment property, for disposal. There may be cases where the collateral may consist of shares, securities or other financial assets, or may consist of stock in trade or receivables.

Irrespective of the type of asset, the key question would be – has the lender acquired a property interest in the collateral, so as to have risks and rewards in the same, or the lender has simply acquired possession over the collateral for causing disposal?

Legal rights in case of collateral

The accounting here is impacted by the legal rights in case of collateral. To  reiterate, we are stating here generic legal position, and it is possible that collateral documents bring rights of the lender which are differential. Further, the legal rights may vary depending upon the kind of security interest being created on the assets, e.g. a pledge would differ from a mortgage.

In the case of Balkrishan Gupta And Ors vs Swadeshi Polytex Ltd[2] the Supreme Court, while also indicating the very distinction between a pawn and a mortgage, observed that even after a pledge is enforced, the  legal title to the goods pledged  would not  vest in the pawnee. the pawnee has only a special  property. A pawnee has no right of foreclosure since he never had absolute ownership at law and his equitable title cannot exceed what  is specifically granted by  law. The right  to property vests in the pledged only so far as is necessary  to secure the debt.[3]

Although, pledge has to be differentiated from a mortgage which wholly passes the thing in the property conveyed[4] However, as noted in     , Narandas Karsondas vs. S.A Kamtam and Anr[5] it is important to note that the mortgagor does not lose the right of redemption until the sale is complete by registration. In selling the property, the mortgagee is not acting as the agent of the mortgagor but under a different (read: superior) claim. No equity or right in property is created in favour of the purchaser by the contract between the mortgagee and the proposed purchaser.

We have mentioned above that the legal rights of a lender differ (a) based on the law of the jurisdiction, as also consistent practices; (b) legal documentation. For instance, in case of mortgage, the common law provides two different rights of a mortgagee – the decree of sale and the decree of foreclosure [Section 67 of Transfer of Property Act, 1882]      Decree of sale implies that the mortgagee may simply cause the sale of the mortgaged property. Decree of foreclosure is foreclosure of the mortgagor’s      right of redemption, and the mortgagee, therefore, becoming absolute owner of the property. There are exceptional circumstances when this is possible, for example, in case of a mortgage by conditional sale.

In case of pledges too, while the general rule as set out in Lallan Prasad vs Rahmat Ali[6]  and GTL Textiles vs IFCI Ltd.[7] is that the pledgee only has the right to cause sale.

In case of US practices, it is quite a common practice of mortgage lenders to hold the foreclosed property as Real Estate Owned.

Thus, there can be two situations:

  • Case 1 – Lender acquires the asset as means of recovery and does not acquire  any risk and reward in the property;
  • Case 2 – Lender acquirers the property in the full and final settlement of the loan.

Our analysis of broad principles is as follows:

Acquisition as means of recovery

The lender could repossess the property as a result of the borrower’s default with the intention securing the possession of the collateral. The seeking of possession of the collateral is simply seeking the custody of the collateral. This is preventive – to ensure that the asset or its value is not  prejudiced. This is intent when a court, receiver, arbitrator or similar agency seeks control over the collateral. The intent is custodial and not proprietary. The actual sale proceeds of the asset, as and when disposed of by the lender, will go to the credit of the borrower; any amounts received in excess of the mortgage balance will be refunded to the borrower; and any shortfall remains the obligation of the borrower.

The FI may continue to charge interest on the outstanding balance. The lender remains exposed to interest rate risk on the  collateral but is not exposed directly to property price risk.

In such cases, there is no question of the loan being set off against the value of the collateral, until the collateral is actually disposed off. While giving the particulars  of the collateral, the lender may separately classify collateral in possession of the lender, as distinct from collateral which is in possession of the borrower or third parties. However, the classification of the loan remains unchanged.

Acquisition of proprietary interest in the collateral:

The lender could repossess the property, which in terms of the law or contract, gives the lender absolute rights in the property. The lender may have the right to collect the unrealised amount from the borrower, or the obligation to refund the excess, if any,  realised, but the issue is, does the lender acquire proprietary interest in the collateral, and whether the lender now is exposed to the risks and rewards, or the variability in the value of the collateral?

However, FASB has prescribed following guidelines to determine whether the charged asset would replace the loan asset. The FASB guidance on Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure[8]  provides that “a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan, upon either upon

(1) the creditor obtaining legal title to the residential real estate property upon completion of a foreclosure or

(2) the borrower conveying all interest in the residential real estate property to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. “

In line with above, where the entity has acquired complete right over the asset there is no doubt that the loan account is closed, and the entity now hold interest entirely in the repossessed asset. Hence the company shall derecognise the loan asset and recognise the charged asset in their books. Whether the asset will be a real asset, financial asset, stock in trade, receivables, PPE or other investment property, will depend on the asset and the intent of the entity in holding it till disposal.

