Accounting Standards

Fair valuation and similar requirements in accounting standards

A number of accounting standards, whether Indian Accounting Standards included the Companies (Indian Accounting Standards) Rules, 2015 (Ind AS) or Accounting Standards Companies (Accounting Standards) Rules, 2006 (AS), require, or provide an option, to preparers of financial statements to measure various assets and liabilities at fair value.

Further, a number of accounting standards require assets and liabilities to be based on measurements which have similarities to fair value but are not fair value.

I have already discussed the definitions of fair value in various accounting standards in one of my earlier posts.

Mandatory fair valuation of income, expense, assets, and liabilities is required under following accountings standards:

Ind AS

  • Ind AS 102, Share-based Payment, requires
    • for equity settled share-based payment transactions, to measure the transaction at fair value of goods or services received unless the fair value cannot be reliably estimated,
    • in case the fair value of goods or services received cannot be estimated reliably (for example in the case of employee share-based payment transactions), then the transaction shall be measured at the fair value of equity instrument issued, and
    • for cash settled share-based payment transactions (such as share appreciation rights or phantom share option plans), to measure the transaction at fair value of goods or services received and the liability incurred. Such liability is remeasured at fair value on each reporting date till the liability is settled.
  • Ind AS 103, Business Combinations, requires all assets and liabilities acquired and purchase consideration paid/ payable in a business combination which is not a common control transaction, to be measured at fair value.
  • Ind AS 107, Financial Instruments: Disclosures, requires disclosure of fair values of certain items on the reporting date, such as
    • assets held as collateral which are freely available to the lender for selling or repledging without any default by the borrower,
    • fair values of various classes of financial assets and financial liabilities except for lease liabilities (including those which are measured at amortised cost, unless such amortised cost reasonably approximates the fair value e.g. in case of short-term trade receivables), and
    • fair values of certain transferred financial assets and their associated liabilities where such financial assets have not been derecognised in their entirety or where there are assets and liabilities which are associated with derecognised financial assets.
  • Ind AS 109, Financial Instruments, for all financial assets where cash flows are not solely payments of principal and interest on the principal outstanding e.g.
    • equity instruments (except those in subsidiaries, associates and joint ventures held by an investment entity such as a mutual fund, unit trust, investment linked insurance fund, alternative investment funds and similar entities),
    • derivative instruments (including derivatives on interests in subsidiaries, associates and joint ventures),
    • convertible instruments such as optionally or compulsorily convertible debentures/ bonds, or optionally or compulsorily convertible preference shares, and
    • loans given where the return is linked to performance measures such as revenue or profitability.
  • Ind AS 109, Financial Instruments, for all financial assets where cash flows are solely payments of principal and interest on the principal outstanding, but the business model of the reporting entity is either to hold such financial assets for trading e.g.
    • investments held for trading, or
    • to hold such financial assets within a business model whose objective is achieved by collecting contractual cash flows and selling financial assets e.g.
      • trade receivables where either the company may hold them till realised or factor them without recourse,
      • investments held in fixed income instruments which may either be held till maturity or sold to realise gains.
  • Ind AS 109, Financial Instruments, for all financial liabilities which are held for trading.
  • Ind AS 110, Consolidated Financial Statements, read with Ind AS 109, Financial Instruments, where investments in a subsidiary are held by an investment entity such as a mutual fund, unit trust, investment linked insurance fund, alternative investment funds and similar entities.
  • Ind AS 116, Leases, requires the manufacturer or dealer lessors to recognise revenue at the lower of fair value of the underlying asset, and the present value of lease payments discounted using a market rate of interest.
  • Appendix A, Distribution of Non-cash Assets to Owners, to Ind AS 10, Events after the Reporting Period, where non-cash assets are distributed to owners (dividend) and such non-cash assets are not controlled by the same parties before and after the distribution. The liability for dividend payable is required to be measured at the fair value of non-cash assets to be distributed.
  • Ind AS 16, Property, Plant & Equipment, Ind AS 38, Intangible Assets, and Ind AS 40, Investment Property, when an item on property, plant or equipment is acquired in exchange for non-monetary assets or a combination of monetary and non-monetary assets. In such a case, the fixed asset acquired shall be measured at its fair value (or the fair value of the assts given up, if the fair value of the asset acquired is not reliably measurable) except in cases where
    • the transaction lacks commercial substance, or
    • the fair value of neither the asset acquired, nor the asset given up is reliably measurable.
  • Ind AS 19, Employee Benefits, requires that plan assets relating to
    • a post-employment defined benefit plan, and
    • other long-term employee benefit plan,be measured at fair value on the reporting date.  
  • Ind AS 20, Accounting for Government Grants and Disclosure of Government Assistance, requires government grant related to assets including non-monetary grant to be measured at fair value. Such fair value of government grant may either then
    • be recognised as deferred income or
    • deducted in arriving at the carrying amount of the respective asset.
  • Ind AS 40, Investment Property, requires fair value of investment property on the reporting date to be disclosed in financial statements.      

