Should you expect adjustment in profits for “Expected Credit Loss”?

– Customised profits for CSR and managerial remuneration under Section 198 of the CA, 2013

– Pammy Jaiswal and Sourish Kundu | corplaw@vinodkothari.com

Background

The presentation of the profit and loss account has been outlined under the Schedule III of the Companies Act, 2013  (‘Act’) and the profit computation method has been provided for under the applicable accounting standards [See IND AS 1]. The basic principle is to showcase a true and fair view of the financial position of a company. Having said that, it is also significant to mention that the Act provides for an alternative method for computing net profits, the basic intent of which is to arrive at an adjusted net profit which does not have elements of unrealised gains or losses, capital gains or losses and in fact any item which is extraordinary in its very nature. The same is contained under the provisions of section 198 of the Act. This section, unlike the general computation method, has a limited objective i.e., calculation of net profits for managerial remuneration as well as corporate social responsibility. 

There are four operating sub-sections under section 198 which provides for the adjustment items:

1. Allowing the credit of certain items – usual income in the form of govt subsidies
2. Disallowing the credit given to certain items – unrealised gains, capital profits, etc.
3. Allowing the debit of certain items – usual working charges, interests, depreciation, etc
4. Disallowing the debit of certain items – capital losses, unrealised losses, usual income tax, etc

It is important to note that items other than those mentioned above need not be specifically adjusted unless their nature calls for adjustment under the said section. Now if we discuss specifically for items in the nature of Expected Credit Loss (‘ECL’) for companies following IND AS, it is important to understand the nature of ECL in the context of making adjustments under section 198 of the Act. See our write on Expected Credit Losses on Loans: Guide for NBFCs.

Understanding ECL and Its Accounting Treatment

Reference shall be drawn from Ind AS 109 which defines ‘credit loss’ as ‘the difference between all contractual cash flows that are due to an entity in accordance with the contract and all the cash flows that the entity expects to receive (i.e. cash shortfalls), including cash flows from the sale of collateral held.’ ECL is essentially a way of estimating future credit losses, even on loans that appear to be fully performing at the time of such analysis (Stage 1 assets). It is based on expected delays or defaults, and the estimated loss is recorded as a charge to the profit and loss account, based on a 12-month probability of default.

As per Ind AS 109, ECL is used for the recognition and measurement of impairment on financial assets both at the time of origination as well as at the end of every reporting period. ECL is a forward-looking approach that requires entities to recognize credit losses based on the probability  of future defaults/ delays.

However, this does not result in a reduction in the carrying value of the asset (unless the asset is already credit-impaired, i.e., Stage 3). In that sense, while ECL reflects asset impairment, it does not operate like a direct write-down. And unlike conventional provisioning, ECL is not a “provision” under traditional accounting – it is a loss allowance rooted in forward-looking estimations. Further, it is also important to understand that the booking of ECL does not mean that there has been a credit loss in the actual sense, the same is a methodical manner of estimating the probable default risk association with the asset value.

Treatment of ECL under Section 198 

Section 198 requires excluding unrealised or notional adjustments, such as fair value changes or revaluation impacts in terms of Section 198(3) of theAct.

The section also refers specifically to actual bad debts, under  Section 198(4)(o). This raises the natural interpretational question: should model-driven, probability-weighted ECL charges – which do not reflect realised losses – really be allowed to remain deducted while computing such customised profits? Well, the answer lies in the requirement and nature of such an item being required to be deducted from the profit and loss account under IND AS 109.  

Alternative approaches -Treatment of ECL

The question around the treatment of ECL can be viewed from two perspectives. The first being the nature of ECL and the second on the routine treatment and calculation of ECL. If we look at the nature, it is clear that while it is imperative for companies to compute ECL at the time of origination as well as at the end of every reporting period, it is important to note that there is no loss or default in the actual sense. This means that the amount computed as ECL has not been an actual default. 

On the other hand, if we look at the need for such computation and the methodical approach to arrive at the value of ECL, the same is likely to be considered as a usual working charge which is charged to the profit and loss account. Accordingly, we have come across two possible and permissible approaches to the treatment of ECL while computing the profits under section 198. The same has been discussed below with the help of illustrations.

