accounting and auditing update - october 2013

October 2013

ACCOUNTINGAND AUDITINGUPDATE

Falling between the

(Goodwill) cracks?

p01

In this issue

Corporate Debt Restructuring p07

Employee share based payments p13

Revised Exposure Draft on Insurance Contracts p21

Reporting on Audited Financial Statements p25

Accounting for loan origination costs by lending institutions p27

Regulatory updates p30

The Companies Act of 2013 is now well and truly a reality and notification of sections and draft rules are coming through thick and fast almost on a weekly basis. We are in the process of issuing a comprehensive publication of our analysis of the various sections and draft rules. You can expect this publication that should be the ‘go-to’ point of reference on the Act shortly.

In this issue of the AAU, we have largely stayed away from the Companies Act and instead focused on a number of other topical accounting and reporting matters that will be relevant to stakeholders in addition to the Companies Act changes that are on their way. Some of the areas we cover this month are critical and gain more relevance in a challenging economic environment.

We lead this issue with a description of the key areas of focus while considering the question of impairment and potential impairment of goodwill under Indian GAAP. We also examine some of the considerations from an accounting perspective of Corporate Debt Restructurings.

We also examine key aspects relating to changes proposed in the exposure drafts on Insurance accounting internationally that could have a fall out impact on Indian insurance companies at a future date. We have explained some of nuances and intricacies associated with the accounting for employee share based payments in this issue. In addition, we have provided an overview of the key changes being proposed to the format and content of the auditors’ report internationally.

Finally, we have a brief overview of the accounting practices by entities in India relating to transaction costs associated with lending/financing businesses in addition to our regular round up of key developments and regulatory updates.

We look forward to continuing to hear from you on what you find useful and what you would like us to cover in future editions of the AAU.

Happy reading!

Editorial

© 2013 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

V. VenkataramananPartner, KPMG in India


Falling between the (Goodwill) cracks?Key challenges in the goodwill impairment analysis

What are the events or circumstances that indicate impairment?

Following are some indications that an impairment loss may have occurred:

External sources of information Internal sources of information

• Significant decline in market value • Obsolescence or physical damage

• Adverse impact on technology, market, economic or legal environment

• Significant changes in the manner in which, an asset is used or is expected to be used (example: discontinued operations)

• Increase in interest rates • Adverse impact on economic performance

• Carrying amount of the net assets more than market capitalisation

• Negative effect on future expected earnings and cash flows

• Entity-specific events such as changes in management, key personnel, strategy, litigations, etc.

• Deterioration in the level of asset’s performance

• Continuous cash losses for two or three successive years

The lists that are mentioned above are not all-inclusive. The presence of an indicator means that a company must perform the next steps in determining whether impairment exists.

Recent announcements by several large corporations for recording goodwill impairment charges in their books have left us bewildered with several questions. Did the companies overpay in their quest for inorganic growth? Or is it primarily due to a weaker macroeconomic and market environment across the globe? Answers to these questions are vital to understand why some of the large corporations in recent years have fallen between the (goodwill) cracks and been hit by significant write-offs. There is a need to closely evaluate the initial accounting of goodwill on acquisition, identification of triggers and its subsequent measurement by the management, accountants and investors.

An impairment loss is the amount by which the carrying amount of an asset exceeds the recoverable amount. The accounting guidelines for goodwill impairment emanate from AS 28, Impairment of Assets under Indian generally accepted accounting principles (IGAAP); IAS 36, Impairment of Assets under IFRS and Accounting Standard Codification Topic 350 (ASC 350) under US GAAP. While there may be some differences in the standards, all sets of rules require a company to consider the impact of the triggers or indicators of impairments. This article attempts to highlight, in the form of questions and answers, some of the practical difficulties in application of the principles provided by AS 28.

• Tell you step by step the process of impairment testing under Indian GAAP

• Share the key challenges in the goodwill impairment analysis.

1

This article aims to:


What is Recoverable Amount?Recoverable amount is the higher of net selling price and value in use (VIU).

Is it always required to determine both the net selling price and VIU?It is not always necessary to determine both the net selling price and VIU. For example, if the VIU of the asset is higher than the carrying value of the asset, then the asset is not impaired and it is not necessary to estimate the net selling price.

Is it always possible to determine both the net selling price and VIU?It may not be always possible to determine both the net selling price and the VIU. It should be noted that an opinion of the Expert Advisory Committee (EAC)1 of the ICAI states that AS 28 does not exempt any entity from calculating VIU under any condition. However, in practice many entities tend to avoid calculating VIU when the net selling price is considerably greater than the carrying amount.

How is net selling price determined?

When there is a binding sales agreement in an arm’s length transaction, the net selling price is the price as per the binding sales agreement less the cost of disposal. When there is no binding sales agreement, but an active market exists for the asset, then the net selling price is the asset’s market price less cost of disposal. If there is no binding sale agreement or an active market for the asset, then the net selling price is based on the best information available to reflect the amount that an enterprise could obtain, at the balance sheet date, for disposal of the asset in an arm’s length transaction between knowledgeable, willing parties, after deducting the costs of disposal. In determining this amount, an enterprise may consider the outcome of recent

transactions for similar assets within the same industry. Net selling price does not reflect a forced sale, unless management is compelled to sell immediately. Costs of disposal, other than that have already been recognised as liabilities, are deducted in determining net selling price. Examples of such costs are legal costs, costs of removing the asset, and direct incremental costs to bring an asset into condition for its sale. Cost associated with reorganisation of business following the sale of the asset is not considered as cost of disposal.

Further, in an EAC opinion1 of the ICAI it has been opined that if there is neither a binding sale agreement in an arm’s length transaction, nor are the assets traded in the active market, nor have there been recent transactions for similar assets within the same industry, a valuation determined by a chartered valuer cannot be considered as the sole basis for the computation of the net selling price.

How is Value in Use (VIU) determined?VIU of an asset is determined based on the following:

a. Estimates of the future cash flows from the use of the asset and its disposal

b. Applying appropriate discount rate to the future cash flows to arrive at the present value of the future cash flows.

Determination of VIU may appear to be a simple 2-step method, but the underlying process of estimating the future cash flows and the discount rate poses significant challenges as discussed below.

How are the future cash flows determined?According to AS 28, the future cash flows should be determined in the following way:

a. Cash flow projections should be based on reasonable and supportable assumptions that represent management’s best estimate of the set of economic conditions that will exist over the remaining useful life of the asset. Greater weight should be given to external evidence in order to determine the reasonableness of assumptions.

b. The business plan should be prepared based on operating cash flows from the continuing use of the asset during its useful life and the cash flows from disposal of the asset at the end of its useful life. Projections based on these

business plans should cover a maximum period of five years, unless a longer period can be justified.

c. Cash flow projections beyond the period covered by the most recent budgets/forecasts should be estimated by extrapolating the projections based on the budgets/forecasts using a steady or declining growth rate for subsequent years, unless an increasing rate can be justified. This growth rate should not exceed the long-term average growth rate for the products, industries, or country/countries in which the enterprise operates, or for the market in which the asset is used, unless a higher rate can be justified.

d. The business plan should not include the following:

• Cash inflows not associated with the asset under review (for example, financial assets)

• Cash outflows that relate to obligations that have already been recognised as liabilities (for example, payables, pensions or provisions)

• Cash inflows or outflows from financing activities

• Income tax receipts or payments

• Cash flows from future restructuring to which an enterprise is not yet committed and future capital expenditure that will improve or enhance the asset’s performance.

Impairment testing is a complex process which can be often challenging for the management of the company, its auditor and the independent valuer. The management of companies may provide an aggressive business plan to be used in calculating the VIU, in order to avoid any impairment charge to be recorded in the books. In such situations, the role of independent valuer becomes critical in determining the VIU and subsequently the impairment charge, if any. Similarly, auditors have to play a critical role in assessing the impairment analysis and assumptions used by the management, keeping in mind the financial performance of the company.

The business plan should be approved by the management of the company and should not reflect views of select employees of the company. Even in case of a management approved business plan, there may be an element of upward bias. For example, the management may

2

Binding sale

agreement

Net selling price

Active market Other

Price as per agreement - cost of disposal

Market price - cost of

disposal

Fair value - cost of

disposal

Source: Accounting and Auditing Update, October 2013

1 EAC Compendium of Opinions Volume XXVI – Query No. 5 Determination of net selling price of a cash generating unit incurring losses


not consider making any adjustments to the business plan originally envisaged at the time of acquisition despite weakening macroeconomic, market or company specific factors. It is therefore, imperative, that the business plan should be reasonable and based on assumptions that represent management’s best estimate of the economic conditions that will exist over the remaining useful life of the asset. In the case of listed companies, it becomes even more critical, from a corporate governance perspective, to use a business plan that is approved by the management as well as the board of directors of the company.

The independent valuer must carry out reasonableness checks based on the various industry parameters, comparable benchmarking and discussions with the management before arriving at the valuation conclusions. The valuer must also compare the trends in the projected revenue growth rates and profitability margins with the historical financial performance and seek detailed explanations from the management in case of significant deviations.

If the acquired business is in a growing stage expecting negative cash flows during the five-year forecast period, the valuer may find it difficult to determine the terminal value based on the negative cash flows. In such a situation, the valuer should ensure that the management extrapolates the business plan using a steady or declining growth rate in the subsequent years till the time business operations reach a constant sustainable growth stage.

If the valuer considers the underlying assumptions of the business plan to be unreasonable and overly optimistic, it should carry out additional sensitivity and scenario analysis in order to arrive at a more reasonable estimate of the value. More importantly, valuers should be extremely cautious in determining the valuation assumptions, such as discount rate and terminal year growth rate, that should reasonably reflect the risk inherent in the business plan provided by the management of the company.

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What factors should be considered to determine the discount rate? In determining VIU, projected future cash flows are discounted using a pre-tax discount rate that reflects:

• current market assessments of the time value of money and

• the risks specific to the asset or CGU.

The discount rate is based on the return that investors would require if they were to choose an investment that would generate cash flows of amounts, timing and risk profile equivalent to those of the asset or CGU. In other words, the discount rate is based on a market participant’s view of the asset or CGU as at the current date. Therefore, although the cash flows in the value in use calculation are entity-specific, the discount rate is not.

In our experience, it is rare that a discount rate can be observed directly from the market. Therefore, an entity will generally need to build up a market participant discount rate that appropriately reflects the risks associated with the cash flows of the CGU being valued. In the absence of a discount rate that can be observed directly from the market, AS 28 refers to other starting points in determining an appropriate discount rate:

• the entity’s weighted-average cost of capital (WACC)

• the entity’s incremental borrowing rate and

• other market borrowing rates.