Accounting for repossession of the collateral:

In the above case, the entity should fair value the collateral on the date of seeking repossession, and to the extent of the fair value, the asset should be debited, crediting the loan. Whether the asset will continue to be subjected to fair valuation, or historical cost valuation, will depend on the applicable accounting standard for the type of asset in question.

any subsequent movement in the value of the collateral will affect the entity, and not the borrower.

Conclusion

Given the current stress in the economy, the rates of default on loans collateralized by all kinds of properties – residential real estate, commercial real estate, vehicles, consumer durables, etc., have zoomed up. There will be substantial collateral calls in time to come, and therefore, the need to have clarity on accounting for collateral is more today than ever before.

This article has tried to fill an apparent gap in literature on accounting for collateral. We will want to develop this article further, with numerical examples, by way of further updates.

[1] Different forms of security interests are discussed at length in Vinod Kothari: Securitisation, Asset Reconstruction and Enforcement of Security Interests. Lexis Nexis publication

[2] Balkrishan Gupta And Ors vs Swadeshi Polytex Ltd

[3] Gtl Limited vs Ifci Ltd

[4] Lallan Prasad vs Rahmat Ali

[5] Narandas Karsondas vs. S.A Kamtam and Anr

[6] Lallan Prasad vs Rahmat Ali

[7] GTL Textiles vs IFCI Ltd

[8] FASB guidance on Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure

 

Funding through crowdfunding platform: whether qualifies to be CSR?

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-Platforms different from implementing agency

-Pammy Jaiswal, Partner and Sachin Sharma, Executive (corplaw@vinodkothari.com)

Crowdfunding Platforms

Crowdfunding platforms are digital platforms which solicit funds for various ventures. They pave way for easy accessibility to a vast network of people through social media. Individuals, charities or companies can create a campaign for specific causes for contribution from anyone, either a corporate, or an association, or an individual. Two broad classes of crowdfunding platforms are: investment-based, which consists of stocks, royalties, and loans, where the funders are investors in a campaign and can obtain monetary benefits. The other is donation-based, where funders do not expect monetary compensation. They fund a campaign because they support its cause. For understanding the concept on crowdfunding in detail, kindly refer to our article here.

Crowd sourcing has become an important aspect for carrying out CSR activities[1]. Around 27% of the crowdfunding campaigns are initiated to cover medical expenses. Several crowdfunding platforms are running parallelly across India as well as the world. Some of the Indian crowdfunding platforms include Impactguru, Milaap, Ketto, etc. As the world is under the grip of COVID- 19, these platforms are playing their remarkable role in sourcing funds for COVID-19 relief through several campaigns. Till now, Ketto has raised ₹324.60cr for its COVID relief campaigns whereas Milaap has raised ₹182.47Cr and Impact Guru has raised ₹61.46cr for their COVID relief campaigns. Further, crowdfunding platforms are not only popular in India but also across the world. Several global platforms are also working to raise funds for various projects/ campaigns. Global Giving collection in its Coronavirus Relief Fund has moved to $13,363,987.

 Growth in transactions of crowdfunding platforms

The crowdfunding platforms have attained greater visibility and importance in India as well as globally as per the statistics[2] given below-

 

 

 

The first figure corresponds to the Indian position and the second figure pertains to global statistics.

What is an ‘Implementing Agency’ (IA)

The term IA has not been defined under the CSR provisions (section 135 of the Companies Act, 2013 as well as the rules made thereunder), however, the report on CSR activities uses the term IA for carrying out CSR indirectly.

IA, as the name suggests is an implementation tool for the entity to carry out its CSR activities. As per Rule-4(1) of the Companies (Corporate Social Responsibility Policy) Rules, 2014, section 8 companies, registered public trusts, and registered societies (collectively, called ‘entities’) can be referred to as IAs. The nature or activities of an IA can be distinguished from that of a beneficiary through a very thin line. Our article containing the detailed discussion on the same can be read here.

While carrying out CSR activities through an IA, there are several things that a company needs to consider after the amendment under the CSR provisions have been notified on 22nd January, 2021. They include:

  • IA which includes a section 8 company, public charitable trusts, or a society either formed by the company or otherwise needs to be registered under section 12A and 80G of the IT Act;
  • All IAs, are required to register themselves with MCA by filing e-form CSR-1; and
  • IAs which include a section 8 company, public charitable trusts, or a society not formed by the company require a track record of three years in carrying out similar CSR projects.

Crowdfunding platform working as a connecting point

Crowdfunding Platforms simply acts as connecting point between CSR contributors and CSR opportunities. It neither gets into implementation nor acts as agent for implementation, it acts merely as a connection point.

Deprived of the crowd sourcing mechanism, each company would have to look for its own sources for their CSR activity which will be a very inefficient way for carrying out CSR. India is a vast country and therefore huge number of CSR opportunities are present where each company would like to carry out its CSR obligations strategically so as to fulfil their CSR objectives. Crowdfunding platforms have filled up the information asymmetry and plays a role of an information bridge similar to what media does. Since it does not go into the implementation role at all, there is nothing wrong in routing/ using such platforms for carrying out CSR activities.