Approach 1: Disallowing ECL in the year of its booking and subsequent adjustment of bad debt

Year 1	Year 2
PBT – 1000 Depreciation – 20 ECL – 40 Loss on sale of fixed asset – 15	PBT – 1200 Depreciation – 20 ECL – 35 Actual Bad Debt – 15 Profit on sale of equity shares – 25

Year 1	Amount	Year 2	Amount
PBT	1000	PBT	1200
Depreciation	–	Depreciation	–
Add: ECL	40	Add: ECL	35
Add: Loss on sale of fixed asset	15	Less: Profit on sale of equity shares	(25)
PBT u/s 198	1055	PBT u/s 198	1210

Notes: 

• ECL has been ignored in profit computation u/s 198 considering the same is an unrealised loss and therefore reversed.
• Depreciation and actual bad debt has not been adjusted again as it has already been deducted under normal profit computation.
• Capital gains and losses have been adjusted/ reversed under the computation.

Approach 2: Allowing ECL in profit computation and netting off actual bad debt from the same in subsequent period

Year 1	Year 2
PBT – 1000 Depreciation – 20 ECL – 40 Loss on sale of fixed asset – 15	PBT – 1200 Depreciation – 20 ECL recovered – 35 Actual Bad Debt – 15 Profit on sale of equity shares – 25

Year 1	Amount	Year 2	Amount
PBT	1000	PBT	1200
Depreciation	–	Depreciation	–
ECL	–	ECL	–
Add: Loss on sale of fixed asset	15	Actual bad debt	–
		ECL recovered	–
		Less: Profit on sale of equity shares	(25)
PBT u/s 198	1015	PBT u/s 198	1185

Notes:

• ECL has been considered in profit computation u/s 198  and therefore, not adjusted to reverse the impact
• Similarly, ECL recovered has been considered part of normal or routine adjustment and hence, not reversed.
• Actual bad debt is not to be considered at the time of profit computation under  the regular computation since it can be adjusted from the ECL already booked.
• Capital gains and losses have been adjusted/ reversed under the computation.

Concluding remarks

All listed companies are required to comply with Ind AS and given that an instance of a company having nil receivables is a rare occurrence, the discussion on how ECL is to be treated while computing net profit in terms of Section 198 becomes more than just an academic debate.

As long as the impact of any P&L item being extra ordinary in nature is taken off from the profits computed u/s 198, the same serves the purpose and intent of section 198 of the Act. ECL, while valid for accounting, is fundamentally an estimated, non-actual loss. It exists because accounting standards demand alignment of income with credit risk  and not because a real outflow has occurred. However, it cannot be said that ECL already deducted while calculating profit before tax as per applicable accounting standards will be reversed while calculating profits in terms of Section 198. 

Further, given that ECL is based on expectation calculated using due accounting principles, the actual bed debt, if within the ECL limit, does not impact the P&L. On the contrary, in case of the actual bad debt being in excess, the P&L warrants a subsequent debit of the net amount. For example, under approach 2 if the actual bad debt would have been 50, i.e. in excess of the ECL booked in the previous period by 10, the normal profit computation would have allowed a debit of 10.

In fact, both the approaches lead to the fulfilment of the intent of section 198 and hence, it is not necessary to consider any one approach as correct. Having said that, it is imperative to follow uniform practice in this regard in the absence of which the profits u/s 198 may be impacted. 

Therefore, where the statutory and accounting frameworks intersect – but are not necessarily aligned – companies must adopt a carefully considered, principle-based approach as even a single line item like ECL can materially influence the base for managerial remuneration and CSR spending unlike other estimate based items such as revenue deferrals viz. sales returns or warranties, which are made as a matter of accounting prudence, but does not represent outflows for statutory computation purposes. Accordingly, there is no reason for deviating from the Indian GAAP principles for the purpose of customised calculation of net profits for specific purposes. 

Read more: 

Cash in Hand, But Still a Loss? 

Impact of restructuring on ECL computation

Knowledge Centre for Corporate Social Responsibility (CSR)