The weighted average cost of capital (WACC) of an enterprise is calculated using the Capital Asset Pricing Model (CAPM) for cost of equity, the incremental borrowing rate or other market borrowing rates and the capital structure. CAPM is explained as:

Cost of Equity = Risk Free Rate + Beta x (Equity Market Return – Risk Free Rate) + CSRP 2

A key factor to be considered in determining the discount rate for VIU is that it should be based on a market participant’s view. Therefore, the first step is to arrive at a set of comparable companies in the industry in which the

subject company operates. The selection process is subjective and depends on specific valuer’s judgement. However, the valuer should avoid any biases or ‘cherry-picking’ in selecting the comparable companies. The beta and the capital structure are, therefore, based on industry average parameters reflecting a market participant’s view.

The WACC is a post-tax rate. In order to convert the WACC to a pre-tax rate, pre-tax cost of debt and equity should be considered. Determination of a pre-tax discount rate is generally not as simple as grossing up the post-tax discount rate by a standard tax rate. The effective tax rate, for example, may not be the same as the statutory tax rate due to factors such as the utilisation of future tax losses or taxable temporary differences relating to the asset. AS 28 indicates that a pre-tax discount rate can be determined by an iterative computation so that value in use determined using pre-tax cash flows and a pre-tax discount rate equals VIU determined using post-tax cash flows and a post-tax discount rate.

The valuer should ensure that the discount rate is adjusted for country risk, currency risk and company specific risks such as size, access to capital markets, breadth of customer base, geographic concentration, key executive dependence, limited product line, etc. The operating risk associated with the ability of the enterprise to achieve the estimated future cash flows should also be captured in the discount rate. The key challenge here is how to quantify each of these risk factors in percent to be added to the base discount rate. This is a very subjective concept and almost entirely depends on the specific valuer’s judgement.

In certain cases, the future cash flow estimates may have been adjusted by the management of the company to incorporate certain risk factors. Therefore, the same should not be included in the discount rate calculation by the valuer. In addition, careful consideration is required in determining appropriate terminal growth rate assumptions.

2 Company Specific Risk Premium


What are the various ‘crosschecks’ that are applied in determining the reasonableness of the VIU when a substantial portion of the entity is tested for impairment?There are additional cross-checks that can be performed in testing the reasonableness of a VIU calculation, especially when a substantial portion of the entity is tested for impairment. Some of these checks include:

a. Comparison to market capitalisation

b. Consideration of any recent offers made to acquire the cash generating unit (CGU) or an asset

c. Comparison to other recent valuations performed for other purposes (i.e., for tax reasons)

d. Consideration on what analysts are saying in their articles, reports and briefings

e. Comparison of the overall movement in VIU and discount rates since the last impairment test

f. Consideration as to how comparable a company’s share prices have moved? For example, if the CGU was acquired close to the high points in equity markets and there has been a large fall in comparable companies’ share prices, one might expect that the value in use would show a lower value than the acquisition price

g. Reconciliation of the total fair value of CGUs to total market capitalisation, particularly if the market comparables are used to value CGUs.

How is the impairment loss accounted?

If the asset is recorded at its historical cost then the impairment loss is recorded as a loss in the profit and loss statement. If the asset has been revalued in the past then the impairment loss is adjusted against the revaluation reserve. If the impairment amount exceeds the revaluation reserve then the difference is accounted as a loss in the profit and loss statement.

What is a Cash Generating Unit (CGU)? How is it identified? If it is not possible to estimate the recoverable amount of the individual asset, an enterprise should determine the recoverable amount of the CGU to which the asset belongs. A CGU is defined as the smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets.

Identification of CGUs requires significant judgement as also specifically indicated in AS 28 and continues to create much debate. In order to identify whether cash inflows from an asset are largely independent of the cash inflows from other assets, an enterprise considers various factors including how management monitors the enterprise’s operations. While monitoring by the management may help in identifying a CGU, greater emphasis should be placed on the requirement that the identification of CGUs is based on largely independent cash inflows. For example, in media and entertainment industry, while the publisher may separately monitor cash inflows from individual newspapers, but if each of the newspapers contains mostly advertisements that are bundled with other mastheads owned by the publisher, such cash inflows may be interdependent. Although the management may monitor each newspaper, the cash inflows are not largely independent, and therefore, the mastheads would form one CGU on a consolidated basis.

If an active market exists for the output produced by an asset, this asset should be identified as a separate CGU, even if some or all of the output is used internally. This is because this asset could generate cash inflows from the continuing use that would be largely independent of the cash inflows from other assets. However, if the internal transfer prices do not reflect

management’s best estimate of future market prices for CGU’s output, one should adjust the forecasts related to this CGU.

In the process of identifying CGUs, a key challenge arises while dealing with corporate assets (for example, headquarters or a division of the enterprise, EDP equipment or a research centre) that do not generate cash inflows independently from other assets or groups of assets and, therefore, they are a part of more than one CGU. Their carrying amount cannot be fully attributed to the CGU under review. If the carrying amount of the corporate asset can be allocated on a reasonable and consistent basis to the CGU under review then an enterprise should apply the ‘bottom-up’ test only, else the enterprise should apply both the ‘bottom-up’ and ‘top-down’ tests.

Another challenge arises when an asset or a CGU merges with an existing CGU either due to new acquisition or due to internal reorganisation of the reporting structure. When an acquired asset merges with the existing CGU, it may not be possible to determine the real impact on the goodwill of the existing CGU versus goodwill on account of new acquisition. This is because when the impairment testing is carried out post merger, recoverable amount would be determined for the combined CGU and not separately for the existing CGU and the new acquired asset. This becomes even more critical especially if the company has overpaid for the new acquisition because even though the existing CGU may not be impaired, the combined CGU may take an impairment charge due to the expensive acquisition. Now consider another situation where the company reorganises its reporting structure that results in a change in the composition of CGUs to which goodwill has been allocated. While there is no specific guidance under Indian GAAP, IFRS requires that in such a case the goodwill should be reallocated to the CGUs affected using a relative value approach similar to that used when an entity disposes of an operation within a CGU.

4

Revalued amount Historical cost

Charge to equity to the extent of the

reserve

Excess Charge to profit and loss

Recognise impairment loss



5

How is the impairment analysis of goodwill carried out?

Goodwill arising on acquisition represents a payment made by an acquirer in anticipation of future economic benefits. Goodwill does not generate cash flows independently from an asset or groups of assets and, therefore, the recoverable amount of goodwill as an individual asset cannot be determined. If there is an indication that goodwill may be impaired, the ‘bottom-up’ approach is used to determine the recoverable amount for the CGU to which goodwill belongs. This amount is then compared to the carrying amount of this CGU to recognise the impairment loss. If the enterprise could not allocate the carrying amount of goodwill on a reasonable and consistent basis while performing the bottom-up test then the enterprise should also perform a ‘top-down’ test to test the goodwill for impairment.

If there are indefinite lived intangibles like say brand, goodwill and other long lived assets within a single CGU being evaluated for impairment, on what order should the impairment loss be recognised? The impairment loss should be allocated in the following order:

a. first, to goodwill allocated to the CGU (if any) and

b. then, to the other assets (including indefinite lived intangibles) of the unit on a pro-rata basis based on the carrying amount of each asset in the unit.

While allocating the impairment loss, the carrying amount of an asset should not be reduced below the maximum of its recoverable amount or zero.

It is interesting to note that although goodwill is an indefinite lived intangible similar to a brand, the impairment loss is first allocated to goodwill primarily because it is an intangible asset with the most subjective value.

What are the circumstances for reversal of a previously recognised impairment loss? An enterprise should assess at each balance sheet date whether there is any internal or external indication that an impairment loss recognised for an asset in prior accounting periods may no longer exist or may have decreased. If any such indication exists, the enterprise should estimate the recoverable amount of that asset. The external and internal indicators mirror the indictors considered to identify impairment.

Possible

Impairment of Goodwill


Not Possible

Allocation of goodwill to CGU

Apply bottom-up approach

Apply bottom-up approach

Apply top-down approach

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How is the reversal of impairment loss allocated?

Individual AssetA reversal of an impairment loss for an asset should be recognised as income immediately in the statement of profit and loss, unless the asset is carried at revalued amount. A reversal of an impairment loss on a revalued asset is credited directly to equity under the heading revaluation surplus. However, to the extent that an impairment loss on the same revalued asset was previously recognised as an expense in the statement of profit and loss, a reversal of that impairment loss is recognised as income in the statement of profit and loss. After a reversal of an impairment loss is recognised, the depreciation/amortisation charge for the asset should be adjusted in future periods to allocate the asset’s revised carrying amount over its remaining useful life.

Cash-Generating UnitA reversal of an impairment loss for a CGU should be allocated to increase the carrying amount of the assets of the unit in the following order:

a. first, assets other than goodwill on a pro-rata basis based on the carrying amount of each asset in the unit

b. then, to goodwill allocated to the CGU (if any). An impairment loss recognised for goodwill should not be reversed in a subsequent period unless:

• the impairment loss was caused by a specific external event of an exceptional nature that is not expected to recur and

• subsequent external events have occurred that reverse the effect of that event.

In allocating a reversal of an impairment loss for an individual asset or a CGU, the carrying amount of an asset should not be increased above the lower of:

a. its recoverable amount (if determinable) and

b. the carrying amount that would have been determined (net of amortisation or depreciation) had no impairment loss been recognised for the asset in prior accounting periods.

Conclusion

In this current uncertain economic and financial environment, auditors may approach impairment differently than in the past. Due to lack of visibility on business plans, the assumptions used in calculating the fair value of assets would be heavily scrutinised and subjected to an increased level of skepticism than before. Impairment testing should not be considered as a tick-in-the-box item but a critical evaluation and a reality-check of the current state of operations of the company including previous acquisitions.



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Corporate Debt RestructuringTrends and Accounting challenges

What is Corporate Debt Restructuring (CDR)?There are occasions when a corporate finds itself in financial difficulties because of factors beyond its control and due to certain internal organisational reasons. For the revival of such corporates as well as to safeguard the money lent by the banks and financial institutions (hereinafter referred to as ‘B & FI’), timely support through restructuring of genuine cases is warranted.

CDR can be bilateral or multilateral. In multilateral arrangements, the restructuring could be through a mutually agreed forum or through the CDR cell constituted by the Reserve Bank of India (RBI). To do away with operational delays and to bring uniformity and a formal structure to India’s corporate debt restructuring program a CDR System was evolved and a CDR cell was established. Detailed guidelines issued by the RBI for implementation by B & FI are now in place.