AS

  • AS 10, Property, Plant & Equipment, AS 13, Accounting for Investments (in respect of investment properties), and AS 26, Intangible Assets, when an item on property, plant or equipment is acquired in exchange for non-monetary assets or a combination of monetary and non-monetary assets. In such a case, the fixed asset acquired shall be measured at its fair value (or the fair value of the assts given up, if the fair value of the asset acquired is not reliably measurable) except in cases where
    • the transaction lacks commercial substance, or
    • the fair value of neither the asset acquired, nor the asset given up is reliably measurable.
  • AS 13, Accounting for Investments, requires that
    • if an investment is acquired, or partly acquired, by the issue of shares or other securities, the acquisition cost should be the fair value of the securities issued, or
    • if an investment is acquired in exchange for another asset, the acquisition cost of the investment should be determined by reference to the fair value of the asset given up. Alternatively, the acquisition cost of the investment may be determined with reference to the fair value of the investment acquired if it is more clearly evident.
  • AS 13, Accounting for Investments, requires that current investments should be measured at lower of cost and fair value on the reporting date, determined either on an individual basis or by category of investments but not on an overall (or global) basis.
  • AS 15, Employee Benefits, requires that plan assets relating to
    • a post-employment defined benefit plan, and
    • other long-term employee benefit plan be measured at fair value on the reporting date.  
  • AS 19, Leases, requires a lessee to recognise a finance lease, at inception, as an asset and a liability at the lower of
    • the fair value of the asset, and
    • present value of minimum lease payments computed based on interest rate implicit in the lease or if such interest rate is not practicable to determine, then the incremental borrowing rate of the lessee. 
  • AS 20, Earnings Per Share, requires dilutive options and other dilutive potential equity shares to be considered as exercised at fair value of the underlying shares to calculate dilutive earnings per share.

Following accounting standards provide financial statement preparers an option to measure certain assets and liabilities at fair value:

Ind AS

  • Ind AS 101, First-time Adoption of Indian Accounting Standards, provides an option to first-time preparers of Ind AS financial statements to not restate business combinations prior to the date of transition, in accordance with Ind AS 103, Business Combinations. However, an entity may choose to restate earlier business combinations on and from a specific date. Such restatement will then require fair valuation of all assets and liabilities of the Acquiree on the acquisition date.
  • Ind AS 101, First-time Adoption of Indian Accounting Standards, provides an option to first-time preparers of Ind AS financial statements to fair value items of property, plant and equipment, intangible assets and right-to-use assets (or to use a previous GAAP revaluation) and then use such fair value/ previous GAAP revaluation as deemed cost of such assets.
  • Ind AS 101, First-time Adoption of Indian Accounting Standards, provides an option to first-time preparers of Ind AS financial statements to fair value investments in subsidiaries, associates and joint ventures and then use such fair value as deemed cost of such investments in its separate financial statements.
  • Ind AS 106, Exploration for and Evaluation of Mineral Resources, provides for a reporting entity to elect between cost model and revaluation model for subsequent measurement of exploration and evaluation assets following either the revaluation model as provided in Ind AS 16, Property, Plant & Equipment, or in Ind AS 38, Intangible Assets, depending upon the classification of such assets as tangible or intangible.
  • Ind AS 109, Financial Instruments, provides an option to preparers of financial statements to designate financial assets and financial liabilities at fair value through profit or loss, and hence fair value such items, if there is an accounting mismatch between financial assets and liabilities, and in case of financial liabilities, also if certain other conditions are met.
  • Ind AS 16, Property, Plant & Equipment, and Ind AS 38, Intangible Assets, provide for a reporting entity to elect between cost model and revaluation model.
    • In case of revaluation model, the reporting entity is required to measure one or more classes of property, plant and equipment or intangible assets at fair value on the reporting date.
    • If revaluation model is used, then revaluations shall be made with sufficient regularity to ensure that the carrying amounts do not materially differ from those which would be determined using fair value at the end of the reporting period.
    • However, in case of intangible assets, fair value has to be determined with reference to an active market and hence, may not be practicable in most cases.
  • Ind AS 27, Separate Financial Statements, provides an option to the preparers of financial statements to elect to measure investments in subsidiaries, associates, and joint ventures either at cost or at fair value in separate (stand-alone) financial statements. However, such election is available only to entities which are not investment entities and on a category by category basis.
  • Presently, Ind AS 40, Investment Property, does not allow for investment properties to be measured at fair value, though a disclosure of fair values on the reporting date is required. However, The Institute of Chartered Accountants of India (ICAI) has issued an exposure draft to allow financial statement prepares to elect revaluation model for measurement of investment properties, in line with the option provided in International Accounting Standard 40, Investment Property.

AS

  • AS 10, Property, Plant & Equipment, provides for a reporting entity to elect between cost model and revaluation model.
    • In case of revaluation model, the reporting entity is required to measure one or more classes of property, plant and equipment or intangible assets at fair value on the reporting date.
    • If revaluation model is used, then revaluations shall be made with sufficient regularity to ensure that the carrying amounts do not materially differ from those which would be determined using fair value on the balance sheet date.
  • AS 14, Accounting for Amalgamations, provides that in case of an amalgamation in the nature of purchase, the transferee company has an option either
    • to record assets and liabilities of the transferor company at their existing carrying amounts, or
    • to allocate the purchase consideration to individual identifiable assets and liabilities on the basis of their fair values on the date of amalgamation.

However, AS 26, Intangible Assets, requires that the amount recognised for intangible assets should be restricted to an amount that does not create or increase the capital reserve arising at the date of the amalgamation.

