Analysis of Companies (Amendment) Act, 2019

Lease Accounting under IFRS 16- A leap towards transparency!

Megha Mittal

mittal@vinodkothari.com

Our mission is to develop IFRS Standards that bring transparency, accountability and efficiency to financial markets around the world”, the International Accounting Standards Board (IASB) is indeed on a way towards fulfilling its mission. The International Financial Reporting Standards (IFRS) have been worldwide acknowledged and appreciated as a benchmark of transparency, trust and growth. In another specimen of its attempt to increase transparency in financial markets around the world, the IASB, back in 2016, introduced the IFRS 16, to be applicable w.e.f. annual reporting period beginning on or after 01.01.2019.

Introduced with the objective of introducing a single lessee accounting model, the IFRS-16, aims at ensuring faithful representation of lease transactions and pioneers the concept of “Right-to-Use” Assets.

In this article, we intend to delve deeper into what IFRS-16 brings to the table, its objective and most importantly its impact.

Understanding the Concept

In the present financial set-up of our economy and business environment, “Lease” is an indispensable element. With the advantages it carries and the flexibility it has provided to financing, the concept of lease has penetrated to every strata of being. However, from an accounting perspective, the nexus of “lease” with “assets” makes it essential to understand the procedure of incorporating the lease transactions in the books of both the lessor (legal owner of the asset) and the lessee (user of the asset); and, IFRS-16 is the answer.

While it does not modify the accounting treatment in the books of the lessors from that laid down in IAS 17, IFRS-16 introduces a single lessee accounting model and requires a lessee to recognise assets and liabilities for all leases with a term of more than 12 months, unless the underlying asset is of low value. A lessee is required to recognise a right-of-use asset representing its right to use the underlying leased asset and a lease liability representing its obligation to make lease payments.

To understand better, let us now take an illustration:

Illustration 1:

A is the legal owner of a car. B, a small businessman, intends to take the car on lease for a period of 3 years. Here, A becomes the Lessor, and B, steps into the shoes of a Lessee. Now that B has the right to use the car, he must identify this car as a right-to-use asset, more colloquially knows as RTU Asset.

Hence, the Lessee records the car along with other non-financial assets like property, plant and building, and the lease liabilities along with other liabilities. It is pertinent to note that the RTU asset must however, be recorded at its present value, arrived at by discounting at its Internal Rate of Return (IRR). As a result, the lessee also recognises depreciation of the RTU Asset and interest on the lease liability in its Statement of Profit and Loss.

Rationale behind IFRS-16:

By what can be called the “5 Rule Check”, IAS 17, distinguishes leases into two broad classesviz. Operational and Financial Leases. While the leased assets wererecorded in the books of the lessor, in case of both operational and financial leases; as per IAS 17, an operational lease in the books of a lessee was treated as an “off-balance sheet” item. Regards the objective with which the new standard was introduced, IASB Chairman, Mr. Hans Hoogervorst, said that “These new accounting requirements bring lease accounting into the 21st century, ending the guesswork involved when calculating a company’s often-substantial lease obligation. The new standard will provide much-needed transparency on companies’ lease assets and liabilities, meaning that off balance sheet lease financing is no longer lurking in the shadows. It will also improve comparability between companies that lease and those that borrow to buy.

Hence, it is clearly a step towards IASB’s vision of transparency, accountability and efficiency.

Impact:

Put simply, IFRS 16 eliminates the distinction between operational and financial lease in the books of a lessee. We shall now analyse its impact in the real field and compare the outcome with the expectations.

Overall Impact:

On the surface, the accounting treatment will have a knock-off effect on financial elements; for instance, Earnings before Interest, Tax, Depreciation & Amortization (EBITDA) and Profit After Tax (PAT).

Let us understand this effect with the help of an illustration:

Illustration 2:

A Ltd., an aviation company, has taken on lease, aircrafts worth Rs. 1000 crore, having residual value (RV) 20%, for 36 months, @ 12% p.a., having revenue of Rs. 15,000 crore

On the basis of the above information, we get the following:

  • Lease Rental p.a. : Rs. 342.86 crores
  • Right to Use Asset (RTU) : Rs. 860.22 crores
  • Depreciation on RTU Asset (on SLM Basis) : Rs. 286.74 crores
  • Annual Interest @ 12% p.a. : Rs. 89.59 crores

Now let us compare the impact of the accounting treatment under IAS 17 vs. IFRS 16:

Note: Unlike IFRS-16, under IAS 17, the entire operating lease transaction remains to be an off-balance sheet transaction. Under IFRS 16, the RTU less depreciation is recorded under the assets side vis-à-vis. Lease payables under the liabilities head.

Hence, as evident from the above illustration, sum towards rentals (fixed cost) under IAS 17, have now been substituted with Interest obligation under IFRS 16, and as such the EBIDTA is higher in the initial years. Further, recording the asset at RTU value also gives way for depreciation, and hence, as a result of depreciation along with interest, the PBT reduces in the initial years. From a bird’s eye view, both the assets and liabilities of the lessees adopting IFRS 16 will increase.

Re-negotiation of Loan Covenants:

Further, now that the lease assets are to be recorded, it will typically result in companies appearing to be more debt leveraged; however, since leases are most likely on the operating transaction side vis-à-vis loan transactions, this is not the true picture. This pseudo-presence of huge liabilities is also likely to take a toll on the lessee’s credit rating. Hence, formal communication with the lenders will become a matter of concern, and a sound two-way communication and transparency with the lenders will be the key to managing the transition from IAS 17 to IFRS 16, smooth and efficient.

Industry-wise Impact:

With the first quarter of F.Y. 2019-20 embarking the first quarter of implementation of IFRS 16, the author makes a humble attempt to study the impact, on the basis of financial results declared by several industry-majors.

BPM Industry-

According to a study by Cushman & Wakefield in June 2019, the Indian markets show a strong presence in office space leasing. It has also been observed that the IT-BPM sector, has a higher share in office lease activities, as compared to its contemporaries. Hence, it is evident that the “leasing” is an essential element in the BPM industry.

As the Mumbai-based BPM giant, WNS Global announced its first quarter results; we observe that while the operating profit increased as a result of IFRS 16, the profit for the quarter has decreased. This increase in the operating margins comes to picture as fixed costs reduce with interests of lease payments replace the rentals; the counter result of which is the increase in finance costs due to which the ultimate profit dips.

It is said that the three objectives of any business is Survival, Profit and then Growth. However, as may be seen from above, application of IFRS 16 has led to fall in the profit. It is apprehended that the fall in profit may hold back companies, in the BPM sector from continuing office-space leasing.

Aviation Industry-

Ever imagined that the airplanes we fly in, are most likely not even present on the company’s balance sheet? This non-appearance in the balance sheets was the outcome of accounting standards laid down under IAS 17. However, with IFRS 16 in the picture, the new financial year will be different from previous fiscals, especially for the aviation industry, as they now have to record all lease transactions in their books.