The CDR mechanism set up by the RBI is a voluntary non-statutory system based on Debtor-Creditor Agreement (DCA) and Inter-Creditor Agreement (ICA) and the principle of approvals by super-majority of 75 percent creditors (by value) which makes it binding on the remaining 25 percent to fall in line with the majority decision. The CDR Mechanism covers only multiple banking accounts, syndication/consortium accounts, where all banks and institutions together have an outstanding aggregate exposure of INR 100 million and above. It covers all categories of assets in the books of member-creditors classified in terms of the RBI’s prudential asset classification standards.

Current trendsGiven the current economic scenario and general slowdown in the industrial growth, there are increasing instances of corporates approaching B & FI’s to restructure their debts. This statistics is reflected in the table provided below (cases referred to the CDR cell):

• explain corporate debt restructuring requirements and accounting implications on banks and financial institutions

• provide our observations on the impairment model under CDR

• highlight important matters that should be considered while following the CDR model


INR in millions

Year ending 31 March

Total references received

Cases rejected/ closedCases under

finalisation of restructuring

packages

Total cases approved (including cases

withdrawn/exited

No. of cases

Aggregate Debt

No. of cases

Aggregate Debt

No. of cases

Aggregate Debt

No. of cases

Aggregate Debt

2013 522 2,981,410 88 370,450 33 320,830 401 2,290,130

2012 392 2,064,930 59 208,170 41 351,610 292 1,505,150

2011 305 1,386,040 42 96,670 21 180,230 242 1,109,140

2010 256 1,159,900 32 70,500 9 46,410 215 1,042,990

2009 225 958,150 29 50,180 12 42,610 184 865,360

The above numbers in each year are cumulative numbers as at 31 March for respective years.

Source: www.cdrindia.org


Accounting implications - For B & FI’sGiving cognizance to the significance of CDR in the financial services business, accounting standards and regulatory guidelines specifically address accounting requirements on occurrence of a CDR event. IFRS and US GAAP require measurement of impairment losses on assets carried at amortised cost by discounting future cash flows by the assets original effective interest rate.

Under Indian GAAP, regulatory guidelines require discounting by current market rate reflecting the risk profile of the customer, this has been discussed below in the comparative analysis.

The following table presents a summary of accounting treatment and disclosure requirements under Indian and international accounting framework.

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Sr. No. Particulars Indian GAAP IFRS US GAAP

1 Applicable Literature RBI Master Circular - Prudential Norms on Income Recognition, Asset Classification and Provisioning pertaining to Advances

IAS 39, Financial Instruments: Recognition and Measurement

ASC 310-40, Receivables - Troubled Debt Restructurings by Creditors

2 Definition of a Restructured Asset

A restructured account is one where the bank, for economic or legal reasons relating to the borrower’s financial difficulty, grants to the borrower concessions that the bank would not otherwise consider. Restructuring would normally involve modification of terms of the advances/securities, which would generally include, among others, alteration of repayment period/repayable amount/the amount of installments/rate of interest (due to reasons other than competitive reasons).

A financial asset or a group of financial assets is impaired and impairment losses are incurred if, and only if, there is objective evidence of impairment as a result of one or more events that occurred after the initial recognition of the asset (a ‘loss event’) and that loss event (or events) has an impact on the estimated future cash flows of the financial asset or group of financial assets that can be reliably estimated.

A restructuring of debt constitutes a troubled debt restructuring if the creditor for economic or legal reasons related to the debtor’s financial difficulties grants a concession to the debtor that it would not otherwise consider. The concession is granted by the creditor in an attempt to protect as much of the investment as possible.

3 Asset Classification Restructuring of advances could take place in the following stages:a. before commencement of commercial

production/operationb. after commencement of commercial

production/operation but before the asset has been classified as ‘sub-standard’

c. after commencement of commercial production/operation and the asset has been classified as ‘sub-standard’ or ‘doubtful’.

An account classified as ‘standard assets’ should be immediately re-classified as ‘sub-standard assets’ upon restructuring.

Non-performing assets (NPA), upon restructuring, would continue to have the same asset classification as prior to restructuring.

A part of the outstanding principal amount can be converted into debt or equity instruments as a part of restructuring. The debt/equity instruments so created will be classified in the same asset classification category in which the restructured advance has been classified.

Financial asset carried at amortised cost (adjusted by testing for impairment) – Impaired assets

Troubled Debt Restructuring – disclosed as part of impaired assets

4 Income Recognition In case of restructured accounts classified as ‘standard’, the income, if any, generated by these instruments is recognised on an accrual basis.

In case of restructured accounts classified as ‘NPAs’, the income, if any, generated by these instruments is recognised only on cash basis.

Income should be recognised as per accrual method of accounting, using the effective interest rate.

Income can be recognised as per accrual method of accounting using the effective interest rate or cash method depending upon the accounting policy followed by the bank.


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Sr. No. Particulars Indian GAAP IFRS US GAAP

5 Provision norms[Refer illustration after the table]

Erosion in the fair value of the advance should be computed as the difference between the fair value of the loan before and after restructuring.

Fair value of the loan before restructuring will be computed as the present value of cash flows representing the interest at the existing rate charged on the advance before restructuring and the principal, discounted at a rate equal to the bank’s Benchmark Prime Lending Rate (BPLR) or base rate (whichever is applicable to the borrower) as on the date of restructuring plus the appropriate term premium and credit risk premium for the borrower category on the date of restructuring.

Fair value of the loan after restructuring will be computed as the present value of cash flows representing the interest at the rate charged on the advance on restructuring and the principal, discounted at a rate equal to the bank’s BPLR or base rate (whichever is applicable to the borrower) as on the date of restructuring plus the appropriate term premium and credit risk premium for the borrower category on the date of restructuring.

The amount of provision is measured as the difference between the asset’s carrying amount and the present value of estimated future cash flows (excluding future credit losses that have not been incurred) discounted at the financial asset’s original effective interest rate (i.e., the effective interest rate computed at initial recognition).

The amount of provision is measured as the difference between the asset’s carrying amount and the present value of estimated future cash flows discounted at the financial asset’s original effective interest rate (i.e., the effective interest rate computed at initial recognition).

6 Disclosure Requirements

With effect from the financial year 2012-13, banks are required to disclose:• number and amount of advances

restructured, and the amount of diminution in the fair value of the restructured advances

• total amount outstanding in all the accounts/facilities of borrowers whose accounts have been restructured along with the restructured part or facility

• The disclosure format prescribed, inter-alia, includes the following:

i. details of accounts restructured on a cumulative basis excluding the standard restructured accounts which cease to attract higher provision and risk weight (if applicable)

ii. provisions made on restructured accounts under various categories and

iii. details of movement of restructured accounts.

IFRS 7, Financial Instruments: Disclosures prescribes following disclosures

• Analysis of financial assets that are individually determined to be impaired as at the end of the reporting period, including the factors the entity considered in determining that they are impaired

• When financial assets are impaired by credit losses and the entity records the impairment in a separate account (e.g., an allowance account used to record individual impairments or a similar account used to record a collective impairment of assets) rather than directly reducing the carrying amount of the asset, the entity discloses a reconciliation of changes in that account during the period for each class of financial assets.

ASC 310-40

A)

1. The Total recorded investment in the impaired loans

2. Unpaid principal of the impaired loans

3. The recorded investment in (1) for which there is a related allowance for credit losses

4. The recorded investment in (1) for which there is no related allowance for credit losses.

The above 4 requirements are to be disclosed for the following types of loans:.

i. Loans that meet the definition of an impaired loan and have not been charged of fully, separately reported by class

ii. Loans that meet the definition of an impaired loan and have been charged of fully

iii. Large groups of smaller-balance homogenous loans that are collectively evaluated for impairment.

B) Disclosure on corporate TDRs occurring during the year.

C) Corporate loans modified in a TDR as well as those TDRs defaulted during previous 2 years and for which the payment default occurred within 1 year of the modification.


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Illustrative example to measure impairment lossHELP Bank had participated in a consortium lending to REVIVAL Limited. REVIVAL Ltd. has been referred for CDR on 31 March 2013. The relevant financial information is as follows:

Original contracted interest rate (assume effective interest rate) 12%

Interest rate post restructuring 10%

Banks prime lending rate + credit risk premium for Revival Ltd., on the date of restructuring

14%

Current carrying value of the loan (amortised cost as on 31 March 2013) INR 1,000

Residual loan tenor 4 years

Future cash flows (as per original contracted interest rate, i.e., @12%)[A] 1,480

Future cash flows (as per interest rate post restructuring, i.e., @10%)[B] 1,400

Present value (PV) of A (Discounted at 14%) 942

PV of B (Discounted at 14%) 883

PV of B (Discounted at 12%) 939

Impairment loss under Indian GAAP: [942 – 883] = 59

Impairment loss under IFRS/ US GAAP: [1,000 – 939] = 117


Under Indian GAAP, a further provision based on asset classification would be made based on the rates prescribed under the RBI guidelines. Since REVIVAL Limited, is individually assessed and a specific impairment provision has been made, it would not be considered for the pool of assets assessed for general/portfolio provision under IFRS and US GAAP.



11

Future cash flowsIt is pertinent to note that the key element for measuring impairment loss is future cash flows. How do B & FI’s project future cash flows for debt which are under CDR?

There are two important considerations and assessment which a B & FI has to undertake, viz.

1. Ascertain whether the loan is impaired and

2. Measure the quantum of cash flow loss.

A conclusion on point (1) is automatic and obvious given that the circumstances which have put financial burden on the corporate has led to it being referred to CDR and hence, in most cases B & FIs would identify such exposures as impaired. The accounting and audit challenge is in relation to point (2), which inherently has a degree of judgement and in cases referred to CDR, B & FIs have a bias to fall back on the CDR plan for determining future cash flows and consequential measurement of impairment loss, if any.

In a multilateral CDR arrangement, there is a designated bank which is appointed as the lead monitoring bank and which in turn appoints various consultants, including concurrent auditors to first prepare and validate a restructuring plan and subsequently to monitor the progress.

In turn, most of the information relevant for measurement of impairment losses is made available from the initial and periodic reports submitted by the lead monitoring bank. Invariably the lead banker is the B & FI which has the largest exposure.

Any estimate which is based on the projections or future cash flows involves various assumptions and to a large extent is dependent on data and forecasts submitted by the corporate. Needless to say, for any B & FI participating in a CDR, the degree of ‘dependency’ on the corporate and the lead banker for data points is significant.

‘Dependency’ factor

The role of CDR in reviving and aiding companies to overcome financial stress is unquestionable, however, the cross pollination of the details available in the CDR plan in measuring cash flow losses may not always result into a fair and reasonable accounting conclusion.