A number of accounting standards require assets and liabilities to be based on measurements which have similarities to fair value but are not fair value. These are:

Ind AS

  • Ind AS 105, Non-current Assets Held for Sale and Discontinued Operations, requires
    • a non-current asset (or disposal group) held for sale to be measured at lower of its carrying value and fair value less costs to sell, and
    • a non-current asset (or disposal group) held for distribution to owners to be measured at lower of its carrying value and fair value less costs to distribute.
  • Ind AS 2, Inventories, requires various types of inventories to be measured as
    • inventories held by producers of agricultural and forest produce, agricultural produce after harvest, and minerals and mineral products which are measured at net realisable value in accordance with well-established practices in those industries,
    • inventories held by commodity broker-traders at fair value less costs to sell, and
    • other inventories at lower of cost and net realisable value. Net realisable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale.
  • Ind AS 19, Employee Benefits, requires defined benefit liability in respect of post-employment benefit plans and other long-term employee benefit plans, to be measured on the basis of actuarial valuation using the projected unit credit method.
  • Ind AS 33, Earnings Per Share, requires options, warrants and their equivalents to be considered as exercised at the average market value of the underlying shares to calculate dilutive earnings per share.
  • Ind AS 36, Impairment of Assets, requires calculation of the recoverable amount of an asset or a cash-generating unit (CGU) for the purposes of testing impairment of such asset or CGU. Recoverable amount is higher of the fair value less cost of disposal of the asset or CGU or its value in use. Value in use is the present value of future cash flows expected to be derived from an asset or CGU. Value in use differs from fair value in a number of respects such as
    • unlike fair value, which is calculated from a market participant’s perspective, value in use is entity specific and considers factors, such as synergies, which a market participant may not consider;
    • the cash flow projections to calculate value in use are limited to the remaining life of the asset or assets included in the CGU and cash flows from disposal at the end of life of such assets, and also do not consider capacity enhancement or improvement in efficiency of asset or CGU;
    • pre-tax cash flows are required to be considered for calculating value in use;
    • cash flow projections should be based on a steady or declining rate of growth unless an increasing rate can be justified;
    • the growth rate shall not exceed the long-term average growth rate for the products, industries, or country or countries in which the entity operates, or for the market in which the asset is used; and
    • the discount rate to be used for discounting the cash flows is required to be a pre-tax rate which comprises the time value of money, and the risks specific to the asset for which the future cash flow estimates have not been adjusted. Such risks also include country risk, currency risk and price risk, as applicable.
  • Ind AS 37, Provisions, Contingent Liabilities and Contingent Assets, requires that a provision should be computed using a discounted cash flow approach and should be based on
    • the best estimate of the expenditure required to settle the obligation at the end of the reporting period considering the risks and uncertainties surrounding events and circumstances, and
    • discounting to present value using a pre-tax discount rate that reflects the market assessments of the time value of money and the risks specific to the liability if such risks have not been adjusted in the estimated cash flows.
  • Ind AS 41, Agriculture, requires
    • a biological asset to be measured at fair value less costs to sell on initial recognition and on the reporting date, and
    • agricultural produce harvested from an entity’s biological assets to be measured at its fair value less costs to sell at the point of harvest.

AS

  • AS 2, Valuation of Inventories, requiresmeasurement of
    • inventories held by producers of livestock, agricultural and forest products, and mineral oils, ores and gases to the extent that they are measured at net realisable value in accordance with well-established practices in those industries, and
    • other inventories at lower of cost and net realisable value. Net realisable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale.
  • AS 10, Property, Plant and Equipment, requires items of property, plant and equipment that are retired from active use and held for disposal to be stated at lower of their carrying amounts and net realisable value.
  • AS 15, Employee Benefits, requires defined benefit liability in respect of post-employment benefit plans and other long-term employee benefit plans, to be measured on the basis of actuarial valuation using the projected unit credit method. 
  • AS 28, Impairment of Assets, requires calculation of the recoverable amount of an asset or a cash-generating unit (CGU) for the purposes of testing impairment of such asset or CGU. Recoverable amount is higher of net selling price (defined as amount obtainable from the sale of an asset in an arms’ length transaction between knowledgeable, willing parties less the cost of disposal) of the asset or CGU or its value in use. Value in use is the present value of future cash flows expected to be derived from an asset or CGU. Value in use differs from fair value in a number of respects such as
    • unlike fair value, which is calculated from a market participant’s perspective, value in use is entity specific and considers factors, such as synergies, which a market participant may not consider;
    • the cash flow projections to calculate value in use are limited to the remaining life of the asset or assets included in the CGU and cash flows from disposal at the end of life of such assets, and also do not consider capacity enhancement or improvement in efficiency of asset or CGU;
    • pre-tax cash flows are required to be considered for calculating value in use;
    • cash flow projections should be based on a steady or declining rate of growth  unless an increasing rate can be justified;
    • the growth rate shall not exceed the long-term average growth rate for the products, industries, or country or countries in which the entity operates, or for the market in which the asset is used; and
    • the discount rate to be used for discounting the cash flows is required to be a pre-tax rate which comprises the time value of money, and the risks specific to the asset for which the future cash flow estimates have not been adjusted. Such risks also include country risk, currency risk and price risk, as applicable.
  • AS 29, Provisions, Contingent Liabilities and Contingent Assets, requires that a provision for decommissioning, restoration and similar liabilities which are recognised as cost of property, plant, and equipment, should be computed using a discounted cash flow approach and should be based on
    • the best estimate of the expenditure required to settle the obligation at the end of the reporting period considering the risks and uncertainties surrounding events and circumstances, and

be discounted to present value using a pre-tax discount rate that reflects the market assessments of the time value of money and the risks specific to the liability if such risks have not been adjusted in the estimated cash flows.