Adopting IAS 116, the Indian counterpart of IFRS 16, the airline industries now have to capitalise operating leases as RTU assets. While recording lease transactions and its by-products like interest, depreciation, the impact will majorly depend on factors like

  • Proportion of operating lease in the overall asset pool;
  • Duration of leases.

With leasing forming an indispensable element of airline companies, even though accounting should not be the key driver in commercial negotiations, market behaviour might change towards shorter lease tenures to minimize lease liabilities.

Owing to the fall in profits in the initial years, it is expected that there might be fall in operating leases, and sale & lease-back arrangements, which will prompt the airlines to purchase more aircrafts. Mr. Wui Jin Woon, Head of Aviation, Asia Pacific, Natixis CIB, also said that “Airline with sufficient access to liquidity may be more incline to purchase now that there is no difference from an accounting perspective between operating and finance leases.

However, adopting IAS 116, the Indian counterpart of IFRS 16, the airline industry major, IndiGo stated that while there might be changes in the future reported profits, which may necessitate a change in current P/E based valuation methodology, it will not impact IndiGo’s cash profits, cash flows and growth strategy.

Hence, while there is broad consensus on how the standard will affect various financial metrics, there is considerably less agreement on how it might influence operating decisions and market sentiments.

Communication Industry:

Most Communications companies enter into lease agreements both as lessors and lessees, as such, leases in the industry are prevalent. The new standard is likely therefore to have a material impact for Communications companies.

Arrangements which may contain leases could include – customer contracts for using identified network or infrastructure equipment, equipment provided to customers through which the operator delivers communication services such as set top boxes and modems, and data centre services etc.

As a consequence of IFRS 16, the potential business impact could include renegotiation of network development and network sharing agreements. Further, companies already having large asset bases, may be prey to the impairment risk with the addition of further assets in the balance sheet.

Automobile Industry

(a) Corporate Car Leasing

Corporate Car Leasing is a very innovative employee benefit scheme that has cropped up off late. Under this scheme, big corporates provide its employees, car taken on operational lease, which the end of tenure is sold to the employee at a nominal value.Hence, while the car is essentially for the benefit of the employees, the company is the actual lessee. As this set up was in the nature of an operating lease, the lessee, as per IAS 17, was not required to record the car in its balance sheet.

However, will the roll in of IFRS 16, the corporates will be required to record these cars at their RTU as assets and a corresponding lease liability in their books; as a result of which, the balance sheet of the corporate shall increase manifold.

(b) Fleet Management

In the Fleet Management market, leasing, especially operating lease has proven to be a smart move to optimise its costs and maintain adequate ratios, as until now, it was not required to be recognized in the balance sheet of the lessee.

Murray Price, managing director of EQSTRA Fleet Management said, “These include the impact on the company’s financial report, key ratios, disclosures, the cost of implementation, the ability to access desired information, the impact of covenants and debt renegotiations and leasing strategies.

This magnification of balance sheet, by virtue of change in accounting policies is anticipated to be detrimental to this industry. It is expected that this will hold back corporates from entering into such arrangements.

Change in the Lessors’ Approach:

Like every action has a reaction, even though IFRS 16 does not essentially alter or modify accounting methodologies adopted by the lessors,  the lessors may be impacted in their business models due to change in lessees’ behaviour. From the foregoing, a common thread that can be observed is that lessees having better liquidity, will now tend to incline towards purchasing the assets rather than leasing, as such, lessors may be required to revaluate the current portfolio of leases and prospective targets to identify lessees that may seek to alter their strategies as a result of IFRS-16.

Global Scenario:

Moving ahead from the industry wise acceptance, we shall now see how the new standard has been welcomed at the global level.While India has come up with IAS 116, drawn on the same lines and principles as IFRS 16, the United stated shall continue to follow ASC 842, dealing with the same subject.

Further, barring variances in implementation due to local regulatory requirements, IFRS 16 has been relatively consistently adopted in most of the Asia-Pacific markets. In Hong Kong, for example, most companies have a December financial year-end and submit financial statements to in around August in the following year. IFRS 16 impacts may become more apparent when listed companies release interim results in July 2019.

In Australia, most year-ends are in June, so some companies will not technically need to grapple with IFRS 16 until the second half of 2019.Similar patterns are evident in Singapore, Malaysia, India and the Philippines, where common accounting periods and reporting practices mean many companies won’t have to address IFRS 16 until later in the year.

The equivalent standards in Thailand and Indonesia are not effective until January 2020. In China, the Ministry of Finance only released the local version of the standard in December 2018, giving non-listed companies up to 2021 to adopt.

Conclusion:

Given the gravitas and indispensable presence of leases and the fact that it resides on such a large scale ground, to judge with certainty, the impact of IFRS 16 certainly requires more time. The dust around the same has not settled yet, hence one can say the picture is not yet vivid; however, it surely sets up the pace for what might unveil in days to come.

Ind AS vs Qualifying Criteria for NBFCs-Accounting requirements resulting in regulatory mismatch?

-Financial Services Division and IFRS Division,  (finserv@vinodkothari.com  ifrs@vinodkothari.com)

The transition of accounting policies for the non-banking financial companies (NBFCs) is on the verge of being completed. As was laid down in the implementation guide issued by the Ministry of Corporate Affairs, the Indian Accounting Standard (Ind AS) was to be implemented in the following manner:

Non-Banking Financial Companies (NBFCs)
Phase I

 

 From 1st April, 2018 (with comparatives for the periods ending on 31st  March, 2018)
·         NBFCs having net worth of rupees five hundred crore or more (whether listed or unlisted)
·         holding, subsidiary, joint venture and associates companies of above NBFC other than those already covered under corporate roadmap shall also apply from said date
Phase II From 1st April, 2019 (with comparatives for the periods ending on 31st March, 2019)
·         NBFCs whose equity and/or debt securities are listed or in the process of listing on any stock exchange in India or outside India and having net worth less than rupees five hundred crore

 

·         NBFCs that are unlisted companies, having net worth of rupees two-hundred and fifty crore  or more but less than rupees five hundred crore
·         holding, subsidiary, joint venture and associate companies of above other than those already covered under the corporate roadmap
· Unlisted NBFCs having net worth below two-hundred and fifty crore shall not apply Ind AS.

· Voluntary adoption of Ind AS is not allowed (allowed only when required as per roadmap)

· Applicable for both Consolidated and Individual Financial Statements

As may be noted, the NBFCs have been classified into three major categories – a) Large NBFCs (those with net worth of ₹ 500 crores or more), b) Mid-sized NBFCs (those with net worth of ₹ 250 crores – ₹ 500 crores) and c) Small NBFCs (unlisted NBFCs with net worth of less than ₹ 250 crores).

The implementation of Ind AS for Large NBFCs has already been completed, and those for Mid-sized NBFCs is in process; the Small NBFCs are anyways not required implementation.