Under all accounting frameworks impairment losses are determined based on best estimates of future cash flows. However, most B & FIs use the CDR plan as a basis for estimating losses. It is generally observed that most CDR plans often predict full recovery of dues, unless there is explicit commitment of interest or principal sacrifice. Invariably B & FIs use the CDR plan as a basis to justify that there would be no future cash flow losses, without necessarily fully challenging the viability of the plan.

Limited choices

It would be fair to state that in most circumstances, when a debt is considered for restructuring, B & FI’s have limited choice but to collectively agree to a restructuring plan or else the quantum of losses could be significant and immediate. The CDR mechanism also provides B &

FI’s greater access and oversight on the company’s management, operations and financial information. Hence, B & FI’s invariably consent to admit the case into CDR, once they have exhausted all means of a bilateral settlement or an exit arrangement.

Another incentive though not entirely based on merits of the case, to agree for a CDR is to avoid classifying an exposure as a NPA in its financial books, for a prolonged period. Since in India, the RBI regulations permit B & FI’s to upgrade asset classification from sub standard to standard, provided there is satisfactory performance as per the CDR plan for one year. A fairly reasonable (or so to say ‘relaxed’) 1st year financial commitment for the corporate would make it eligible for such an upgrade. Asset classification plays as important role in the Indian context as key performance indicators of B & FI’s are measured based on level of NPA’s.

Practices in this context have more recently elicited regulatory scrutiny and some concern that too many cases have been admitted and succeeded in applying CDRs than would be ideally required or merited.

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What is expected to be done?In the past, CDR cases were few and generally had a shorter revival and repayment plan. However, this has changed significantly in recent times. The current trend reflects referrals of large corporates with debts amounting to millions of dollars across various B & FIs and the plan for restructuring are long tenured. This further heightens the significance of impairment assessment and measurement from a financial statement perspective. Keeping in line the principles of various accounting frameworks, the following matters deserve consideration:

1. Primarily a revival tool – CDR is a revival tool for distressed assets and hence, in the first instance the assumption should be that there will be an element of leniency and optimism in drafting and finalising a restructuring proposal. Considering the CDR plan as the sole basis for measuring impairment loss could be inappropriate in certain circumstances, if these are not backed by hard demonstrable facts.

2. Back test CDR experience – B & FIs should back test their historical experiences of participating in CDR plans and analyse the outcome to substantiate the fairness of cash flow prediction laid down in the CDR plan. This would help build in contingencies which is based on historical trends.

3. Constantly tracking plan vs. actual – It is imperative that there is close monitoring of actual performance and comparing it with the original cash flow forecast. Corrections to impairment loss estimate are required based on a recast of the cash flows. The CDR cell will not necessarily refresh the cash flows periodically. However, it is necessary that B & FIs periodically assess reasonableness of the cash flows projected.

4. Monitoring agency – In a CDR, there is a designated bank which is appointed as the lead banker and which in turn appoints various consultants, including concurrent auditors to first prepare and validate a restructuring plan and subsequently to monitor the progress. Hence, critical information based on which impairment losses are estimated is provided by reports issued by such consultants. Needless to add, it is important for B & FI’s to independently assess the experience and competence of such consultants and also review the contents of the reports issued by them, as these are not necessarily meant to address accounting considerations.

All CDR plans require continuous monitoring, independent challenge and rigor of recovery. From an accounting

perspective, the CDR plan is a good starting point. However, it cannot be the only means of assessing and measuring an

impairment loss.



13

Employee share based payments

In today’s corporate world, share based payments to employees, directors, key executives is considered to be an important constituent of remuneration for their services to an enterprise. It is also used as an incentive to motivate the employees to continue their services with the employer. Accounting for share based payment to employees has been a complex accounting subject which has evolved over a period of time. Currently under Indian GAAP, there are two authoritative documents on employee share-based payment transactions, one is SEBI’s Employee Stock Option Scheme and Employee Stock Purchase Scheme Guidelines, 1999 and Guidance Note on Accounting for Employee Share-based Payments (Guidance Note) issued by the Institute of Chartered Accountants of India (ICAI). The SEBI guidelines are applicable to listed enterprises and the Guidance Note applies to unlisted enterprises. As part of its initiatives to converge with the International Financial Reporting Standards (IFRS), the ICAI had issued an Exposure Draft (ED) for an Accounting Standard on Share-based Payment. However, this ED has not been converted into an Accounting Standard.

This article discusses some of the key matters that affect accounting of share-based payments to employees under the Guidance Note. Accounting for share-based payments made to non-employees is not discussed in this article.

What is an employee share-based payment?In share-based payment transactions, an enterprise receives goods or services from a counterparty and grants equity instruments (equity-settled share-based payment transactions) or incurs a liability to deliver cash or other assets (cash settled share-based payment transactions) as a consideration. When the counterparty is an employee, it is considered as an employee share-based payment. Employee share-based payments can be made in the form of grant of shares, share options to employees or grant of share appreciation right to employees, which entitle them to future cash payments based on the increase in the entity’s share price. Enterprises also issue employee share-based payment plans in which the terms of the arrangement provide the employee or the employer a choice of whether the enterprise settles the transaction in cash, other assets or equity instruments.

In case the counter party supplying goods or services is not an employee of the enterprise, i.e., a third party, such transactions are not covered by the Guidance Note. Further, transactions with shareholders who are also employees are also not covered by the Guidance Note.

As per the Guidance Note, a transfer of shares or stock options of the parent of the enterprise, or shares or stock options of another enterprise in the same group as the enterprise is also an employee share-based payment. This is discussed in detail under the section ‘Group Arrangements’.

• Tell you the key matters that affect accounting of share-based payments to employees under Indian GAAP (Guidance Note)


Basic PrinciplesThe accounting for share based payment arrangement is determined based on the classification of the share-based payment arrangement. Further, the conditions subject to which the share-based payment arrangement is issued also affects the measurement of cost to be recognised in accordance with the Guidance Note.

Classification of share-based payment transactions

In order to account for an employee share-based payment arrangement, it is important to determine whether the arrangement is:

a. An equity settled employee share based payment

b. Cash settled employee share-based payment or

c. Either the employee or the employer has a choice of whether the enterprise settles the payment in cash or by issue of equity shares.

The classification as cash or equity-settled is based on the enterprise’s obligation to the employees (i.e., whether the enterprise is or can be required to settle in equity instruments or settle in cash) and the entity’s intended settlement method.

Equity-settled share-based transactions

Equity-settled share-based transactions are transactions in which employees receive shares or stock options upon meeting the vesting conditions. Equity-settled share-based payment transactions with employees require indirect measurement i.e., shares or stock options granted are fair valued on their grant date rather than valuing the services rendered by the employees since the value of services rendered by different employees cannot be measured reliably.

Cash-settled share-based transactions

Cash-settled share-based transactions are transactions in which employees receive cash or other assets based on the price (or value) of the enterprise’s shares.

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Vesting and non-vesting conditions

Share-based payment transactions with employees are often conditional on the achievement of conditions. The enterprise should also evaluate whether the conditions subject to which the employee share-based payment arrangement is issued are vesting conditions or non vesting conditions.

The Guidance Note defines ‘vesting conditions’ as the conditions that must be satisfied for the employee to become entitled to receive cash, or shares/options of the enterprise, pursuant to an employee share-based payment plan. Vesting conditions are further classified as service condition and performance conditions. Vesting conditions include:

a. Service condition: requires employee’s continued employment with the enterprise for a period of time) or

b. Performance condition: requires achievement of a particular level of performance e.g., a level of profit before taxes by the enterprise in an accounting period, over the accounting periods (non-market performance condition) or specified performance targets to be met such as a specified increase in the enterprise’s share price over a specified period of time (market condition).

Share-based payment transactions can also contain ‘non-vesting conditions’. Any condition(s) other than vesting conditions as described above that determine whether an employee receives a share-based payment are considered as non-vesting conditions. Examples of non-vesting conditions are employees required to make contributions towards the purchase (or exercise) price on a monthly basis or complying with transfer restrictions.

In addition to accounting implications, an entity is required to make the requisite disclosures of the plan, details of movement in the options granted and exercised during the period, method of valuation, etc.

In determining the impact of share based payment arrangements and its accounting implications, it may be noted that the impact of:

a. market conditions and non-vesting conditions is reflected in the grant-date fair value of each equity instrument.

b. a service or non-market condition is not reflected in the grant-date fair value of the share-based payment. Instead, the number of equity instruments is estimated for which the service and non-market performance conditions are expected to be satisfied.

Service condition

Market conditionNon-market performance

condition

Source: KPMG’s IFRS Handbook: IFRS 2 Share-based Payment, May 2013

Vesting condition

Performance condition

Does the condition require only a specified period of service to be completed?

Is the condition related to the market price of the entity’s equity

instruments?

Does the condition determine whether the entity receives the services that entitle the counterparty to the share-based payment?

Yes No

Non-vesting condition

Yes

Yes

No

No

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Source: KPMG’s IFRS Handbook: IFRS 2 Share-based Payment, May 2013


Accounting for equity settled employee share-based paymentsThis cost is generally recognised as an expense over the vesting period with a corresponding credit in equity. If the payment is not subject to a service condition, then it is recognised immediately.

Subsequent to initial recognition and measurement, the estimate of the number of equity instruments for which the service and non-market performance conditions are expected to be satisfied is revised during the vesting period. The cumulative amount recognised is based on the number of equity instruments for which the service and non-market performance conditions are expected to be satisfied. However, no adjustments are made in respect of market conditions - i.e., neither the number of instruments nor the grant-date fair value is adjusted if the outcome of the market conditions differs from the initial estimate.

Practical application issues

Multiple vesting conditionsIt is possible, though not common, that an option plan has multiple vesting conditions either as ‘and’ conditions or as ‘or’ conditions. For example:

a. One market condition and a non-market performance condition need to be met together with a service condition. In this case, the fair value should reflect the probability of not achieving the market condition. If the non-market performance condition is not satisfied, then the entity should true up the cumulative share-based payment cost.

b. One market condition or a non-market performance condition should be satisfied together with a service condition. Share-based payment arrangements containing multiple vesting conditions raise complicated accounting issues, because there is limited guidance in relation to grants of share-based payments that combined market and non-market performance conditions.

Valuation

As per the Guidance Note, an entity should measure the cost based on the fair value of the shares or stock options. Alternately, an entity is permitted to apply the intrinsic value method for the valuation though the fair valuation approach is recommended. If the intrinsic value method is applied, fair value disclosures are still required.

The valuation exercise is not always straight forward, specifically for unlisted companies. Unless the option with the same or comparable terms is listed, an entity cannot obtain the fair value externally. Therefore, it must estimate the fair value using an option-pricing model. The method is not mentioned in the guidance note, though valuation methodology is explained with the help of few examples.