Relationship between Retrospective Restatement and Reopening (Revision) of Financial Statements

Ind AS 8, Accounting Policies, Changes in Accounting Estimates and Errors (Ind AS 8) defines Retrospective Restatement (Restatement) as “correcting the recognition, measurement and disclosure of amounts of elements of financial statements as if a prior period error had never occurred” (emphasis supplied).

Ind AS 8 defines Prior Period Errors as

 “Omissions from, and misstatements in, the entity’s financial statements of one or more prior periods arising from a failure to use, or misuse of, reliable financial information that:

  1. was available when financial statements for those periods were approved for issue; and
  2. could reasonably be expected to have been obtained and taken into account in the preparation and presentation of those financial statements.

Such errors include the effects of mathematical mistakes, mistakes in applying accounting policies, oversights and misinterpretation of facts, and fraud”.

Restatement requires the correction of material prior period errors retrospectively in the first set of financial statements approved for issue after their discovery by:

  1. restating the comparative amounts for the prior period(s) presented in which the error occurred; or
  2. if the error occurred before the earliest prior period presented, restating the opening balance of assets, liabilities and equity for the earliest period presented.

Ind AS 1, Presentation of Financial Statements (Ind AS 1) also requires a presentation of a third balance sheet as at the beginning of the preceding period if the restatement has a material effect on the information in the balance sheet at the beginning of the preceding period.

Accounting Standards included in the Companies (Accounting Standards) Rules, 2006 (AS) do not require any retrospective restatement of financial statements on discovery of a prior period error.

AS 5, Net Profit or Loss for the Period, Prior period Items and Changes in Accounting Policies (AS 5) defines prior period items as “items of income or expense which arise in the current period as a result of errors or omissions in the preparation of the financial statements of one or more prior periods”.

AS 5 does not require any retrospective restatement of financial statements on discovery of prior period items but requires such items to be disclosed in the statement of profit or loss of the current financial period.

Hence, the concept of restatement of financial statements is applicable to only those companies which prepare financial statements in compliance with Indian Accounting Standards (Ind AS).

Now coming to reopening of financial statements.

Reopening of financial statements is not covered in any accounting standards whether AS or Ind AS.

Reopening  (revision) of financial statements can be defined as revision of the financial statements of a company after they have already been adopted by the shareholders.

There was no provision for such reopening or revision of financial statements under the Companies Act, 1956. The Institute of Chartered Accountants of India (ICAI) required a Chartered Accountant who was an auditor of the company which revised its already adopted financial statements to qualify the audit report in this aspect quantifying all the amendments made to revised financial statements.

However, there are specific provisions regarding reopening of financial statements in the Companies Act, 2013 (Act).

Section 130 of the Act prescribes that a company shall not re-open its books of account or recast its financial statements unless an application has been made by the Central Government or a regulatory body or authority to a court of competent jurisdiction or to the National Company Law Tribunal (NCLT) and such appropriate order is passed by such court or NCLT. It may be noted that an application under this section can only be made in case:

  1. The relevant earlier accounts were prepared in a fraudulent manner; or
  2. The affairs of the company were mismanaged during the relevant period, casting a doubt on the reliability of financial statements.

Section 131 of the Act allows the Board of Directors of a company to prepare revised financial statements or revised Board report in respect of any of the three preceding years financial years after obtaining the approval of NCLT after making an application. The section allows a company to revise its financial statements only if it appears to the directors that

  1. the financial statements of the Company; or
  2. the report of the Board

do not comply with section 129 or section 134 of the Act.

Section 129 of the Act states that the financial statements shall be prepared in compliance with the accounting standards prescribed under section 133 of the Act. Section 134 prescribes the manner of approval and authentication of the financial statements and the Board report and the contents of the Board report.

In my opinion, a reopening and revision of earlier years’ financial statements would be required in cases where the discovery of errors (including fraud) and/ or other facts and circumstances that come to light, lead to a conclusion that the earlier years’ financial statements may not be reflecting a true and fair view of the financial position and financial performance of the company in those years.

An example of reopening and revision of financial statements is that of CG Power and Industrial Solutions Limited (CGPISL), which upon discovering certain fraudulent financial transactions in earlier years first restated the comparative numbers in its financial statements for the year ended 31 March 2019 and thereafter applied to NCLT under section 131 of the Act to allow it to reopen and revise its financial statements of earlier years. Also, Ministry of Corporate Affairs (MCA), filed an application, in November 2019, to reopen and revise the financial statements of the Company under section 130 of the Act.

Based on news reports, NCLT approved MCA’s application to reopen and revise CGPISL’s financial statements in March 2020.

Prior to this, NCLT had allowed, in January 2019, to reopen financial statements for past five years of IL&FS and its subsidiaries. 

A retrospective restatement of financial statements may lead to reopening and revision of earlier years’ financial statements. However, a reopening and revision of earlier years’ financial statements will not lead to restatement of financial statements since the revised financial statements of previous year will form the comparatives to be included in current year’s financial statements.