The NBFCs are facing several implementation challenges, more so because the regulatory framework for NBFCs have not undergone any change, despite the same being closely related to accounting framework. Several compliance requirements under the prudential norms are correlated with the financial statements of the NBFCs, however, several principles in Ind AS are contradictory in nature.

One such issue of contradiction relates to determination of qualifying assets for the purpose of NBFC classification. RBI classifies NBFCs into different classes depending on the nature of the business they carry on like Infrastructure Finance Companies, Factoring Companies, Micro Finance Companies and so on. In addition to the principal business criteria which is applicable to all NBFCs, RBI has also laid down special conditions specific to the business carried on by the different classes of NBFCs. For instance, the additional qualifying criteria for NBFC-IFCs are:

(a) a minimum of 75 per cent of its total assets deployed in “infrastructure loans”;

(b) Net owned funds of Rs.300 crore or above;

(c) minimum credit rating ‘A’ or equivalent of CRISIL, FITCH, CARE, ICRA, Brickwork Rating India Pvt. Ltd. (Brickwork) or equivalent rating by any other credit rating agency accredited by RBI;

(d) CRAR of 15 percent (with a minimum Tier I capital of 10 percent)

Similarly, there are conditions laid down for other classes of NBFCs as well. The theme of this article revolves the impact of the Ind AS implementation of the conditions such as these, especially the ones dealing with sectoral deployment of assets or qualifying assets. But before we examine the specific impact of Ind AS on the compliance, let us first understand the implications of the requirement.

Relevance of sectoral deployment of funds/ qualifying assets for NBFCs

The requirement, such as the one discussed above, that is, of having 75% of the total assets deployed in infrastructure loans by the company happens to be a qualifying criteria. IFCs are registered with the understanding that they will operate predominantly to cater the requirements of the infrastructure sector and therefore, their assets should also be deployed in the infrastructure sector. However, once the thresholds are satisfied, the remaining part of the assets can be deployed elsewhere, as per the discretion of the NBFC.

The above requirement, in its simplest form, means to have intentional and substantial amount of the total assets of the NBFC in question to be deployed in the infrastructure area, both, at the time of registration, as well as a regulatory requirement, which has to be met over time. Breaching the same would result in non-fulfilment of the RBI regulations.

Impact of Ind AS on the qualifying criteria

The above requirement might seem simple, however, with the implementation of Ind AS on NBFC, there can be important issues which might result in the breach of the above requirement.

With the overall slogan of “Substance over Form”, and promoting “Fair Value Accounting” and an aim to make the financial statements more transparent and just, Ind AS have been implemented. However, the same fair value accounting can result in a mismatch of regulatory requirement, to such an extent that the repercussion may have a serious impact on the existence of being an NBFC.

As already stated above, once an NBFC satisfies the qualifying criteria, it can deploy the remaining assets anywhere as per its discretion. Let us assume a case, where the remaining assets are deployed in equity instruments of other companies. All this while, under the Indian GAAP, investments in equity shares were recorded in the books of accounts as per their book value, but with the advent of Ind AS, most of these investments are now required to be recorded on fair values. This logic not only applies in case of equity instruments, but in other classes of financial instruments, other than those eligible for classification as per amortised cost method.

The problem arises when the fair value of the financial instruments, other than the NBFC category specific loans like infrastructure loans, exceed the permitted level of diversification (in case of IFC – 25% of the total assets). Such a situation leads to a question whether this will breach the qualifying criteria for the NBFC. A numeric illustration to understand the situation better has been provided below:

Say, an NBFC-IFC, having a total asset size of Rs. 1,000 crores would be required to have 75% of the total assets deployed in infrastructure loans i.e. Rs. 750 crores. The remaining Rs. 250 crores is free for discretionary deployments. Let us assume that the entire Rs. 250 crores have been deployed in other financial assets.

Now, say, after fair valuation of such other financial assets, the value of such assets increases to ₹ 500 crores, this will lead to the following:

Under Indian GAAP Under Ind AS
Amount

(in ₹ crores)

As per a % of total assets Amount

(in ₹ crores)

As per a % of total assets
Infrastructure Loans 750 75% 750 60%
Other financial assets 250 25% 500 40%
Total assets 1000 100% 1250 100%

 

Therefore, if one goes by the face of the balance sheet of the NBFC, there is a clear breach as per the Ind AS accounting, as the qualifying asset comes down to 60% as against the required level of 75%. However, is it justified to take such a view?

The above interpretation is counter-intuitive.

It may be noted that the stress is on “deployment” of its assets by an IFC. Merely because the value of the equity has appreciated due to fair valuation, it cannot be argued that the IFC has breached its maximum discretionary investment limits. The deployment was only limited to 25% or so to say that even though the fair value of the exposure has gone up but the real exposure of the NBFC is only to the extent of 25%. Under Ind AS, the fair value of an exposure may vary but the real exposure will remain unchanged.

Taking any other interpretation will be counter-intuitive. If the equity in question appreciates in value, and if the fair value is captured as the value of the asset in the balance sheet, the IFC will be required to increase its exposure on infrastructure loans. But the IFC in question may be already fully invested, and may not have any funding capability to extend any further infrastructure loans. Under circumstances, one cannot argue that the IFC must be forced to disinvest its equities to bring down its investment in equities, particularly as the same had nothing to do with “deployment” of funds.

This is further fortified by Para 10. Accounting of Investments, Chapter V- Prudential Regulations of the Master Direction – Non-Banking Financial Company – Systemically Important Non-Deposit taking Company and Deposit taking Company (Reserve Bank) Directions, 2016 about valuation of equities:

“Quoted current investments for each category shall be valued at cost or market value whichever is lower”.

Hence, the RBI Regulations have been framed keeping in view the historical cost accounting. There is no question of taking into consideration any increase in fair value of investments.

Conclusion

Therefore, it is safe to say that while determining the compliance with qualifying criteria, one must consider real exposures and not fair value of exposures as the same is neither in spirit of the regulations nor seems logical. This will however be tested over time as we are sure the regulator will have its own say in this, however, until anything contrary is issued in this regard, the above notion seems logical.

ICSI Auditing standards -A guidance to the Members in Practice

By Kanakprabha Jethani | Executive

Kanak@vinodkothari.com

Background

ICSI has recently issued four Auditing Standards[1] (‘Standards’) for the members in practice namely:

  • CSAS-1 – Auditing Standard on Audit Engagement
  • CSAS-2 – Auditing Standard on Audit Process and Documentation
  • CSAS-3 – Auditing Standard on Forming of Opinion
  • CSAS-4 – Auditing Standard on Secretarial Audit

in order to enable them to carry out the audit engagements more effectively. The first three Standards will be applicable to all kind of audit engagements and the fourth one will specifically be applicable for the Secretarial Audit under Section 204 of the Companies Act, 2013. In terms of ICSI’s own language, the Standards shall be mandatorily effective from the audit engagements accepted on or after 1st April, 2020.