Inputs generally used in a valuation model and their impact on increase/decrease in the valuation:

There are several challenges that one may face as part of the fair valuation exercise:

• For an unlisted company, determining the current value and volatility. The guidance note permits an unlisted company to assume that the volatility is zero. However, by contrast, this is not permitted under IFRS.

• The expected term is determined based on the expectation of exercise by the management i.e., the length of the vesting period. However, this is influenced by several factors such as the average length of time for

similar options. This may not be easily determinable if the entity does not have history of similar options.

• Validating the assumptions used in the valuation exercise is often a challenge for the auditors of the entity.

The higher the... The… is the value of the option

Share price Higher

Exercise price Lower

Expected volatility Higher

Expected dividends not receivable

Lower

Risk-free rate Higher

Expected term Generally higher


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Accounting for cash settled employee share-based paymentsCash-settled share-based transactions are transactions in which employees receive cash or other assets based on the price (or value) of the enterprise’s shares.

Cash-settled share based payment transactions are measured initially at fair value of the liability or capitalised as an asset if the asset recognition criteria are met. If the payment is subject to a service condition, then the amounts are recognised over the vesting period. At the end of each reporting period, and ultimately at settlement date, the recognised liability is remeasured at fair value with changes recognised in profit or loss. If the payment is not subject to a service condition, then it is recognised immediately.

Practical application issues

Measurement and valuationThe Guidance Note indicates that the terms and conditions should be taken into account to determine the fair value of a cash-settled plan. However, it does not provide guidance on how to measure the fair value with market and/or non-market conditions. Therefore, it is unclear whether:

a. By analogy to the method for equity-settled share based payments, only market and non-vesting conditions should be taken into account when measuring fair value or

b. All conditions – including service and non-market conditions – should be taken in account to determine fair value.

The example in the appendix IV to the Guidance Note appears to indicate that the first approach should be applied. However, arguably an entity could make an accounting policy decision and apply it consistently using either approach. In either case, there would be a requirement for re-measurement of the liability.

Contingently cash-settleable equity instruments

An enterprise may approve such employee share based arrangements where the method of settlement is contingent upon one or more future events. Whether such arrangement should be classified as equity settled or cash settled is a question which requires careful evaluation of the facts and circumstances of each case. To illustrate this let us consider the following example:

Company X grants stock options to its employees with a condition that in the event Company X is listed by March 20XX, the employees would be entitled to exercise the option and purchase the shares at the exercise price as per the share based payment arrangement agreed with the employees However, if the company is not able to get its shares listed by March 20XX, company X would settle the transaction by payment of an amount equal to the difference between the fair market value of the shares at the time of the buy-back and the fair market value of shares at the date of grant of the option to the employee. While company X intends to settle the obligation by issue of shares to the employees, the arrangement provides for cash settlement in the event the equity shares of the company do not get listed on a stock exchange by March 20XX. The Company’s intention to settle the obligation by issue of shares is contingent upon factors like market, the Company’s ability to get appropriate

valuation, etc. This contingency surrounding the Company’s intention to settle the obligation by issue of equity shares makes the classification of these stock options a judgemental issue.

The Guidance Note does not specifically deal with this issue. An approach that is commonly adopted in this situation where an entity issues a share-based payment that is contingently cash-settleable and the contingency is not within the control of the issuer, is to determine whether to classify the share-based payment as cash- or equity-settled based on the liability recognition criteria of AS 29, Provisions, Contingent Liabilities and Contingent Assets. When determining whether a liability to the employee exists, the contingent feature would affect the classification only if the contingent event is probable, i.e., more likely than not. In the above example, if Company X can demonstrate that it is probable that it would be able to get its shares listed by March 20XX or in other words, the likelihood of Company X not being able to list its equity shares is less than probable, the share based payment arrangement with the employees would be classified as equity settled.

After initial classification the entity should reassess at the end of each reporting period the probability of cash outflow is to determine whether the share-based payment is equity- or cash-settled. This is because AS 29 requires reassessment of probabilities and estimates of expected cash flows at the end of each reporting period.


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Accounting for employee share-based payments with settlement options

Employee share-based payment plans in which the terms of the arrangement provide the employee with a choice of settlement

According to the Guidance Note, if the employees have the right to choose whether a share-based payment plan is settled in cash or by issuing shares, the plan has two components, viz., (i) liability component, i.e., the employees’ right to demand settlement in cash, and (ii) equity component, i.e., the employees’ right to demand settlement in shares rather than in cash. The Guidance Note requires that the enterprise should first measure, on the grant date, fair value of the employee share-based payment plan presuming that all employees will choose for cash settlement of the transaction. The fair value so arrived at should be considered as the fair value of the liability component. Thereafter, the fair value of the employee share-based payment should be measured presuming that all employees will choose equity settlement. The Guidance Note requires that in case the fair value under equity-settlement is greater than the fair value under cash-settlement, the excess should be considered as the fair value of the equity component. Otherwise, the fair value of the equity component should be considered as zero. The equity component should be accounted for as equity-settled employee share-based payment plan. The liability component should be accounted for as cash-settled employee share-based payment plan.

The Guidance Note also provides that at the date of settlement, the enterprise should re-measure the liability to its fair value. If the enterprise issues shares on settlement rather than paying cash, the amount of liability should be treated as the consideration for the shares issued. However, if the enterprise pays in cash on settlement rather than issuing shares, that payment should be applied to settle the liability in full. By electing to receive cash on settlement, the employees forgo their right to receive shares. The enterprise should transfer any balance in the stock options outstanding account to general reserve.

Employee share-based payment plans in which the terms of the arrangement provide the enterprise with a choice of settlement

Where the enterprise has the choice of whether to settle in cash or by issuing shares, the enterprise should determine whether it has a present obligation to settle in cash and account for the share-based payment plan accordingly. As per the Guidance Note, the enterprise has a present obligation to settle in cash if the choice of settlement in shares has no commercial substance (e.g., because the enterprise is legally prohibited from issuing shares), or the enterprise has a past practice or a stated policy of settling in cash, or generally settles in cash whenever the employee asks for cash settlement. The Guidance Note states that if the enterprise has a present obligation to settle in cash, it should account for the transaction as cash settled share based payment. However, if no such obligation exists, the Guidance Note requires that the enterprise should account for the transaction as equity-settled employee share-based payment plan.

As per the Guidance Note, upon settlement:

a. If the enterprise elects to settle in cash, the cash payment should be accounted for as a deduction from the stock options outstanding account except as noted in (c) below.

b. If the enterprise elects to settle by issuing shares, the balance in the relevant equity account should be treated as consideration for the shares issued except as noted in (c) below.

c. If the enterprise elects the settlement alternative with the higher fair value (e.g., the enterprise elects to settle in cash the amount of which is more than the fair value of the shares had the enterprise elected to settle in shares), as at the date of settlement, the enterprise should recognise an additional expense for the excess value given, i.e., the difference between the cash paid and the fair value of the shares that would otherwise have been issued, or the difference between the fair value of the shares issued and the amount of cash that would otherwise have been paid, whichever is applicable.


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Group arrangements

Parent grants its own equity instrumentsWhen a parent grants rights to its equity instruments directly to employees of a subsidiary, the transaction is classified as an equity- settled arrangement in the financial statements of the subsidiary if the share-based payment is classified as equity-settled in the consolidated financial statements of the parent. This is because the subsidiary has not incurred an obligation to transfer cash or a financial asset to its employees.

The subsidiary recognises a capital contribution from its parent equal to the amount at which the services from the employee are measured. When a parent grants rights to its equity instruments to employees of a subsidiary, the identifiable consideration received by the parent for the equity instruments is nil. When the identifiable consideration received is less than the fair value of the equity instruments granted (or liability incurred), there is an indication that other consideration has been or will be received. When a parent grants rights to its equity instruments to employees of a subsidiary, the parent receives goods or services indirectly through the subsidiary in the form of an increased investment in the subsidiary, i.e., the subsidiary receives services from employees that are paid for by the parent, thereby increasing the value of the subsidiary.

In its separate financial statements the parent should recognise in equity the equity-settled share-based payment and a corresponding increase in its investment in the subsidiary. The amount recognised as an additional investment is based on the grant-date fair value of the share-based payment. The equity-settled share- based payment should be recognised by the parent as an increase in investment and a corresponding increase in equity over the period in which the employees provide the services to the subsidiary, i.e., over the vesting period of the share-based payment. In recognising these amounts, the normal requirements for accounting for forfeitures should be applied. However, in practice diversity exists while

accounting group share based payments by parent and subsidiary companies in their standalone financial statements.

Subsidiary grants equity instruments of the parentA transaction in which a subsidiary grants to its employees rights to equity instruments of its parent, or another group entity, is classified by the subsidiary as a cash-settled arrangement. This is because the subsidiary has incurred an obligation to transfer equity instruments of another entity rather than own equity instruments. Since these shares are, or would be, financial assets of the subsidiary, the subsidiary has an obligation to settle in cash or other assets. Classification of the arrangement as cash-settled applies irrespective of how the subsidiary obtains the equity instruments to satisfy its obligations to employees; this is a separate transaction from its transactions with employees.

Repurchase by the parentA parent may be required to repurchase shares of a subsidiary that were acquired by employees of the subsidiary through a share-based payment arrangement. For example, a subsidiary issues options to its employees that it settles by issuing its own shares. Upon the termination of employment, the parent entity is required to purchase the shares of the subsidiary from the former employee. The classification of the share-based payment in the financial statements of the subsidiary should be based on the subsidiary’s perspective. The repurchase arrangement is separate from the subsidiary’s arrangement with its employees and therefore, should not impact the classification of the share based payment by the subsidiary. As the subsidiary only has an obligation to deliver its own equity instruments, the arrangement should be classified as equity-settled in its financial statements. However, the arrangement should be classified as cash-settled in the consolidated financial statements of the parent.

Cancellations and modificationsAn entity sometimes modifies or cancels share-based payment awards before they actually vest because the vesting conditions become too onerous to achieve, or the share price of an option has dropped so far below the exercise price that it is unlikely it will ever be ‘in the money’ during its life. An entity may replace the original vesting conditions of the share-based payment award with less onerous conditions, making the award easier to attain.

If an entity modifies an award, it must recognise, at a minimum, the cost of the original award as if it were not modified. If the modification increases the fair value of the award, the entity must recognise that additional cost. The additional cost is spread over the period from the modification date until the vesting date of the modified options, which may differ from the vesting date of the original award. Whether a modification increases or decreases the fair value of an award is determined at the modification date. If an entity modifies a vested option, it recognises any additional fair value given on the modification date.