Another difference between a retrospective restatement of financial statements and a reopening and revision of earlier years’ financial statements is that while restatement is permitted only under Ind AS, the provisions of the Act regarding reopening and revision of financial statements apply to all financial statements whether prepared in compliance with Ind AS or in compliance with AS.

Also, while a restatement of the financial statements is in the Company’s own hands, a reopening and revision of financial statements requires approval of NCLT. As noted from the example of CGPISL above, the process of obtaining such approval may be time consuming.

The relationship between restatement of financial statements and reopening of financial statements can be explained with the help of the following two examples.

EXAMPLE 1

A Ltd.’s financial year ends on 31 March.

A Ltd had income from providing services in a foreign country, say USA, for a number of years.

Based on advice received by A Ltd., that its provision of services in the USA amounts to having a Permanent Establishment in the USA and that it is liable to pay tax in USA on its income earned in the USA, A Ltd. started making a provision for income tax payable in USA and interest thereon from year ended 31 March 2016 onwards.

The interest payable on income tax payable in USA was also included in the income tax expense and the income tax provision made.

During the year ended 31 March 2020, A Ltd. paid the income tax payable in USA and interest thereon upto the date of payment of the tax.

Based on the provisions of the Indian income tax law, A Ltd. has determined that the interest on income tax paid in USA can be claimed by it as a deduction (on payment basis) in arriving at taxable income in India, and accordingly, it has computed its current tax expense and current tax provision for the year ended 31 March 2020 after considering the interest paid.

There has been no change in the Indian income tax law provisions in this regard in the last 10 years.   

A Ltd. had a net worth in excess of Rs. 250 crores as of 31 March 2018 and accordingly it prepared its first Ind AS compliant financial statements for the year ended 31 March 2019 with the transition date of 1 April 2017.

For simplicity’s sake, it is assumed that there is no GAAP difference between AS and Ind AS so far as A Ltd. is concerned. Also, that the Indian income tax rate has been considered at a constant 30% for all the years presented. Under India – USA double tax avoidance treaty, credit for income tax paid in USA can be availed while paying Indian income tax.

Relevant extracts of the financial statements of A Ltd. for various years are as follows:

It may be noted that under both AS 22, Accounting for Taxes on Income (AS 22) and Ind AS 12, Income Taxes (Ind AS 12) define income tax as tax based on taxable profits. Accordingly, interest paid/ payable on delayed payment of income tax does not meet the definition of income tax. Instead, such interest is in the nature of a financing charge and accordingly, should be disclosed as a part of interest expense.

Accordingly, interest on USA income tax should be reclassified as interest expense for the year ended 31 March 2020. Also, the comparative figures for the year ended 31 March 2019 should be restated to show such interest as part of interest expense. Since, in earlier years, such interest has already been considered as a deduction to arrive at profit after tax, there is no adjustment required in retained earnings as of 1 April 2018.

However, since such interest is allowed as a deduction for computing taxable income in India on payment basis, creation of a provision for such interest without actual payment is a deductible temporary difference (under Ind AS 12) and timing difference (under AS 22), and accordingly, deferred tax asset should have been created on provision of such interest.

Hence, comparatives for the year ended 31 March 2019, included in the financial statements for the year ended 31 March 2020, should be restated to include deferred tax assets in respect of provision made during the year. Further, opening retained earnings as of 1 April 2018 should be adjusted for deferred tax adjustment and creation of deferred tax asset on the amount of provision existing as of 31 March 2018.

Based on the above, the restated financial statements of A Ltd. are as follows:

Considering that the change in amount of total current liabilities, income tax provision, deferred tax assets, interest expense and total income tax expense is material for all the earlier years, apart from restatement of comparatives in the financial statements for the year ended 31 March 2020, A Ltd. should assess whether the changes are material enough for it to reopen and revise its financial statements of preceding three years following the provisions of section 131 of the Act.

EXAMPLE 2

B Ltd.’s financial year ends on 31 March. B Ltd. prepares its financial statements following Ind AS. The transition date to Ind AS was 1 April 2016.

C Ltd. amalgamated with B Ltd.  C Ltd. is not under common control with B Ltd. The appointed date of amalgamation as per the scheme of arrangement filed with NCLT is 1 April 2017. The approval of NCLT to the scheme of arrangement was received in April 2020 and the scheme became effective as of 1 May 2020.

For each of the financial years, the assets, liabilities, income, and expenses of C Ltd. are roughly half those of B Ltd.

B Ltd.is yet to issue its financial statements for the year ended 31 March 2020.

Ind AS 103, Business Combinations (Ind AS 103) provides that a business combination (including amalgamations) should be accounted for on the acquisition date which is the date on which the acquirer obtains control of the acquiree.  Accordingly, in case of an amalgamation, the acquisition date is the date on which the scheme of arrangement became effective since before that date both the amalgamating and the amalgamated companies were independent companies. However, as per a circular dated 21 August 2019 issued by the Ministry of Corporate Affairs (MCA), in case of a scheme under the Companies Act, 2013, the Appointed Date is deemed to be the acquisition date/ date of transfer of control under Ind AS 103.

Accordingly, B Ltd. is required to account for the amalgamation of C Ltd. with itself on and from 1 April 2017.