Objective of the Standards

Seemingly, ICSI is seeking to promote best auditing practices, uniformity and consistency in conduct of the audits by the members in practice. These are expected to strengthen the audit process and corporate governance practices. Since, varied audit practices are being carried over by different auditors, monitoring of audit process becomes cumbersome and troublesome at the same time. These Standards are expected to harmonise the audit practices among the auditors all over the country. The objective is to streamline and enable members to effectively undertake secretarial audit and ensure compliance. It is also expected that these Standards will enhance the quality of compliance.

Applicability of Standards

These Standards shall be effective and recommendatory to be accepted by the auditors on or after 1st July 2019. However, the same shall be mandatorily applicable to the audit assignments obtained on or after 1st April 2020.

Whether these Standards are statutorily required?

In order to be statutorily applicable and binding, legal backing to the provision is required. For example, for the Secretarial Standard-1 and secretarial Standard-2 have a backing of legal provision i.e. Section 118 of the Companies Act 2013. Section 118(10) provides that every company shall observe secretarial standards with respect to general and Board meetings specified by the Institute of Company Secretaries of India. In compliance of aforesaid section, companies follow these two secretarial standards. The same is not the case for other secretarial standards issued by ICSI such as, Secretarial Standard -3 relating to Dividend or Secretarial Standard-4 relating to maintenance of registers and records and hence purely voluntary.

Likewise, the Auditing standards issued by ICSI also do not carry a legal backing as of now though the same is being brought in by ICSI with an intent to make it mandatory.

What are the various audits a PCS can undertake?

A Practising Company Secretary is authorised to undertake various audits as prescribed under the Companies Act 2013, SEBI regulations and other applicable laws, some of which are as under:

  • Secretarial Audit as per provisions of Section 204 of the Companies Act 2013;
  • Half-yearly certificate certifying that all share certificates were issued by Share transfer Agent/ Registrar and transfer Agent within 30 days of lodgement of transfer as provided under regulation 40(9) of SEBI(Listing Obligations and Disclosure Requirements) Regulations;
  • Annual Secretarial Compliance Report as per SEBI Listing Regulations;
  • Half-yearly certification of maintenance of 100% asset cover for non-convertible debt securities as per regulation 56(d) of SEBI(Listing Obligations and Disclosure Requirements) Regulations;
  • Certificate regarding compliance of conditions of corporate governance as per SEBI Listing Regulations;
  • Share Reconciliation Certificate as per SEBI (Depositories and Participants) Regulations, 2018 etc.

These Standards shall be applicable to all these audits along with any other audit required to be done by PCS. Thus, for the purposes of these Standards, ‘Auditor’ shall mean a Practising Company Secretary undertaking any of such audits.

The list of TO DO’s for auditors

CSAS-1 – AUDITING STANDARD ON AUDIT ENGAGEMENT

This deals with roles and responsibilities of Auditor undertaking audit engagement. They also elaborates procedures and principles for entering into agreement with appointing authority.

Eligibility to take audit engagement

  • Auditor shall not hold, singly or along with partners, spouse, parent, sibling, and child of such person or of the spouse, any of whom is either dependent financially on such person, more than 2% in the paid up share capital or shares of nominal value of Rs. 50,000, whichever is lower or more than 2% voting power in the Auditee, as the case may be.
  • Auditor shall not be indebted to the Auditee for an amount of five lakh rupees or more except if such indebtedness is arising out of ordinary course of business.
  • If an Auditor was in employment of the Auditee, its holding or subsidiary company and 2 (two) years must have lapsed from the date of cessation of employment.

Things to do pursuant to CSAS-1:

  • Ensure that appointment is made as per provisions of Companies Act 2013 and rules made thereunder.
  • Submit eligibility certificate to appointing authority.
  • Obtain audit engagement letter and copy of resolution passed by appointing authority and provide acceptance thereto.
  • Ensure audit engagement letter includes:
  1. The objective and scope of the audit; if the same has been established by law, reference to relevant provisions must be stated.
  2. The responsibilities of the Auditor and the Auditee;
  3. Written representations provided and/or to be provided by the Management to the Auditor, including particulars of the Predecessor or Previous Auditor;
  4. The period within which the audit report shall be submitted by the Auditor, along with milestones, if any;
  5. The commercial terms regarding audit fees and reimbursement of out of pocket expenses in connection with the audit;
  6. Limitations of audit, if any.
  • Intimate previous auditor about such engagement, in writing.
  • Ensure that such engagement is within the limits prescribed by ICSI from time to time.
  • Maintain confidentiality of information obtained during the course of audit unless there is a legal obligation to disclose such information. Also, ensure that employees, staff and other team members also be bound by duty of confidentiality.
  • Do not agree to change in terms of engagement unless there is reasonable justification for doing so.
  • If terms of appointment are changed resulting in lower level of assurance, it shall be accepted only after considering the appropriateness of the same.
  • Any changes in terms of engagement must be agreed by way of supplementary or revised engagement letter.

 

CSAS-2 AUDITING STANDARD ON AUDIT PROCESS AND DOCUMENTATION

This Standard deals with the roles and responsibilities of Auditor with respect to maintenance of proper audit records that provides-

  • sufficient and appropriate record to form the basis for the Auditor’s Report; and
  • evidence that the audit was planned and performed in accordance with the applicable Auditing Standards and statutory requirements.

Things to do pursuant to CSAS-2

  • Formulate an audit plan as per terms of audit engagement.
  • Ensure adherence to audit plan.
  • Conduct risk assessment of auditee considering business, environmental and organisational structure and compliance requirements.
  • Evaluate high-risk areas relating to internal control systems, transparency, prudence, probity, changes in compliance team etc.
  • Obtain sufficient information of the auditee for conduct of audit.
  • Make use of systematic and comprehensive checklists.
  • Obtain necessary evidence and evaluate the same so as to support the opinion. This shall be adequately documented in audit working papers.
  • Obtain third-party confirmations wherever required.
  • Document discussions with management of the auditee in significant matters.
  • Collate the documentation for records within 45 days of date of signing of auditor’s report.
  • Maintain documentation in physical or electronic form for a period of 8 years from date of signing of auditor’s report.

Features of audit plan

  • The audit shall be planned in a manner which ensures that qualitative audit is carried out in an efficient, effective and timely manner.
  • Audit planning shall ensure that appropriate attention is accorded to crucial areas of audit and significant issues are identified in a timely manner.
  • Audit plan should be based on professional scepticism, so that it is possible to exercise professional judgment in an objective manner.

CSAS-3 – Auditing Standard on Forming of Opinion

This Standard provides details about the manner of evaluation of conclusions derived out of audit evidence which leads to formation of Auditor’s opinion.