How is a crowdfunding platform different from being an IA?

An IA is regarded to work as an extended arm of the company in carrying out CSR activities. The whole purpose of involving an IA is to relieve the company from using its time to identify reliable projects and programs wherein the funds may be used or allocated. Another reason to involve an IA for carrying out CSR is that the company may not have the requisite expertise and experience to shortlist the authentic activities or entities where the money can be spent.

Having said that, on the other hand, a crowdfunding platform does not work as an extended arm of the company, rather, it is a voluntary body which acts a connecting point between the IA/ beneficiary and the company. It does not have the liberty to allocate the money in the project of its own choice, rather, the fund giver chooses the exact project or IA where it wants the money to be used.

Further, to be eligible to carry out CSR activities as an IA, registration with the MCA and under IT Act (except for govt entities and those set up under an Act of Parliament or State Legislature) is necessary while crowdfunding platforms may be relieved from such mandatory requirement considering its role as a connecting point between the fund raiser and the fund giver. Therefore, crowdfunding platforms cannot be regarded as IA.

The third point of difference between the two is when a CSR activity is routed through the IA, monitoring and utilisation report is required to be supplied by such IA to the Company. Whereas, when funds are contributed through crowdfunding platform, the ultimate beneficiary or IA which takes the funding, is liable to provide a utilisation report to the fund giver.

Features of the crowdfunding platform which distinguishes it from an IA

As discussed above, a crowdfunding platform acts as a medium to connect the contributor and the contribute. If it also relevant to understand the extent these crowdfunding platforms differ from an IA.

We have gone through the websites of several crowdfunding platforms and have presented a tabular presentation of areas where they are different from becoming an IA.

Basis Ketto[1] ImpactGuru[2] Milaap[3] Role of IAs
Accountability It shall not in any manner be responsible or held accountable for any transaction between the Users. No obligation to become involved in disputes between any Users, or between Users and any third party arising in connection with the use of the Site Assume no responsibility to verify whether the Donations are used in accordance with any applicable laws, and such responsibility rests solely with the Champion or Charity, as applicable Accountable to the companies donating the funds.
Utilisation of funds It is merely an intermediary and does not interfere in the transaction between Donors / Contributors and Campaigner Not responsible in any way whatsoever towards the end utilization of funds Facilitates the Donation transaction between Champions and Donors, but is not a party to any agreement between a Champion and a Donor, or between any user and a Charity. It decides the areas and entities where funds are to be allocated
Obligations or liabilities wrt funds collected Does not hold any right, title or interest over the funds or rewards or have any obligations or liabilities in respect of such providing the same to the Donor / Contributor Does not take any responsibility for making sure that the project for which the funds are raised through its Site is completed and made available to the Funders No control over the conduct of, or any information provided by a Champion or a Charity, and Milaap hereby disclaims all liability in this regard Liable if the same remains unspent or not spent within the permitted activities. Utilisation reports have to be shared signifying the utilisation of funds for permitted activities
Liability for correctness of information on the platform Not liable Not liable Not liable Liable
Responsibility for success/ outcome of the project Not liable Not liable Not Liable Liable
Verification whether funds are used as per applicable laws or fund-raising purpose Responsibility on the Campaigner Responsibility on the Campaigner Responsibility on the Campaigner Responsibility on the IA

Safeguards/ points of consideration in funding through the platform

  1. Funds are going to the beneficiary directly:

The fund is put directly from the crowdfunding platform to the beneficiary’s account and no third party is involved here. In this, it becomes a case of direct CSR activity. Utilisation report is required.

  1. Funds are going to another IA (registered):

Where the funds raised by crowdfunding platform goes to an entity registered as an IA with MCA, monitoring as well as utilization report will be required

  1. Funds are going to another IA (registered) which itself carries out CSR activities:

Where the fund raiser is a registered IA, however, carries out the CSR activities itself, it will be a case of direct CSR and not through an IA.

Conclusion

 Crowdfunding platforms are emerging as promising sources for business houses to fulfil their CSR goals. These platforms should be expected and at the same time be bound by the mandatory registration provisions with the MCA since their role is not be act as an IA but a mere platform where fund raisers and fund givers can meet.

Ministry of Corporate Affairs (MCA) vide several circulars have brought several relaxations and broad based the activities under Schedule VII in relation to COVID-19 and health care.

Looking at the ongoing era of the pandemic, it has become very common for several digital platforms to come forward and act as source of link between the agencies/ beneficiaries and the corporates for several activities which are also covered under Schedule VII of the Companies Act, 2013.

Our other resources on CSR can be read here

[1] Read more here

[2] https://www.statista.com/outlook/dmo/fintech/alternative-financing/crowdfunding/worldwide?currency=INR

[1] https://www.ketto.org/terms-of-use.php

[2] https://www.impactguru.com/terms-of-use

[3] https://milaap.org/about-us/terms-and-conditions