While, a retrospective acquisition date is not a prior period error, I believe that B Ltd. is required to restate the comparative figures in the financial statements for the year ended 31 March 2020 and also the opening balance of retained earnings and assets and liabilities as of 1 April 2018 to reflect the business combination from 1 April 2017. Considering that the restatements are material, B Ltd. is also required to present a third balance sheet as of 1 April 2018 (restated) as  a part of its financial statement for the year ended 31 March 2020. It may be noted that Ind AS 103 does not specifically require the third balance sheet.

Further, considering that the date of acquisition as per Ind AS 103 read with MCA’s circular is 1 April 2017, in my opinion, B Ltd. should also reopen and revise its financial statements for the years ended 31 March 2018 and 31 March 2019 following the provisions of section 131 of the Act.

Alternatively, considering the time period involved in obtaining approval of NCLT, B Ltd. may first reopen and revise its financial statements for the years ended 31 March 2018 and 31 March 2019 following the provisions of section 131 of the Act and then, prepare the financial statements for the year ended 31 March 2020 which will include comparatives based on the revised financial statements for the year ended 31 March 2019. I hope, I have been able to explain the relationship between retrospective restatement and reopening/ revision of financial statements.

Expected Amendments to Indian Accounting Standards (Ind AS) in 2020

As we know, amendments to Ind AS follow amendments to IFRSs (International Financial Reporting Standards). IASB (International Accounting Standards Board) has issued a few amendments to IFRS which are effective from 2020. Accordingly, it is expected that these amendments will be incorporated in Ind AS this year by Ministry of Corporate Affairs (MCA) by issuing Companies (Indian Accounting Standards) Amendment Rules.

Amendments to IFRS are as follows:

IFRS 3, Business Combinations (IFRS 3)

IASB has amended the definition of “business” and related guidance included in the standard for the purposes of identifying where an acquisition is a business to apply business combination accounting. These amendments are effective from accounting periods beginning on or after 1 January 2020 with earlier application permitted.

Previous definition of business included in IFRS 3 is as follows:

“An integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs or other economic benefits directly to investors or other owners, members or participants”.

The amended definition of business is as follows:

“An integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing goods or services to customers, generating investment income (such as dividends or interest) or generate other income from ordinary activities”.

Key change is that the definition of business is narrowed to focus on providing goods or services to customers, generating investment income or generate other income from ordinary activities instead of the earlier wider focus of providing a return in the form of dividends, lower costs or other economic benefits directly to investors or other owners, members or participants.

Earlier the standard also provided that a business need not include all of the inputs and processes that the seller used in operating that business if market participants are capable of acquiring the business and continuing to produce outputs, for example, by integrating the business with their own inputs and processes. This requirement is now deleted. Instead, the amended guidance requires that to be considered a business, an integrated set of activities and assets, must include at a minimum, an input and a substantive process that together contribute to the ability to create output. Further, to be a business without outputs, there will now need to be an organised workforce for it to constitute a business.

Further, the amended guidance provides that if an acquired set of activities and assets has outputs, continuation of revenue does not on its own indicate that both an input and a substantive process have been acquired. Additional guidance has been provided to assess whether a process is substantive or not.

The standard earlier also provided that if a particular set of activities and assets included goodwill, then such set of activities and assets was presumed to be a business. This presumption has now been deleted.

The amendment also provides that an entity can apply a ‘concentration test’ that, if met, eliminates the need for further assessment. Under this optional test, where substantially all of the fair value of gross assets acquired is concentrated in a single asset (or a group of similar assets), the assets acquired would not represent a business. The amended standard provides detailed guidance in this respect.

The changes to the definition of a business will likely result in more acquisitions being accounted for as asset acquisitions across all industries, particularly real estate, pharmaceutical, and oil and gas.

IFRS 9, Financial Instruments (IFRS 9)

IASB has amended the hedge accounting requirements included in IFRS 9 to provide limited relief to financial statement preparers from the effects of the forthcoming IBOR (Interbank Offered Rate) reform. These amendments are effective from accounting periods beginning on or after 1 January 2020 with earlier application permitted.

For details on IBOR reform and its business and accounting consequences please read my or on my blog post at https://joy-consulting.in/2020/06/15/ibor-reform-what-in-the-heavens-is-that/  or my linkedin post at https://www.linkedin.com/feed/update/urn:li:activity:6678171533095108608/.

IFRS 16, Leases (IFRS 16)

IASB has amended IFRS 16 to provide limited relief to lessees in respect of rent concessions arising due to Covid-19 pandemic. No relief has been allowed to the lessors. These amendments are effective from accounting periods beginning on or after 1 June 2020 with earlier application permitted.

The amendments provide a practical expedient that lessess may elect to not treat any rent concessions, provided by lessors as a direct consequence of Covid-19 pandemic, as lease modifications. However, to be eligible for this relief,

  1. the revised consideration for the lease should be less than or equal to the lease consideration immediately before the change,
  2. the rent concession should be for a period that does not extend beyond 30 June 2021, and
  3. there is no substantial modification to the other terms and conditions of the lease.

This means that such rent concessions can be taken by the lessees directly to the statement of profit and loss. However, the lessees will have to continue to account for interest expense and depreciation on right-of-use assets as before.

Lessees are also required to provide disclosures about application of the practical expedient and its impact on profit or loss.

IAS 1, Presentation of Financial Statements (IAS 1) and IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors (IAS 8)  

IASB has amended the definition of “materiality” and related guidance. The amendment is effective for accounting periods beginning on or after 1 January 2020. Early application is permitted.