Things to do pursuant to CSAS-3

  • Consider materiality while forming opinion.
  • Consider all relevant audit evidence before issuing audit report.
  • Apply professional judgement and scepticism to ensure evidence is factually correct.
  • Prepare audit report within the agreed time-frame.
  • Verify accuracy of facts and responses from concerned persons.
  • Adhere to generally accepted principles and practices in relation to audit process.
  • Indicate if any third-party report or opinion is being relied on.
  • Indicate if third-party report is provided by the auditee and also consider important findings of third party.
  • Carry out a supplemental test to check veracity of third-party report.
  • Express unmodified opinion if satisfied that applicable laws have been duly complied with and relevant records are free from misstatement.
  • Express modified opinion in bold or italic letters. Modified opinion is to be issued if:
    • non-compliance of applicable laws is found,
    • relevant records aren’t free from misstatement,
    • sufficient and appropriate audit evidence to ensure the above is not available.

 

 

  • Ask auditee to remove any such limitation on scope of audit which is likely to make the Auditor give modified opinion or disclaimer.
  • Give unmodified opinion, if in case of absence of sufficient and appropriate evidence, Auditor can conclude that effects of unavailability of such evidence will be non-material. However, if the effects are likely to be material, the auditor shall express disclaimer of opinion.

Format of audit report

  • The report shall be addressed to appointing authority unless the terms of engagement provide otherwise.
  • Report must be detailed. Specific formats, if any, must be followed.
  • Provide annexures for detailing of certain aspects, wherever necessary.
  • Include a section named Auditor’s responsibility in the audit report.
  • This section shall state that the audit was conducted in accordance with applicable Standards.
  • The report shall state that due to the inherent limitations of an audit, there is an unavoidable risk that some material misstatements or material non-compliances may not be detected, even though the audit is properly planned and performed.
  • Signature block shall mention name of auditor/firm, certificate of practice number/registration number and membership number of the auditor.
  • Mention clearly the date and place of signing audit report.

CSAS-4 – Auditing Standard on Secretarial Audit

This Standard lays down the manner of evaluation of statutory compliances and corporate conduct in the process of doing secretarial audit u/s 204 of the Companies Act, 2013. It gives a broad structure to the audit process.

Things to do pursuant to CSAS-4

  • Take note of laws applicable to the auditee. This includes specific laws as well as general laws.
  • Review Memorandum of Association, Articles of Association, statutory books, disclosure by the auditee etc.
  • Identify events and corporate actions that took place in the audit period by reviewing website of the auditee, disclosures made to stock exchanges, statutory records of the auditee etc.
  • Verify event based as well as calendar compliances of the auditee.
  • Verify composition of Board of directors is in compliance with applicable rules and regulations i.e. optimum combination and strength is maintained and directors are not disqualified.
  • Ensure formation of required committees and proper composition of such committees.
  • Ensure decisions by board of directors are taken in compliance with the law i.e. in properly constituted meeting or by circulation.
  • Ensure that systems of compliance are adequate and effective.
  • Analyse instances of receipt of show cause notices, prosecutions initiated, fee or penalty levied etc.
  • Collect further evidence and conduct in-depth checking if a fraud is suspected.
  • If there is a sufficient reason to believe that a fraud has been committed, the same shall be reported to Audit Committee/Board/Central Government as per the process laid down under the Companies Act, 2013. Also, the same shall be included in Secretarial Audit Report.
  • Verify the comments received on reporting fraud.
  • Include fraud detected by other auditor in the audit report.
  • Report all the events that affect auditee’s going concern or alters the charter or capital structure or management or business operation or control, etc.

Conclusion

These Standards provide a broad structure to the audit process and direction as to proceeding the audit. Having a direction to proceed will make the audit more systematic. To establish these structures and systems would initially require plenty of clerical nature work. However, this is a one-time labour to be put in for structuring all the future audits.

These Standards are issued with a motive to enhance the level and quality of compliance and at the same time harmonise the audit practices being followed by various auditors. Unity of procedures ensures clarity to the auditee which enables them to ensure systematic compliance. Application of these Standards is believed to be beneficial for the Auditors as well as the companies and regulators in the long run.

[1] https://www.icsi.edu/media/webmodules/ICSI_Auditing_Standards.pdf

New lease accounting standard kicks off from 1st April, 2019

Financial Services Division

(finserv@vinodkothari.com)

The Ministry of Corporate Affairs (MCA) has put a small announcement on its website that the new lease accounting standard, IndAS 116 will get implemented from 1st April 2019. The new Standard, globally implemented in several countries from 1st Jan 2019, is called IFRS 16. The Standard eliminates the 6-decade old distinction between financial and operating leases, from lessee accounting perspective, thereby putting all leases on the balance sheet. The phenomenon of off-balance sheet lease transactions was one of the burning analyses after bankruptcy of Enron in 2001, and since then, had been erupting off and on, until the global standard setter decides to push the new standard on the rule book in Jan 2016, effective 1st Jan 2019.

After the introduction of IFRS 16, the ICAI came out with an exposure draft on the new standard in 2017 and kept it open for comments for some days. However, nothing further was heard about it thereafter.

The exposure draft and the final published Ind AS 116 are same except for the below mentioned change which has been incorporated in the final published Ind AS 116:

Para 47 dealing with presentation in books of lessee:
In Exposure Draft Text of published Ind AS 116
Para 47 A lessee shall either present in the balance sheet, or disclose in the notes: Para 47: A lessee shall either present in the balance sheet, or disclose in the notes:
(a) right-of-use assets separately from other assets. (a) right-of-use assets separately from other assets. If a lessee does not  present right-of-use assets separately in the balance sheet, the lessee shall:
(i) include right-of-use assets within the same line item as that  within which the corresponding underlying assets would be  presented if they were owned; and
(ii) disclose which line items in the balance sheet include those  right-of-use assets.
(b) lease liabilities separately from other liabilities. (b) lease liabilities separately from other liabilities. If a lessee does not  present lease liabilities separately in the balance sheet, the lessee  shall disclose which line items in the balance sheet include those liabilities.

(above para is same as para 47 IFRS 16, thereby making IFRS 16 and Ind AS 116 exactly same now, except for the fair value option for investment property- ref para 1 of comparison with IFRS 16 )

Giving the above option makes it clear how the lessee is going to show the asset in books.

For example, if A takes Aircraft-1 on lease and owns Aircraft-2, A can either include both of them in PPE or can show Aircraft-1 in PPE and Aircraft-2 just below PPE under the head ROU.

Correspondingly, a lease liability can be disclosed separately, if not disclosed separately, then disclose which line item in BS includes the lease liability.

Globally, several jurisdictions have implemented the Standard with effect from 1st January, 2019. A list of jurisdictions which have already adopted can be viewed here.