When an award is cancelled or settled:

a. If the cancellation or settlement occurs during the vesting period, it is treated as an acceleration of vesting and the entity immediately recognises the remaining amount that it otherwise would have recognised for services over the remaining vesting period .

b. If an entity grants new awards during the vesting period and, on the grant date identifies the award as replacing the cancelled or settled award, the entity accounts for the new award as if it were a modification of the cancelled award. Otherwise, it accounts for the new award as an entirely new award.


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Specific issues

Earnings per share

Basic EPS Shares and share options are included in the weighted-average number of outstanding shares for determination of basic EPS from the date on which consideration is receivable. However, following guidance provides more insights on when the consideration is considered as receivable:

• Equity shares issuable for substantive consideration are included from the date of exercise.

• Equity instruments granted for no or little consideration, subject to service conditions, are included in the determination of the basic EPS from the date on which the service conditions are met.

• Contingently issuable ordinary shares are included from the date on which the conditions are met and not from any later date actually being issued. Unvested shares or options that do not require only service condition as a vesting condition, but instead include market conditions or non-market performance conditions, are treated as contingently issuable ordinary shares and options if they are issuable for little or no cash or other consideration.

Expenses related to goods or services received in share-based payment transactions are already included in profit or loss and there is no adjustment made in determining the numerator. However, there could be some ordinary shares that may be unvested or are contingently returnable to the enterprise (i.e., shares subject to recall). For the purposes of calculation basic EPS, the profit or loss should be adjusted for any non-forfeitable dividends and any undistributed earnings attributable to these shares.

Diluted EPSThe numerator is not adjusted for equity-settled share-based payment costs when calculating diluted EPS. However, if there is a remeasurement expense from a liability of a cash-settled share-based payment, then the numerator is adjusted for such an amount when calculating diluted earnings. Adjustments are required for unvested share options to the denominator in the computation of the diluted EPS based on the treasury share method – i.e., the bonus element of the issue is reflected in the diluted EPS:

• If options are subject only to service condition (i.e., no performance conditions), then they are treated as outstanding options and are considered in diluted EPS from the grant date.

• If the options are subject to conditions other than service conditions – e.g., a market or non-market performance condition - then they are treated as contingently issuable ordinary shares. Contingently issuable ordinary shares are treated as outstanding and included in the calculation of basic EPS from the date on which the contingency conditions are satisfied (i.e., the events have occurred). If the conditions are not satisfied, then the number of shares included in the diluted EPS calculation is based on the number of shares that would be issuable if the end of the reporting period were the end of contingency period.

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Graded vesting vs. cliff vestingGraded vesting: This represents a scenario wherein options granted under a share based payment arrangement vest to the employees in a structured manner over the period. The Guidance Note requires each installment to be treated as a separate award. For example, an entity grants 3,000 options to an employee, wherein 1,000 awards each vest after one year of service.

Cliff vesting: This represents a scenario wherein options granted vest to the employees at the end of a defined tenure. For example, an entity grants 3,000 options to an employee wherein all the awards vest after three years of service.

The chart provides a comparison of the compensation expense in case share options to an equity settled arrangement vest in a graded manner against vesting at the end of the tenure in case of awards issued against a service condition. It may be noted that in the case of graded vesting, the compensation expense is significantly higher in the initial years as compared to the cliff vesting scenario.

80%

60%

40%

20%

0%

40%

30%

20%

10%

0%1 12 23 3

Compensation cost-Graded vesting Compensation Cost-Cliff vesting

Conclusion

Share based payments are an important means of employee compensation and have considerable and complicated application issues associated with their accounting. It would be appropriate that a comprehensive accounting standard is issued in India to deal with this area to ensure consistency of accounting practices and also to determine to what extent, do we converge with IFRS/other international practices in this context.

However, the Guidance Note provides an alternative to the graded vesting accounting. As per Guidance Note, an enterprise has an option to recognise the share-based compensation cost on a straight line basis over the requisite service period for the entire award (i.e., over the requisite service period of the last separately vesting portion of the award).

However, the amount of compensation cost recognised at any date must be at least equal to the portion of the grant-date value of the award that is vested at that date. An enterprise should make a policy decision as to whether to follow the accounting treatment as graded vesting or its alternative straight line recognition.



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Revised Exposure Draft on Insurance contracts

On 20 June 2013, the International Accounting Standards Board (IASB or the Board) issued its long awaited revised exposure draft on Insurance Contracts as part of its ongoing insurance contracts project. This Exposure Draft (ED) is a key milestone in the IASB’s continuing efforts to eliminate the current diversity that exists in insurance contracts accounting by providing a consistent basis for the accounting for insurance contracts and to make it easier for users of financial statements to understand how insurance contracts affect an entity’s financial position, financial performance and cash flows.

While the model presented in the 2010 Exposure Draft was broadly supported, some specific issues were raised that the IASB has addressed in the revised ED. The revised proposals respond to those issues by introducing enhancements to the presentation and measurement of insurance contracts while seeking to minimise artificial accounting volatility.

The IASB selected the following five key areas for comments only:

• Adjusting the contractual service margin

• Treatment of contracts that specify a link to the return on underlying items

• Presentation of insurance contract revenue and expenses

• Interest expense in profit or loss and

• Approach to transition.

Given the Indian context and impending convergence to IFRS in India, the provisions of this revised ED are important as they may guide the corresponding provisions of the Indian accounting guidance/regulations to be issued by the Insurance Regulatory and Development Authority of India (IRDA) for Life and General Insurance Companies in India.

This article provides an overview of the key proposals published for public comment by the Board and certain key differences with regards to the existing practice in India for the Insurance Industry.

• tell you the key proposals in the exposure draft

• key differences to the existing practice in India in the Insurance Industry



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Key proposals at a glance

• The IASB is seeking comments on five key areas that have changed significantly since its previous ED. In addition, the IASB is asking whether the proposal appropriately balances costs and benefits. The 2013 revised ED builds on the proposals contained in the IASB’s 2007 Discussion Paper ‘Preliminary Views on Insurance Contracts’ and the 2010 Exposure Draft ‘Insurance Contracts’.

• The new proposals apply to all insurance contracts, including certain financial guarantees, rather than insurance entities, and to investment contracts with a discretionary participation feature (DPF) issued by insurance companies.

• The insurance contract measurement principles that are set out in the IASB’s revised ED are similar to those in the 2010 ED (building block measurement model):

– a current measurement model comprising the expected present value of future cash flows

– a discount rate that adjusts those cash flows for the time value of money

– an explicit risk adjustment and

– a contractual service margin (referred to as residual margin in the 2010 ED).

• For short-duration contracts, there continues to be simplified (or premium-allocation) measurement approach, which would be expected to reduce the operational complexity of applying the measurement model to short-duration contracts.

• The use of other comprehensive income (OCI) to present changes in the measurement of insurance liabilities arising from changes in discount rates.

• A new presentation approach for both, the statement of profit or loss and OCI and the statement of financial position, which would significantly change the way insurers – in particular, life insurers, report performance.

• An unlocked contractual service margin, which would change the timing of profit recognition.

• The transitional provisions have been amended to include a contractual service margin for existing business when implementing the future insurance standard.

• A mirroring approach for measuring contracts, when the amount, timing or uncertainty of cash flows arising from a contract depend wholly or partly on the returns from specific underlying assets.

• The transitional provisions have been amended to include a contractual service margin for existing business when implementing the revised ED.

• The revised ED does not propose an effective date, but instead, states that the effective date will be around three years after the issuance of the final standard. Adoption is expected to require retrospective restatement of all previous periods.

The revised proposals are intended to result in a more faithful representation and more relevant and timely information about insurance contracts compared to the proposals in 2010 ED. The Board has sought to balance those benefits with the costs of greater operational complexity for preparers, and any increased costs for users of financial statements in understanding the information produced. Some of the key aspects of the proposals are described in more detail below.

Adjustments for changes in cash flows relating to future insurance coverage (Contractual Service Margin):

• The contractual service margin is recorded when the contracts are initially recognised and eliminates any day-one gains in an insurance contract, thereby representing unearned expected profit in the contract. The contractual service margin is determined at the portfolio level, as the excess, if any, of the expected present value of the cash inflows over the expected present values of future cash outflows plus the risk adjustment. If the contractual service margin is negative, the same should be recognised in profit or loss as an expense.

• The revised ED proposes that the contractual service margin should not

be ‘locked in’ at inception. Instead the margin should be adjusted (‘re-measured’) for subsequent changes in future cash flows to reflect difference between current and previous estimates of future cash flows that related to future insurance coverage and contractual service margin is sufficient to absorb any unfavorable changes.

Treatment of contracts that specify a link to the return on underlying items:

• The revised ED proposes an exception to how the insurance contract is measured and how changes in measurements are presented when there can be no economic mismatch between the insurance contract and those assets backing such contracts. This exception will apply only when the contract requires that the entity holds underlying items and specifies a link to returns on those underlying items. It ensures that this linkage is reflected in the financial statements by making the measurement of the insurance contract consistent with that of the underlying item. The 2010 ED did not specify different requirements for such contracts. The 2010 ED proposed that, when the amount, timing or uncertainty of cash flows arising from an insurance contract depend wholly or partly on the returns from specific assets, an insurer should reflect that dependency in the discount rate used to measure the insurance contracts.

• The revised ED retains the existing principle, but provides an exception, from the building block measurement model when the insurer is required to actually hold the underlying items, such as specific assets, or underlying pool of insurance contracts, or the assets and liabilities of an insurer as a whole and the actual contractual terms requires the insurer to include a link between the payments to the policyholder and those underlying assets.

• The components of the fulfillment cash flows that are not expected to vary directly with the returns on underlying items are measured in accordance with the building block model. This implies that the insurer would have to segregate the cash flows of such contracts in to such categories based on the underlying items for measurement purposes. The revised ED contains application guidance to perform such categorisation.

Presentation of insurance contract revenue and expense:

• The 2013 ED proposes that entities present revenue from all insurance contracts consistently with the presentation of revenue in accordance with IFRS for other transactions as against the 2010 ED, which proposed that an entity should present only net margin information in the statement of comprehensive income. The operating result is unchanged from that in the 2010 ED. Only the presentation of revenue and expenses has been changed. To summarise insurance contract revenue represents consideration for providing insurance coverage and other services, paying expected claims, benefits and expenses and bearing risk in that period.

Interest Expense:

• The other significant change in presentation in the revised ED is the use of OCI to recognise some of the changes in the insurance contract liability. The revised ED requires that an insurer would recognise and present in OCI the difference between:

– Discounting the cash flows arising from the insurance contract using a current discount rate

– Discounting the cash flows using the rate when the insurance contract was initially recognised i.e., the locked in rate at inception.