Previous definition of materiality included in IAS 1 and IAS 8 is as follows:

“Omissions or misstatements of items are material if they could, individually or collectively, influence the economic decisions that users make on the basis of the financial statements. Materiality depends on the size and nature of the omission or misstatement judged in the surrounding circumstances. The size or nature of the item, or a combination of both, could be the determining factor”.

The amended definition of materiality is as follows:

“Information is material if omitting, misstating or obscuring it could reasonably be expected to influence the decisions that the primary users of general purpose financial statements make on the basis of those financial statements, which provide financial information about a specific reporting entity”.

The amendments clarify that the information is obscured if it is communicated in a way that would have a similar effect for primary users of financial statements to omitting or misstating that information. The amendments also state that an entity assesses materiality in the context of the financial statements as a whole.

The amendments also clarify the meaning of ‘primary users of general purpose financial statements’ to whom those financial statements are directed, by defining them as ‘existing and potential investors, lenders and other creditors’ that must rely on general purpose financial statements for much of the financial information they need.

Ind AS 7, Statement of Cash Flows (Ind AS 1)

It appears that an inadvertent error has crept into Ind AS 7 consequent to the amendments made by Ind AS 116, Leases (Ind AS 116). 

Paragraph 17 of Ind AS 7 provides examples of cash flows arising from financing activities.

Instead of replacing paragraph 17(e) “Cash payments by a lessee for the reduction of the outstanding liability relating to a finance lease”, paragraph 17(c) “Cash proceeds from issuing debentures, loans, notes, bonds, mortgages, and other short-term and long-term borrowings” has been replaced by “Cash payments by a lessee for the reduction of the outstanding liability relating to a lease”.

Consequently, an important element of financing activities has been removed as an example from IAS 7 and instead we have two examples relating to leases of which one i.e 17(e) is no longer applicable since, consequent to the issuance of Ind AS 116,  there is no concept of a finance lease with respect to a lessee. Members of NFRA (National Financial Reporting Authority) are cognizant of this error and it is expected that MCA will correct this error at the earliest.

IBOR Reform – What in the heavens is that?

After reading the heading, some of you may be asking what is IBOR?

Well, IBOR stands for Interbank Offered Rate which is a benchmark interest rate. There are number of IBORs in the world today including well known ones to us such as LIBOR (London Interbank Offered Rate), Euribor (Euro Interbank Offer Rate) and MIBOR (Mumbai Interbank Offer Rate). Such rates include credit risk of banks/ financial institutions offering such rates.

Now, many of you might be asking, okay, I know what IBOR stands for but why should I worry about IBOR reform?

IBOR reform is important as most regulators are moving away from IBORs. In fact, most IBORs including LIBOR and Euribor are expected to be phased out by the end of 2021 and replaced with other benchmark rates such as SOFR (Secured Overnight Funding Rate) for US Dollar denominated instruments, SONIA (Reformed Sterling Overnight Interest Average) for British Pound denominated instruments, and €STR (Euro Short Term Rate). Such rates are usually risk-free rates as these are based on government bond rates.

Regulators have become uncomfortable with IBOR because of because they are based on trader quotes rather than actually observed rates. Regulators’ discomfort significantly increased after the LIBOR rate fixing scandal came to light in 2012. The traders were colluding with each other to rig LIBOR and thus to make profits.

Now, some of you might say, the IBORs are phasing out, so what?

Well, it should matter to all those who are involved with companies which have lent or borrowed money in foreign currencies. This will particularly have significant impact on banks and other financial institutions who borrow and lend money in foreign currencies. All such companies, whether following Indian Accounting Standards (“Ind AS”) or Accounting Standards (“AS”), will be impacted. However, banks and financial institutions may also have to follow any guidelines issued by the Reserve Bank of India in this respect.

It should be noted that a vast majority of financial instruments in the world (especially lending/ borrowings) are linked to IBORs. PwC[1] has indicated that financial instruments of over 350 trillion US Dollars are linked to LIBOR alone.

In the Indian context, most of the lending/ borrowings denominated in foreign currency are linked to IBOR, mostly to LIBOR. These could be plain vanilla loans, bonds, debentures, and convertible instruments such as foreign currency convertible bonds (“FCCBs”). Also, other financial instruments such as supplier’s credit and interest-bearing advances against contracts which are in foreign currency may also be linked to IBOR.

The first impact of IBOR reform is at business and finance/ treasury level.

Since, interest rates in current contracts are linked to IBOR, the interest rate clauses in all lending/ borrowing agreements will become inoperative when respective IBORs are phased out. Hence, all lenders and borrowers need to renegotiate their contracts to move away from IBOR and link the interest rates from the current IBOR to another applicable benchmark rate. The lenders need to ensure that their interest income on lending does not decrease while the borrowers need to ensure that the interest expense on their borrowings does not increase.

In fact, it is quite possible, that lenders may already have reached out to borrowers for renegotiating the agreements. Also, some lenders have already started to include clauses to cover other benchmark rates on phasing out of applicable IBOR in their lending contracts.

Second impact is at the accounting level.

There are two accounting impacts – first relates to modification of the lending/ borrowing contract and second relates to hedge accounting if the lender/ borrower has a hedge in respect of foreign currency lending/ borrowing, particularly against the interest rate, and follows hedge accounting.