Some of the key takeaways from the implementation of this Standard are:

  • Currently, there are two accounting standards for lease transactions, first, Ind AS 17, which is applicable to the Ind AS compliant companies and second, AS 19, which is applicable to the remaining classes of companies. Ind AS 116 proposes to replace Ind AS 17, therefore, the companies which are not covered by Ind AS shall continue to follow old accounting standard. 
  • The applicability of this standard shall have to be examined separately for the lessor and the lessee, that is, if the lessor is Ind AS compliant and lessee is not Ind AS compliant, then lessor will follow Ind AS 116 whereas lessee will follow AS 19. 
  • The new standard changes treatment of operating leases in the books of the lessees significantly. Earlier, operating leases remained completely off the balance sheet of the lessee, however, vide this standard, lessees will have to recognise a right-to-use asset on their balance sheet and correspondingly a lease liability will be created in the liability side. 
  • Lease of low value assets and short tenure leases (up to 12 months) have been carved out from the requirement of recognition of RTU asset in the books of the lessee.
  • No change in the accounting treatment in case of financial leases. 
  • No change in the lessor’s’ accounting.

While leasing has not been greatly popular in India compared to the world, there has been a substantial pick up in interest over recent years. Therefore, a question comes – will the new standard put a death knell to the feeble leasing industry in India? To the extent the demand for leasing comes from off balance sheet perspective for a lessee, the standard may have some impact. However, there are many economic drivers for lease transactions – such as the ease of usage, tax benefits, better residual realisation, etc. Those factors remain unaffected, and in fact, the focus of lease attractiveness will shift to real economic factors rather than balance sheet cosmetics.

The apparent question that arises here is whether the new standard unsettle the taxation framework for lease transactions in India, especially direct taxes – the answer to this question is negative. The tax treatment of lease transaction does not depend on the treatment of the transaction in books of accounts. Instead, it depends on whether the transaction is case a true lease or is merely a disguised financial transaction. There will be no impact on the indirect taxation framework as well.

Indefinite deferral of IFRS for banks: needed reprieve or deferring the pain?

Vinod Kothari (vinod@vinodkothari.com); Abhirup Ghosh (abhirup@vinodkothari.com)

On 22 March, 2019, just days before the onset of the new financial year, when banks were supposed to be moving into IFRS, the RBI issued a notification[1], giving Indian banks indefinite time for moving into IFRS. Most global banks have moved into IFRS; a survey of implementation for financial institutions shows that there are few countries, especially which are less developed, where banks are still adopting traditional GAAPs. However, whether the Notification of the RBI is giving the banks a break that they badly needed, or is just giving them today’s gain for tomorrow’s pain, remains to be analysed.

The RBI notifications lays it on the legislative changes which, as it says, are required to implement IFRS. It refers to the First Bi-monthly Monetary Policy 2018-19[2], wherein there was reference to legislative changes, and preparedness. There is no mention in the present  notification for preparedness – it merely points to the required legislative changes. The legislative change in the BR Act would have mostly been to the format of financial statements – which is something that may be brought by way of notification. That is how it has been done in case of the Companies Act.

This article analyses the major ways in which IFRS would have affected Indian banks, and what does the notification mean to the banking sector.

Major changes that IFRS would have affected bank accounting:

  • Expected Credit Loss – Currently, financial institutions in India follow an incurred credit loss model for providing for financial assets originated by them. Under the ECL model, financial assets will have to be classified into three different stages depending on credit risk in the asset and they are:
    • Stage 1: Where the credit risk in the asset has not changed significantly as compared to the credit risk at the time of origination of the asset.
    • Stage 2: Where the credit risk in the asset has increased significantly as compared to the credit risk at the time of origination of the asset.
    • Stage 3: Where the asset is credit impaired.

While for stage 1 financial assets, ECL has to be provided for based on 12 months’ expected losses, for the remaining stages, ECL has to be provided for based on lifetime expected losses.

The ECL methodology prescribed is very subjective in nature, this implies that the model will vary based on the management estimates of each entity; this is in sharp contrast to the existing provisioning methodology where regulators prescribed for uniform provisioning requirements.

Also, since the provisioning requirements are pegged with the credit risk in the asset, this could give rise to a situation where the one single borrower can be classified into different stages in books of two different financial institutions. In fact, this could also lead to a situation where two different accounts of one single borrower can be classified into two different stages in the books of one financial entity.

  • De-recognition rules – Like ECL provisioning requirements, another change that will hurt banks dearly is the criteria for derecognition of financial assets.

Currently, a significant amount of NPAs are currently been sold to ARCs. Normally, transactions are executed in a 15:85 structure, where 15% of sale consideration is discharged in cash and the remaining 85% is discharged by issuing SRs. Since, the originators continue to hold 85% of the SRs issued against the receivables even after the sell-off, there is a chance that the trusts floated by the ARCs can be deemed to be under the control of the originator. This will lead to the NPAs coming back on the balance sheet of banks by way of consolidation.

  • Fair value accounting – Fair value accounting of financial assets is yet another change in the accounting treatment of financial assets in the books of the banks. Earlier, the unquoted investments were valued at carrying value, however, as per the new standards, all financial assets will have to be fair valued at the time of transitioning and an on-going basis.

It is expected that the new requirements will lead to capital erosion for most of the banks and for some the hit can be one-half or more, considering the current quality of assets the banks are holding. This deferment allows the banks to clean up their balance sheet before transitioning which will lead to less of an impact on the capital, as it is expected that the majority of the impact will be caused due to ECL provisioning.

World over most of the jurisdictions have already implemented IFRS in the banking sector. In fact, a study[3] shows that major banks in Europe have been able to escape the transitory effects with small impact on their capital. The table below shows the impact of first time adoption of IFRS on some of the leading banking corporations in Europe:

Impact of this deferment on NBFCs

While RBI has been deferring its plan to implement IFRS in the banking sector for quite some time, this deferral was not considered for NBFCs at all, despite the same being admittedly less regulated than banks. The first phase of implementation among NBFCs was already done with effect from 1st April, 2018.

This early implementation of IFRS among NBFCs and deferral for banks leads to another issue especially for the NBFCs which are associates/ subsidiaries of banking companies and are having to follow Ind AS. While these NBFCs will have to prepare their own financials as per Ind AS, however, they will have to maintain separate financials as per IGAAP for the purpose of consolidation by banks.

What does this deferment mean for banks which have global listing?

As already stated, IFRS have been implemented in most of the jurisdictions worldwide, this would create issues for banks which are listed on global stock exchanges. This could lead to these banks maintaining two separate accounts – first, as per IGAAP for regulatory reporting requirements in India and second, as per IFRS for regulatory reporting requirements in the foreign jurisdictions.

[1] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11506&Mode=0

[2] https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=43574

[3] https://www.spglobal.com/marketintelligence/en/news-insights/research/european-banks-capital-survives-new-ifrs-9-accounting-impact-but-concerns-remain

Compound financial instruments- A paradigm shift in accounting concepts

By Rahul Maharshi (rahul@vinodkothari.com, ifrs@vinodkothari.com) 

Introduction

Financial instruments accounting has been one of the highlighting issues in implementation of Ind AS in India. Several new concepts have been introduced and compound financial instrument (CFI) is one of them.

Explained in para 28 of Ind AS 32, a CFI is a financial instrument which is a non-derivative financial instrument that, from the issuer’s perspective, contains both liability and equity component. Therefore, when characteristics of both, liability and equity are fused into one instrument, it gives rise to a CFI.