• The revised ED proposes that interest expense from insurance contracts is presented in profit or loss in a way that reflects a cost-based measurement and that the balance sheet carrying amount for insurance contracts reflects a current-value-based measurement.

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• The Board has also proposed the introduction of OCI treatment for some simple debt instruments. This proposal would mean that when an entity has assets measured at amortised cost or fair value through OCI, a cost based profit or loss would result from the combination of the measurement of the insurance contract and those assets. This proposal responds to the feedback received on the 2010 ED that recognising all changes in the insurance contract in profit or loss would obscure the underwriting performance of the insurer.

First time application:

• The revised ED proposes that entities applying the Standard for the first time should estimate the remaining unearned profit and insurance contract revenue on their existing insurance contracts. This allows comparison between contracts entered into before and after transition to the new accounting model.

• This proposal modifies the previous proposal that an entity should assume that there would be no unearned future profit when the entity first applies the Standard. That approach was simple to apply. However, it would have reduced the amount recognised on the balance sheet for existing insurance contracts and no profits would have been recognised on those contracts over their remaining life after the date of transition to the new standard.

Implications of the revised ED on the Indian Insurance Industry

Classification of Insurance Contracts in India

• There is no specific standard for the purpose of classifying Insurance contracts under Indian GAAP. Currently, traditional, Unit Linked Insurance Plan and Pension products are sold by insurance companies and premium received on all these policies are accounted as premium income in the revenue account.

• If the revised ED is applied in its current form, there will be a significant shift in the method of accounting for premium for Life insurance companies as Pension products having zero or insignificant death benefits will not fall under the purview of Insurance Contracts and have to be accounted as Investment contracts and investment component pertaining to ULIP contracts would have to be accounted separately. However, this may be a profit or loss neutral adjustment as currently they are adjusted as part of reserves for insurance liabilities at the period end.



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Measurement of Insurance Liabilities by Indian Insurance Companies

• The Gross Premium Methodology for Life Insurance contracts is governed by the IRDA (Assets, Liabilities and Solvency Margin of Insurers), Regulations, 2000 and Guidance Notes GN1, GN2 and GN7 issued by the Institute of Actuaries of India (IAI). The regulations govern the valuation of liabilities for both non-linked and linked business with some additional requirements for linked business.

• Mathematical reserves are determined separately for each contract. The valuation method primarily takes into account all prospective contingencies including cost of any options that may be available to the policyholder.

• The proposed IFRS measurement model focuses on the key drivers of insurance contract profitability, and would provide users with a clearer insight than they gain from today’s patchwork of different models for different types of contract. The same model would apply to all insurance contracts. However, a modified version would apply to short duration insurance contracts.

• The current problem in cash flow estimates is that the Indian insurers use ‘locked in’ estimates which do not provide current information about insurance liabilities. However, the proposed changes in the revised ED would require changes in cash flow estimates to be reflected in profit or loss in the period in which they arise. This would enhance transparency and provide more relevant information for users.

Acquisition Costs

• The revised ED proposes that both successful and unsuccessful acquisition costs that are directly attributable to a portfolio of contracts would be included in the cash flows of insurance contracts in the building block measurement model. Currently under Indian GAAP the acquisition costs are expensed in the period when incurred. The implication of acquisition costs measurement would be critical considering Indian Insurance companies have expensed them till date. If the proposals of revised ED

are accepted currently as they are, Indian Insurance companies may have the benefit of expensing acquisition costs over the period of the insurance contract subject to positive fulfillment cash flows at the subsequent measurement date.

Separating components from an Insurance Contract

• Insurance contracts may include multiple-elements, such as insurance coverage, investment components and embedded derivatives i.e., insurance contracts contain one or more components that would be within the scope of another IFRS if the insurer accounted for those components as if they were separate contracts, e.g., an investment (financial) component or a service component.

• This may require Indian Life Insurance Companies to separate the investment component from ULIP contracts from total premium and disclose it separately since inception. Currently the deposit portion is separated only at the end of the reporting period by way of including them in the actuarial reserves and then disclosing them in provision for linked liabilities.

• Moreover, the pension and annuity products which are having no or insignificant risk cover i.e., zero death benefits would not be under the purview of Insurance contracts. These would have to be accounted as Investment contracts under the financial instruments standard and the premium received on such contracts would have to separately shown in the balance sheet.

Measurement of short duration contracts (general insurance contracts)

• For short duration contracts (having coverage period one year or less) the revised ED proposes simplified approach for measuring the liability for the remaining coverage based on premium allocation approach over the coverage period. The entity can recognise the contract premium as revenue over the coverage period in a systematic manner that best reflects the transfer of insurance services provided under the contract.

• The revised ED also proposes that an entity may elect to recognise the directly attributable acquisition costs as an expense when it incurs those costs, provided that the coverage period at initial recognition is one year or less.

• Though it appears from the plain reading of the revised ED that application of simplified approach for general insurance contracts is less complex as compared to long term contracts, the entity has to be cognizant that for measurement of claims liability, it still has to go back to building block model approach.

• Given the simplified approach under revised ED, the recognition of Unexpired Risk Reserve (URR) based on the IRDA Guidelines may no longer be required as the revised ED approach is more comprehensive to take care of URR and premium deficiency in the building block model.

Way ahead

Insurance accounting in India is predominantly governed by the IRDA regulations for accounting and reporting. The Institute of Chartered Accountants of India presently does not have any specific standard/guidance for Insurance contracts in India. The proposals in the revised ED on Insurance Contracts may significantly change the current accounting and presentation for insurance companies in India. The insurance and the accounting regulator in India will therefore need to carefully consider and evaluate the potential impact of the proposals in this revised ED, in order to provide constructive and effective feedback in their comment letters keeping in mind the background and the current status of insurance companies in India.


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Reporting on Audited Financial Statements: Proposed New and Revised International Standards on Auditing

On 25 July 2013, the International Auditing and Assurance Standards Board (IAASB) has released an Exposure draft, Reporting on Audited Financial Statements: Proposed New and Revised International Standards of Auditing (ISAs). The proposals include a proposed new ISA and a number of proposed revised ISAs (the Proposed ISAs).

The auditor’s opinion on the financial statements is valued; there has been growing demand for the auditor’s report to be more informative – in particular, for auditors to provide more relevant information to users based on the audit that was performed. The Proposed ISAs represent a significant change in practice and are aimed to improve the auditor’s report on audited financial statements. The primary beneficiaries of the IAASB’s work on auditor reporting will be investors, analysts and other users of the auditor’s report.

The proposals would require an auditor to include in the auditor’s report a description of matters that they consider to be of most significance in the audit (key audit matters). The IAASB’s aim is to significantly expand the content of the auditor’s report, beyond being a simple pass/fail assessment, so that it provides information about the audit to users.

The proposal to describe key audit matters would be mandatory for audits of listed entities. For each key audit matter identified, the auditor would:

• Explain why they consider that matter to be one of the most significant in the audit and – to the extent that the auditor considers it necessary to this explanation – its effect on the audit and

• Include a reference to the related disclosure (if any) in the financial statements.

Auditors would be expected to identify key audit matters from among the matters communicated to those charged with governance, using professional judgement. The proposals suggest a number of areas that the auditor should take into account:

• Significant risks or areas involving significant auditor judgement

• Areas in which the auditor encountered significant difficulty during the audit, including any difficulty in obtaining sufficient audit evidence and

• Circumstances that required significant modification of the auditor’s planned approach.

• describe the new proposals that will significantly enhance and increase the reporting requirements for auditors and explain the proposed changes to the format and content of audit reports



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More general factors – e.g., the industry in which the entity operates, and recent significant economic, accounting, regulatory or other developments – may also be relevant.

The following table summarises the requirements of the Proposed ISAs:

S.No. Name of the standard Significant change

1 Proposed ISA 700 (Revised), Forming an Opinion and Reporting on Financial Statements

Revisions to establish new required reporting elements, including a requirement for the auditor to include an explicit statement of auditor independence and disclose the source(s) of relevant ethical requirements, and to illustrate these new elements in example auditor’s report.

2 Proposed ISA 701, Communicating Key Audit Matters in the Independent Auditor’s Report

New standard to establish requirements and guidance for the auditor’s determination and communication of key audit matters. Key audit matters, which are selected from matters communicated with those charged with governance, are required to be communicated in auditor’s reports for audits of financial statements of listed entities. Auditors of financial statements of entities other than listed entities may also be required, or may decide, to communicate key audit matters in the auditor’s report.

3 Proposed ISA 260 (Revised), Communication with Those Charged with Governance

In light of proposed ISA 701, amendments to the required auditor communications with those charged with governance, for example, to include communication about the significant risks identified by the auditor.

4 Proposed ISA 570 (Revised), Going Concern

Amendments to establish auditor reporting requirements relating to going concern, and to illustrate this reporting within the auditor’s report in different circumstances.

5 Proposed ISA 705 (Revised), Modifications to the Opinion in the Independent Auditor’s Report

Amendments to clarify how the new required reporting elements of proposed ISA 700 (Revised) are affected when the auditor expresses a modified opinion, and to update the illustrative auditor’s reports accordingly.

6 Proposed ISA 706 (Revised), Emphasis of Matter Paragraphs and Other Matter Paragraph in the Independent Auditor’s Report

Amendments to clarify the relationship between Emphasis of Matter paragraphs, Other Matter paragraphs and the Key Audit Matters section of the auditor’s report.

7 Proposed Conforming Amendments to other ISAs

Confirming amendments related to communicating key audit matters.

Source: IAASB ED on Reporting on Audited Financial Statements: Proposed New and Revised International Standards on Auditing

The above proposals reflect a global trend. In June 2013, the UK Financial Reporting Council amended its auditor reporting requirements, effective for periods beginning on or after 1 October 2012. The Public Company Accounting Oversight Board (PCAOB) in the US is also expected to publish similar proposals later in 2013.

Comments are due to the IAASB by 22 November 2013. The IAASB is seeking comments on all matters addressed in the ED – including:

• The overall form and content of the auditor’s report, and whether it meets users’ desire for increased transparency about the audit and

• The potential effect of the proposals on the processes by which management and those charged with governance prepare and present the financial statement, including any additional effort or costs that may be expected.

The IAASB has encouraged audit firms to field test the application of the new standard addressing Key Audit Matters, and thereby gain experience about how it may operate in practice. The IAASB is also seeking feedback from investors, preparers, those charged with governance, regulators and other users as they are the beneficiaries of an audit and have a vested interest in high quality reporting.


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Accounting for loan origination costs by lending institutions

Transactions costs (also known as loan origination costs) is often a topic of discussion between borrowers and lending institutions. Quite often the debate is commercial in nature; how much fees/costs should be charged relating to the origination of a loan/borrowing. The accounting of such costs can sometimes also create interesting debates and is most often an important accounting policy choice for lending institutions.

