The impact of Ind AS adoption has been all pervasive, says a recent PwC report. A look at the key areas affected.
From the Indian Accounting Standards (Ind AS) results reported by Phase-I companies for the year ended 31 March 2017, it is clear that the impact of Ind AS adoption has been all-pervasive and not restricted to only one industry sector. This resulted from a fundamental change in the financial reporting framework, a general shift from the historical cost convention to use of fair value and increased focus over substance, rather than the legal form of the underlying transaction, thereby impacting every company and industry sector.
Overall, the Ind AS transition resulted in a decrease of around 3.5 per cent in the reported net income of companies for the year ended 31 March 2016.
Let us take a look at a few key impact areas...
There was an overall increase in reported revenues of around 4.6 per cent. The main reason for such increase was gross-up of revenue due to excise duty adjustment of around 7.1 per cent. It is interesting to note that, with the implementation of Goods and Services Tax (GST) from 1 July 2017, companies will again see a reduction in their top line, as GST replaces the existing excise-duty tax based on production and will be reported by companies as net of revenues. Excluding the impact of excise duty, revenues declined mainly due to:
• Deferral of revenue on customer contracts where revenue recognition criteria have not been met under Ind AS — for example in service arrangements, maintenance contracts, upfront fees, etc.
• Linked arrangements — sale and subsequent repurchase agreements: Ind AS 18 requires accounting to reflect the economic substance of transactions and not merely their legal form. Ind AS 18 gives the example of a situation where an entity sells goods but, at the same time, enters into an agreement to repurchase the goods at a later date, thus negating the effect of the original sale. In such a situation, the two transactions should be dealt with together as a single transaction, and when the seller has retained the risks and rewards of ownership, even though the legal title has been transferred, the transaction is accounted like a financing arrangement not giving rise to revenue. This results in deferral of revenue, with the inventory continuing to be recognised on the balance sheet;
• Discounting contract consideration to its fair value in case of long-term construction contracts/extended payment terms, including adjustments related to retention money.
• Determination of principal versus agent relationships in customer arrangement – in case of agent relationships the net fees instead of the amount of gross billing is recognised as revenues.
• Awards and incentives given to customers, promotional expenses/customer reimbursements, cash discounts, etc., being netted from revenue.
There was an overall increase in reported net income on account of taxes by around 3.7 per cent. Under Ind AS, deferred taxes are recorded based on the temporary differences – as opposed to timing differences model under Indian Generally Accepted Accounting Principles (GAAP). This approach under Ind AS is broader and results in deferred taxes on more items, and also additional deferred taxes on some items. The major reason for such increase in income was due to the lower recognition threshold under Ind AS compared to the virtual certainty supported by convincing evidence presently required to recognise deferred tax assets on carried forward business and long-term capital losses under Indian GAAP. Other adjustments on account of taxes included:
• Recognition of deferred tax liability on undistributed earnings from subsidiaries and joint ventures.
• Impact of deferred taxes on unrealised profits on intra-group transactions.
• Income tax effects of group share-based payment arrangements.
There was an overall decrease in reported net income of around 1.4 per cent on account of financial instruments. The reasons for Ind AS adjustments included:
• Recognition of impairment losses under the expected credit losses (ECL) as compared to the ‘incurred loss’ model under Indian GAAP. The ECL model seeks to address the criticisms of the incurred loss model which arose during the global economic crisis and contains a ‘three-stage’ approach which is based on the change in credit quality of financial assets since initial recognition – resulting in an overall higher provision.
• Under Indian GAAP, financial liabilities are generally recorded at face value basis the legal form of the instrument, whereas under Ind AS the appropriate liability/equity classification is based on the substance of the contractual arrangement. As an overriding principle, Ind AS requires a financial instrument to be classified as a liability if the issuer is required to settle the obligation in cash or another financial asset. For example, mandatory redeemable preference shares, which were previously shown as part of equity have been classified as a liability under Ind AS. The dividend and dividend distribution tax on such capital also get recorded through the income statement using the effective interest method (instead of equity). This also includes items such as premium on redemption of debentures.
• Ind AS also requires certain compound instruments such as optionally convertible debentures/preference shares to be separated into their liability and equity components. All of this results in higher interest expense/lower net income under Ind AS;
• Under Ind AS, long-term financial assets such as interest-free deposits, long term receivables, and employee loans are also recorded at fair value with the corresponding adjustment to costs/employee benefit expense as applicable;
• Under Indian GAAP, investments were carried at lower of cost and fair value or at cost less impairment, if any (depending on short-term or long-term nature of investment). Ind AS significantly changes this, where except for certain debt instruments, financial assets are recorded at fair value.
• Finally, under Ind AS, all derivatives are recorded at fair value with recognition of both gains and losses, whereas under Indian GAAP, fair value losses were recognised but not gains (except when hedge accounting was applied).
Business Combination and Consolidation
There was an overall decrease in reported net income of around 0.7 per cent on account of business combination and consolidation. The adjustments were mainly due to:
• Retrospective application of business combination principles resulted in increased amounts of tangible/intangible assets due to fair valuation and a consequential impact on subsequent depreciation/amortisation.
• Consolidation of results of certain entities now being classified as subsidiaries, including ESOP trusts and on the other hand de-consolidation of investments to be accounted as associates and joint ventures under Ind AS, which were previously consolidated under Indian GAAP.
• Fair valuation of deferred and contingent consideration in business combinations, including options issued to non-controlling shareholders; and
• Recognition of business acquisition related costs in the income statement vis-à-vis cost of investment/goodwill asset under Indian GAAP.
Reporting of 31 March 2017, annual financial results under Ind AS by Phase-I companies, proved to be a testament of India’s readiness to embrace such a significant change in financial reporting. Investors, stakeholders, and other users will see additional disclosures of financial information in the annual reports of the companies, which will help better understand the company’s business story, performance, and financial position.
With Phase-I transition substantially complete, now it is for Phase-II companies, including financial services companies to embark on this journey and learn from the transition experience of Phase-I companies.
(This data is from the Price Waterhouse & Co. LLP. Ind AS Impact Report published in July 2017)