It is usually observed, as a way of raising funds, many companies go for issuing debt instruments with a conversion feature in it. A bond which is convertible into fixed number of shares of the issuer would generally be preferred over a plain vanilla bond, since there lies a convertibility feature which would be an incentive for the investor over and above the interest income on such a bond. Additionally, if the issuer company is one which is positively growing, the investor would reap out fair amount of benefits with the help of a convertibility option.

Therefore, this makes CFI an interesting topic to discuss. In this article, we intend to discuss the manner of treatment, recognition, classification and various other intricacies associated with CFIs.

Compound financial instrument from investors perspective

The accounting treatment with respect with CFI prescribed in Ind AS 32 deals with the issuer’s books of accounts only, there is no special treatment required in the books of the investor. A CFI is nothing but a financial asset in the books of an investor.

A CFI is required to be accounted for in the books of an investor as a financial asset till redemption, however, at the time of redemption, if the instrument is converted into equity, the same will require reclassification for subsequent measurement of the financial asset as a whole by the investor.

Compound financial instrument vs. Hybrid financial instrument

Yet another new concept in the Ind AS is that of hybrid financial instrument. Differentiating the same with CFI; a hybrid financial instrument, or a hybrid contract is one which has an embedded derivative sitting on a host contract. From an investor’s point of view, a host contract can be of any kind, such as a financial asset or a non-financial asset.

If the host contract is a non-financial asset, the embedded derivative will be required to be separated from the host contract subject to the requirements given in para 4.3.3 of Ind AS 109. After separation, the host contract shall be required to be accounted for in accordance with the appropriate Ind AS(s).

For example, a lease agreement with variable lease payments adjusted to the change in a benchmark interest rate such as LIBOR would result in a hybrid instrument with the host contract being the lease agreement i.e. a non-financial asset and an embedded derivative being the variability feature of the lease payments being leveraged. The lease agreement should be accounted for as per Ind AS 17- Leases and the derivative feature may be required to be accounted for as per Ind AS 109 subject to para 4.3.3.

A host contract being a financial instrument (viz. being a financial asset) is required to be accounted for by the investor as explained in the earlier section.

However, for the purpose of this article, emphasis is required to be given on the treatment of a CFI being a host contract with an embedded derivative (such as a call option) from an issuer’s point of view. Ind AS 32 provides that the value of the derivative embedded on CFI is required to be included in the liability component of the CFI.

It is to be noted that the equity conversion option in a CFI, on a standalone basis, is not a derivative. The derivative that is required to be included in the liability component are those which qualify to be a derivative as defined under Ind AS 109.

The concept of CFI and a Hybrid contract is diagrammatically explained below:

The above diagram can be seen as an example of deriving concepts from application of two Ind AS(s) viz. Ind AS 109 and Ind AS 32. By interpretation, it exhibits the notion that a CFI is in fact, a type of a hybrid contract, but a hybrid contract is not a type of a CFI. Nevertheless, this notion can be questioned on the ground that both the instruments are required to be looked at from different perspectives.

The distinctions between a hybrid contract and a CFI can be tabulated as below:

Basis of distinction Hybrid contract/ Hybrid financial instrument Compound financial instrument
Governing Ind AS for accounting Ind AS 109 Financial Instruments Ind AS 32 Financial Instruments- Presentation
Nature Derivative Derivative /Non- derivative
Split accounting Based on conditions given in para 4.3.3 of Ind AS 109 Mandatory in all cases
Resultant instruments after splitting Financial assets, non-financial assets, financial liability, non-financial liability  and/or equity Equity and financial liability

Split Accounting in case of a CFI

The incidence or event of testing a financial instrument to be a CFI or not is not only to be done at the issuance or on a periodic basis, rather whenever the terms of the contract of a financial instrument reveal a dual character i.e. of equity as well as liability, the same should be classified and accounted for.

The steps involved in accounting for a CFI from the perspective of an issuer is diagrammatically represented below:

Step 1: Identification of the components of the CFI:

Identifying the components of CFI into equity and liability from the issuer’s perspective is done by checking the terms and conditions provided in the contract of the financial instrument.

For example, an issuer issues 7% Optionally Convertible Debentures, convertible into a fixed number of shares. This would mean that the obligation towards debenture holder can be discharged either by payment of cash or by issuing a fixed number of the equity shares of the issuer. The liability component here being the issuer’s obligation to pay 7% interest and the potential redemption of the debenture in cash at maturity. The equity component here being the holder’s call option for the issuer’s shares.

Step 2:  Determination of fair value of CFI as a whole

The fair value of the CFI as a whole would normally be the transaction price as provided in para B5.1.2A of Ind AS 109. In case the transaction has not taken place under market conditions, then the principles of Ind AS 113 would be applied to derive at the fair value of the financial instrument as a whole.

Step 3: Determination of the fair value of the liability component:

Fair value of the liability component is the present value of the contractually determined stream of future cash flows discounted at the rate of interest applied at that time by the market to instruments of comparable credit status and providing substantially the same cash flows, on the same terms but without the convertibility option.

The act of discounting the cash flows of the instrument as a whole with the discounting rate being the rate of interest prevailing in the market on a debenture without the conversion option is done to derive the value of the liability component.

Now if the instrument as a whole has an embedded derivative, like a call option on the equity shares, the liability component is inclusive of the value of the derivative embedded in the CFI.

Step 4: Determine value of the equity component:

The equity component of a CFI is nothing but the residual amount left after subtracting the liability component as computed in step 3 from the fair value of the CFI as a whole (step 2).

This is fairly evident from the definition of equity as provided in para 11 of Ind AS as below:

“An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.”

Also, once the value of the equity component of a CFI is determined, being the residual amount, it is not re-measured or reclassified till final settlement. In cases of conversion, there can merely be a change within equity. Any kind of cost associated with the issue of the CFI shall be proportionately allocated to the liability and equity components.

Since the liability component of a CFI satisfies the definition of a financial liability as per Ind AS 32, the same is required to be subsequently accounted for in accordance with the principles of subsequent measurement of financial liabilities as provided in para 4.2 of Ind AS 109 viz. at Fair value through profit or loss (FVTPL) or at amortised cost method.

Examples

Example 1: 9% Preference shares with partial conversion and partial redemption

Company M has issued 10,000 9% Preference shares having face value Rs. 10 each with mandatory dividends and mandatory conversion of 50% preference shares into equity and balance 50% redemption at the end of 3 years from the date of issue. Market rate for Preference shares with similar credit status and other features except the conversion feature is 12%p.a.

The preference share has two components – (1) Contractual obligation for payment of mandatory dividend and mandatory redemption of 50% Preference shares. (2) Mandatory conversion of 50% Preference shares into equity.

The first component is a financial liability because the same consist of contractual obligation to pay cash and the entity does not have an unconditional right to avoid delivering cash.