A change in benchmark rate in respective contracts will result in modification of respective financial instrument contracts. While we have no guidance regarding modification of financial instruments in accounting standards included in the Companies (Accounting Standards) Rules, 2006 (hereinafter referred to as “AS’), there is extensive guidance in this regard in Indian Accounting Standard 109, Financial Instruments (Ind AS 109) included in the Companies (Indian Accounting Standards) Rules, 2015.

Ideally, companies following AS should also follow the accounting provided in Ind AS 109 to account for the modification of lending/ borrowing contracts, as applicable. However, I hope that the Institute of Chartered Accountants of India (“ICAI”) will issue an advisory on this in due course.

Under Ind AS 109, a gain/ loss on modification needs to be computed and taken to statement of profit and loss when the modification occurs. International Accounting Standards Board (“IASB”) has issued an exposure draft, as part of its phase 2 of the project regarding IBOR reform and its effect on financial reporting,  to amend IFRS 9, Financial Instruments and IFRS 4, Insurance Contracts  to provide some relaxations on financial instruments modification accounting and hedge accounting once an IBOR is replaced with another benchmark rate in financial instrument contracts. It is expected that the final amendments will be issued sometime in third quarter of 2020.

We can expect similar amendments to be made to Ind AS 109 and Ind AS 104 at an appropriate time and also to the Guidance Note on “Accounting for Derivates” (“GN”) issued by ICAI which is applicable to entities which are preparing AS compliant financial statements.

Now coming to the impact of IBOR reform on hedge accounting.

Replacement of benchmark with other interest rates may lead to failure of certain hedges to qualify for hedge accounting. Consequently, hedge accounting will have to be discontinued as of today.

IBOR Reform will affect companies in all industries that have applied hedge accounting for IBOR-related hedges, such as hedges of loans, bonds and borrowings with instruments such as interest rate swaps, interest rate options, forward rate agreements and cross-currency swaps.

This can happen when future interest cash flows that depend upon an IBOR (for example, future LIBOR-based interest payments on issued debt hedged with an interest rate swap) are no longer “highly probable” beyond the date at which the relevant IBOR is expected to cease being published.

Secondly, both Ind AS 109 and the GN require a forward-looking prospective assessment in order to apply hedge accounting. Ind AS 109 requires there to be an economic relationship between the hedged item and the hedging instrument, whereas GN requires the hedge to be expected to be highly effective. Given the uncertainties arising from IBOR reform, including when IBORs will be replaced and with what rate(s), this might become difficult to demonstrate currently. This could give rise to hedge ineffectiveness in the prospective assessment, in particular where the replacement of the benchmark rate is expected to occur at different times in the hedged item and the hedging instrument. The uncertainties described above in the context of prospective assessments could also affect GN’s retrospective effectiveness requirement.

Thirdly, in some hedges, the hedged item or hedged risk is a non-contractually specified IBOR risk component. An example is a fair value hedge of fixed-rate debt where the designated hedged risk is changes in the fair value of the debt attributable to changes in an IBOR. In order for hedge accounting to be applied, both Ind AS 109 and GN require the designated risk component to be separately identifiable. Given the uncertainties arising from IBOR reform, this might cease to be the case.

However, the good news is that IASB, as part of Phase 1of the project regarding IBOR reform and its effect on financial reporting, has issued certain amendments to IFRS 9 and IFRS 7, Financial Instruments Disclosures, providing  reliefs to hedge accounting in the period before the reform.

These amendments are effective from accounting periods beginning 1 January 2020 with earlier application permitted.

We can expect similar amendments in Ind AS 109 and Ind AS 107 to be issued by Ministry of Company Affairs in the near future. ICAI had already issued an exposure draft of the proposed amendments to Ind AS 109 and Ind AS 107 in 2019. We also hope that ICAI will provide similar reliefs in the GN.

These amendments provide as follows:

  • Firstly, the amendments require an entity to assume that the interest rate on which the hedged cash flows are based does not change as a result of the reform. Hence, where the hedged cash flows may change as a result of IBOR reform (for example, where the future interest payments on a hedged forecast debt issuance might be SONIA + X% rather than GBP LIBOR + Y%), this will not cause the ‘highly probable’ test to be failed.
  • Secondly, the amendments provide that an entity assumes that the interest rate benchmark on which the cash flows of the hedged item, hedging instrument or hedged risk are based is not altered by IBOR reform and hence the economic relationship and hedge effectiveness is not affected.
  • Thirdly, under the amendments, where only a risk component is hedged, the risk component only needs to be separately identifiable at initial hedge designation and not on an ongoing basis. In the context of a macro hedge, where an entity frequently resets a hedging relationship, the relief applies from when a hedged item was initially designated within that hedging relationship.
  • IFRS 7 has been amended to require disclosure of the nominal amount of hedging instruments to which the reliefs are applied, any significant assumptions or judgements made in applying the reliefs, and qualitative disclosures about how the entity is impacted by IBOR reform and is managing the transition process.  

I hope I have provided some clarity on the issue. Entities which have financial instruments (loans given/ borrowings, etc.) in foreign currencies should start a dialogue with their counterparties, if not already done so. Also, entities may consult their auditors/ accounting experts on accounting implications arising from IBOR reform based on facts and circumstances in their case.

[1]Source: https://www.pwc.com/gx/en/industries/financial-services/publications/libor-reference-rate-reform.html