Two key aspects dominate the discussion on accounting policies in this area. Firstly, what is the timing of the recognition of these costs in the profit and loss account and secondly, if these costs are to be deferred, how should these costs be reflected in the balance sheet at every reporting date.

Status of literature dealing with transactions costsAS 30, Financial Instruments: Recognition and Measurement provides significant and detailed guidance on the accounting of transaction costs. The Institute of Chartered Accountants of India (ICAI) in 2007 issued AS 30. AS 30, has however, not yet been notified by the Government under the Companies Act. Initially, AS 30 was to come into effect in respect of accounting periods commencing on or after 1 April 2009 and was to be recommendatory in nature for an initial period of two years. However, things have not gone to plan and this standard is still not a mandatory accounting standard for companies in India.

• tell you the Indian GAAP, IFRS and US GAAP requirements for accounting for transaction costs

• provide a summary of industry practice regarding such costs



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What are transaction costs?

The term ‘transaction costs’ or ‘loan origination costs’ are neither defined in the Companies (Accounting Standard) Rules, 2006 nor in the Guidance Notes issued by the ICAI. However, AS 30 defines the term transaction costs as follows:

“Transaction Costs are incremental costs that are directly attributable to the acquisition, issue or disposal of a financial asset or a liability (see Appendix A, paragraph 33). An incremental cost is the one that would not have been incurred if the entity had not acquired, issued or disposed of the financial instrument.”

The following is the text of paragraph A33 of Appendix 1 to AS 30:

“Transaction Costs

A33. Transaction costs include fees and commissions paid to agents (including employees acting as selling agents), advisers, brokers and dealers, levies by regulatory agencies and securities exchanges, and transfer taxes and duties. Transaction costs do not include debt premiums or discounts, financing costs or internal administrative or holding costs.”

The definition of transaction costs is similar to the definition given in IAS 39, Financial Instruments: Recognition and Measurement.

Transactions costs could be both internal costs and external costs. In order to determine whether an external cost incurred in relation to obtaining or disbursing a loan qualifies to be treated as a transaction costs is whether the cost under question would not have been incurred if the entity had not acquired, or originated a loan. Determining which of the internal costs should be considered as transaction costs can pose significant challenges. Each cost incurred needs to be evaluated to determine whether the cost would have been incurred if the entity had not acquired or originated a loan. In practice, few internal costs are likely to meet this requirement, e.g., commissions, bonuses and other payments that are made to employees only on the completion of each individual transaction. The internal semi-variable costs, for example, the cost of marketing a new product or of employing additional staff to deal with an increase in the volume of transactions do not qualify as transaction costs, the costs in relation to the opening,

running and maintaining a branch to seek loan applications would not be considered as transaction costs.

Some entities in India follow the principles laid down in US GAAP ASC 310-20, Nonrefundable Fees and Other Costs. Under ASC 310-20, unlike IFRS, certain internal costs of originating loans that are related directly to specified activities performed by the lender are included in capitalised initial direct costs. Those activities are: evaluating the prospective borrower’s financial condition, evaluating and recording guarantees, collateral, and other security arrangements, negotiating loan terms, preparing and processing loan documents and closing the transaction. As per US GAAP, the costs directly related to those activities should include only that portion of the employees’ total compensation and payroll-related fringe benefits directly related to the time spent performing those activities for that loan and other costs related to those activities that would not have been incurred but for that loan. All other lending-related costs are not considered as loan origination costs.

Transaction costs are generally included in the initial measurement of the instruments on an individual basis. This means that the transactions costs should be identifiable with the acquisition or incurrence of each individual instrument. However, it may be appropriate to accumulate the transaction costs of individual contracts within a portfolio of instruments and then allocate these costs to items in the portfolio using a method that produces results that are not materially different from those achieved if the amounts are identified with individual items. It is necessary to make such an allocation to individual balances in order for unamortised transaction costs to be associated correctly with items that are repaid early, are sold or become impaired. This approach is appropriate only when the portfolio comprises homogeneous items.

Given the fact that India is poised to potentially converge with IFRS, it may be appropriate to determine the transactions costs as defined in AS 30. However, entities that have adopted an accounting policy to determine transaction costs based on guidance contained in US GAAP, may continue to follow the same policy until an authoritative pronouncement is made either by the ICAI or MCA.

It should be noted that most banks in India recognise both loan origination costs and fees upfront as a matter of accounting policy. The main reason for this choice of accounting policy is that most banks believe that the provisions of the Banking Regulation Act, 1949 require an upfront recognition of costs (otherwise impacting their ability to declare dividends). Given that they recognise these costs upfront, they then justify an upfront recognition of fees related to the origination of loans on the basis that this matches costs and income and provides a more faithful representation of the economics of their operations. Non Banking Finance Companies (NBFC), on the other hand, do not have such a requirement to recognise loan origination costs upfront and therefore, there are many more institutions which are NBFCs where deferral of transactions costs is a matter of accounting policy.


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Transaction costs – amortised separately or as part of the recorded value of a financial asset/liability?

With regard to the accounting treatment under Indian GAAP, it may be noted that AS 16, Borrowing Costs recognises that borrowing costs includes amortisation of ancillary costs incurred in connection with the arrangement of borrowings. Taking a cue from this, it could be stated that even Indian GAAP envisages that certain costs associated with borrowing arrangements would require for amortisation over the life of the loan. However, AS 16 does not require such costs to be adjusted against the carrying amount of the borrowings that they relate to.

On the other hand, based on the accounting principles enunciated in AS 30, transaction costs incurred in relation to grant of loan to an unrelated third party in an arm’s length transaction are required to be added to the amount initially recognised as a loan. Similarly, for financial liabilities directly related cost of issuing debt or incurring a liability are deducted from the amount of debt or liability originally recognised.

Any transaction costs that do not qualify for inclusion in the initial measurement of the financial asset are expensed as they are incurred. Transaction costs on loans (or financial assets) should be included in the calculation of amortised costs using the effective interest method and is amortised through profit or loss over the life of the asset.

ConclusionDiversity exists in practice on the accounting for transaction costs. Clearly, even though the lending businesses are essentially similar, there is a significant difference between bank and NBFC practices in this area. Even within NBFCs, there is significant diversity in practices between organisations that focus on retail lending and those that have more institutional/corporate lending.

While amortisation of cost/fees over the expected tenor of underlying financial asset may seem like the most logical approach, different regulations and market practices make it difficult for lending institutions to have a consistent accounting practice in this area.


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Regulatory updates

Disclosure of customer complaints and unreconciled balances on account of ATM transactions

In February 2007, the Reserve Bank of India (RBI) had advised all scheduled commercial banks to disclose brief details on customer complaints, along with their financial results.

Recently RBI has clarified that along with the disclosures mentioned above, any complaints related to the Automated Teller Machines (ATM) transactions even if it involves another bank should be disclosed by the card issuing bank. However, where the card issuing bank can specifically attribute ATM related customer complaints to another bank, the same may be clarified by way of a note after including such compliants in the total number of complaints received.

Further, RBI noticed that few banks are transferring credit balances pending reconciliation representing various cases of excess cash in ATMs on account of failures in retraction of cash, sensor failure and other technical/hardware errors, to their profit and loss account. Therefore, the RBI has clarified that any such ATM related credit balances represent unclaimed balances and should not be transferred to profit and loss account.[Source: RBI/2013-14/218 DBOD.BP.BC.No.49/21.04.018/2013-14 dated 3 September 2013]

Hedging norms eased for exporters and importers

In order to aid exporters and importers due to extreme rupee volatility, the RBI has enhanced the limits up to which exporters and importers can now cancel and rebook forward contracts.

The exporters are now allowed to cancel and rebook forward contracts to the extent of 50 percent of the contracts booked in a financial year for hedging their contracted export exposures. (Hitherto, exporters could cancel and rebook only to the extent of 25 percent of the contracts booked by them).

Similarly, importers are now allowed to cancel and rebook forward contracts to the extent of 25 percent of the contracts booked in a financial year for hedging their contracted import exposures. (Hitherto, importers were not allowed to cancel and rebook forward contracts)

The above measures are expected to reduce losses faced by the exporters and importers due to unstable market conditions and are expected to provide operational flexibility to them to hedge their foreign exchange risk.

[Source RBI/2013-14/227 A.P. (DIR Series) Circular No. 36 dated 4 September 2013]

RBI permits ECB for general purpose corporate use

In yet another step to ensure adequate foreign investment inflows into the country, the RBI has permitted External Commercial Borrowings (ECB) for general corporate purposes. Hitherto, the ECB for general corporate purposes was not permitted.

Corporates can now avail the ECB for general corporate purposes under the approval route from their foreign equity holder company with a minimum average maturity of seven years. However, such ECB are subject to following conditions:

a. Minimum paid-up equity of 25 percent should be held directly by the lender

b. Such ECBs should not be used for any purpose not permitted under existing the ECB guidelines (including on-lending to their group companies/step-down subsidiaries in India) and

c. Repayment of the principal shall commence only after completion of minimum average maturity of seven years. No prepayment will be allowed before maturity.

The above modifications to the ECB guidelines have become effective from 4 September 2013. [Source: RBI/2013-14/221 A.P. (DIR Series) Circular No.31, dated 4 September 2013]

Missed an issue of Accounting and Auditing Update?

Back issues are available to download from: www.kpmg.com/in

The September 2013 edition of the Accounting and Auditing Update discusses the proposals of the SEBI with regard to clause 41 of the Equity Listing Agreement. We also cast our lens on the IASB’s proposals on Regulatory Deferral Accounts providing temporary guidance on accounting for rate-regulated activities. We have examined the accounting and reporting challenges that are relevant to Service Concession Arrangements and Certified Emission Reduction credits under Indian GAAP. The issue also highlights the accounting practices relating to revenue recognition in the real estate industry. Finally, this issue covers key application challenges of the revised Schedule VI of the Companies Act, provides an overview of the key regulatory developments and updates including a snap shot view of the key requirements of the Companies Act, 2013.

The August 2013 edition of the Accounting and Auditing Update examines the RBI’s draft guidelines on unhedged foreign currency exposures which could have significant implications on capital and provisioning requirements for banks. We also focus on the IASB’s proposals on lease accounting and on agricultural assets (bearer plants). The proposals on lease accounting are expected to bring many leases on-balance sheet for lessees for the first time resulting a substantially changed leverage position for numerous entities. We also examine the corporate governance norms issued by SEBI and the common aspects of these proposals with the Companies Bill, 2012. Finally, this issue also describes the accounting landscape under Indian GAAP relating to the recording of goodwill and an overview of key regulatory developments and updates.


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