The second component is equity since there is mandatory conversion into equity shares, which, in substance, signifies that the amount for the equity is already prepended even before receiving the shares in reality.

The values of equity and liability components are calculated as follows:

Present value of Principal payable at the end of the 3 years (Rs. 5,00,000 discounted at 12% for 3 years)= Rs.3,55,890.

Present value of contractual obligation to pay dividends in arrears for 3 years (Rs. 90,000 discounted at 12% for 3 years) = Rs. 2,16,165

Total financial liability= Rs.5, 72, 055.

Therefore, equity component= fair value of CFI, say Rs. 10,00,000 less financial liability component i.e. Rs. 5,72,055=Rs. 4,27,945.

Subsequent year’s profit and loss account is charged with interest amortisation at 12% on the financial liability component and dividend expense of Rs. 90,000 each.

Example 2: 6% optionally convertible debentures (OCDs)

X ltd (issuer) has issued 6% p.a. debentures to Y Ltd. (holder) for a consideration of Rs. 30 lakhs. The holder has an option to convert these debentures to a fixed number of equity instrument of the issuer anytime up to a period of 3 years. If the option is not exercised by the holder, the debentures are redeemed at the end of 3 years. The prevailing market rate for similar debentures without the conversion feature is 9% p.a.

The instrument has two components – (1) Contractual obligation that is conditional on holder exercising his right to redeem, and (2) conversion option with the holder.

The first component is a financial liability because the entity does not have an unconditional right to avoid delivering cash. The other component, conversion option with the holder, is an equity feature.

The values of liability and equity component are calculated as follows:

Present value of principal payable at the end of 3 years (Rs. 30 Lakhs discounted at 9% for 3 years)= Rs. 23,16,550.

Present value of interest payable in arrears for 3 years (Rs. 1,80,000 discounted at 9% for each of 3 years) = Rs. 4,55,632

Total financial liability= Rs. 27,72,182.

Therefore, equity component= fair value of CFI, say Rs. 30 Lakhs less financial liability component i.e. Rs. 27, 72,182=Rs. 2, 27,818.

In subsequent years the profit is charged with interest of 9% on the debt instrument.

Example 3: Accounting for Compound financial instrument on date of transition

On 1st April, 2015, X Ltd. issued 50,000, 7% convertible debentures of face value of Rs. 100 per debenture at par. The debentures are redeemable on 31st March 2020 or these may be converted into ordinary shares at the option of the holder. The interest rate for equivalent debentures without the conversion rights would have been 10%. The date of transition to Ind AS is 1st April, 2017.

As per previous Indian GAAP, the given instrument has been accounted for as a non-current liability and corresponding interest expense of Rs. 3,50,000 each for 2 years should have been charged directly to profit and loss account.

On the date of transition to Ind AS, i.e. 1st April, 2017, the Company has to account for the instrument as a compound financial instrument as per para 28 of Ind AS 32. Subsequently, the value of debt component and equity component has to be calculated (viz. split accounting).

Therefore, for the remaining 3 years, there will be an interest expense at Rs. 3,50,000 each and at the end of 3rd year the instrument either gets redeemed or gets converted into ordinary shares of the Company.

On 1st April, 2017

Value of Debt:

Present value of interest payable for 17-18, 18-19 & 19-20 = (Rs. 3,50,000 discounted at 10% for each of the 3 years)= Rs. 8,70,398

Present value of Principal at the end of 3rd year i.e. as on 31st March, 2020 = (Rs. 50,00,000 discounted at 10% for 3 years) = Rs. 37,56,574

Value of Debt component= Rs. 37,56,574 + 8, 70,398 =Rs.46,26,972

Value of equity component= Rs. 50,00,000-46,26,972=3,73,028

Therefore, on the date of transition i.e. 1/4/2017 amount of Rs. 50,00,000 being the Fair value of CFI will be split into debt & equity as given above.

For the coming 3 years, the following treatment shall be done by the X Ltd.

Particulars 2017-18 2018-19 2019-20
Opening debt component 46,26,972 47,33,669 48,57,015
(+)Interest amortisation @ 10% 4,62,697 4,73,365 4,85,702
(-)Interest expense at 3.5 lakhs p.a 3,50,000 3,50,000 3,50,000
Closing balance of debt component   47,33,669 48,63,635 50,00,000

Conclusion

The move towards substance over form and fair value accounting is fairly reflected with the introduction of the concept of CFI. There has been a fundamental shift in the understanding when a contract is put to test in light of Ind AS governing financial instruments. The instruments which were erstwhile treated to be debt are currently being treated as equity. This is primarily dependant on the notion that equity capital is the amount of money not repaid, accordingly an instrument convertible into equity capital should also be treated as equity. Therefore, a CCD is shown as a CFI.

However, in the midst of split accounting of a CFI, there are certain issues which are of concern to entities in doing the same. The major challenge to stakeholders lies in treatment of the equity component of the CFI from Income tax perspective, since there arises a MAT implication.

On the date of transition to Ind AS, there arises a tax implication on the already issued instruments which require reclassification as a CFI in the current Ind AS regime. The equity component of the CFI is required to be included in the “transition amount” defined in sub-section 2(C) of section 115JB of the Income Tax Act, 1961.

This results in taxing the one-fifth amount of the equity component for 5 years. The same has been further clarified by the CBDT circular dated 25th July, 2017[1] stating that the equity component of a CFI is to be included in the transition amount and further be taxed for MAT purposes over a period of five years. The same is seen as a burden on companies transitioning from erstwhile Indian GAAP to Ind AS because the equity component is not excluded from the purview of book profits as computed for MAT purposes.

Nevertheless, we feel the concept is relatively new to the Indian context and the same shall be developed over a period of time.


[1] https://www.incometaxindia.gov.in/Communications/Circular/Circular_24_%202017.pdf

Accounting for Leasing Transactions: IndAS 116 and IFRS 9

Servicing Asset and Servicing Liability: A new by-product of securitization under Ind AS 109

(finserv@vinodkothari.com)

Securitisation has gained popularity in India in the recent times, however, one more concept that has grown parallel to it is, direct assignment. In fact, at times, direct assignments have overpowered securitisation in the Indian market[1]. Financial institutions have been using these extensively to address their liquidity issues. However, if there is anything that affected the financial institutions dearly, then it is the change in the accounting treatment under the Indian Accounting Standards (Ind AS).

Read more

Classification and reclassification of financial instruments under Ind AS

By Team IFRS & Valuation Services (ifrs@vinodkothari.com) (finserv@vinodkothari.com)

Background

As India moves into Indian Accounting Standards (Ind AS), one standard which the accountants will be wary about is the Ind AS 109: Financial Instruments. This standard is an adaption of the International Financial Reporting Standard 9.  Ind AS 109 specifically provides for the manner in which the financial assets and financial liabilities are to be dealt with the books of the accounts. This standard itself is incomplete, as to draw a meaningful conclusion to any matter relating to financial asset or financial liability, one will also have to refer to the Ind AS 32. Read more