The following article is an initiative of KNAV and is intended to create awareness among the readers.
With the FY 17 closure around the corner, it is normal to see business channels, print and digital media reporting on the latest numbers. While the trend continues unabated, there has been a revolutionary change taking place in the Indian corporate sector over the past few months.
While the Goods and Services Tax (GST) Amendment being passed in Parliament received nationwide coverage and was discussed laboriously, another relatively quiet, albeit important change was in the air. Issued in 2015 by the Ministry of Corporate Affairs (MCA) and in effect since April 2016, Indian companies with a net worth of Rs 5 billion or more had to report their financial statements under the new Indian Accounting Standards (Ind-AS).
A majority of the companies had to report adjustments concerning income tax, revenue recognitions and other financial instruments. Foreseeing the complexity involved, the MCA decided to implement the new standards in a phased manner as companies with a net worth of Rs 2.5 billion will have to report their number under Ind-AS in 2017 while banks, non-banking finance companies (NBFC), and insurance companies will have till 2018.
Bridging the GAAP
At the start of 2016, audit firm PwC surveyed 100 companies most of which would be directly impacted by the 2016 implementation. The study revealed that around 39% had not conducted any impact assessment at all. Meanwhile, Indian companies reported the first quarter results in June making it the only quarter where companies have reported their financial information under the old Indian Generally Accepted Accounting Principles (GAAP) as well as new Ind-AS.
Having two sets of data of the same period allowed KPMG to analyse 71 companies listed on the BSE 100. Their report revealed that revenue was up 2.67% with Ind-AS compared to the calculations as per the old standard, with the difference mainly due to changes in the revenue recognition criteria. The new norms mirror on the International Financial Reporting Standards’ (IFRS) emphasis on fair valuation. Fair value under Ind-AS is defined as 'the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.'
One of the key areas where fair valuation could be a game changer is mergers and acquisitions (‘M&A’) as under the old standards, assets in an M&A were recognised at book value. For example, if a company was acquired for Rs 100 million and its net assets were Rs 60 million (at book value), the remaining Rs 40 million would be recognised as goodwill which would be amortised over the course of the next few years. However, for the same transaction under Ind-AS, the net assets would be calculated at fair value and the remaining amount earlier classified under goodwill would be segregated further into smaller intangibles, like brand value, patents, etc and any residual amount would then be recognized as goodwill. The resulting goodwill would also be tested annually for impairment. Impairment would come into the picture if the fair value of intangibles is less than the carrying value recorded in financial statements. This could be caused by adverse market conditions. If so, then the company has to calculate its assets and liabilities at fair value and remainder would be the recalculated goodwill.
If a company paid more for an acquisition under the erstwhile standards, then it would have been alright as it could amortise over let's say ten years. But under the new standards, if the company paid more for an acquisition and then had a cash-flow problem, it would then look at an adjustment which would be a direct hit on the profit and Earnings per share(EPS).
Apart from goodwill, the new norms also affect the way revenue is calculated. Earlier net sales was calculated excluding excise duty. However, with Ind-AS, excise is classified as a tax on manufacturing and factors into the revenue figure. This increases revenue, but companies have to report lower operating margins.
Fair valuation will also affect shares, derivatives, securities, debentures and foreign exchange held by corporations. If the valuation of these instruments increases, book profits will increase as well which in turn would lead to Minimum Alternate Tax (MAT) being imposed. Also, undistributed earnings from subsidiaries and joint ventures and unrealised profits on intra-group loans will attract deferred taxes.
While the focus is on accounting, Ind-AS clearly goes beyond. Companies will have to ensure timely communication with all stakeholders, contractual vendors, suppliers, lenders and others. It will require them to invest more time and effort in gathering data, preparing disclosures and delve into what goes into reporting the numbers.
However, the objective of the new norms is to provide substance over the legal form. As the push towards better financial reporting coincides with the government’s ‘Make in India’ initiative, Ind-AS hopes to attract the attention of foreign investors as the quality of financial statements will be at par with advanced economies. With IFRS adopted in nearly 140 countries, the familiarity of financial statements will instil confidence and will also help the country to further boost up the ranking in terms of ease of doing business Though the burden of compliance has increased for corporates, investors can rejoice at the prospect of a clearer picture of a company's activities.
In the end, Ind-AS can be a game-changer as once it is implemented across the board, a lot of balance sheets and profit/loss accounts will depict the actual economic reality.The above article is authored by Rajesh Khairajani, Lead Partner for Transaction support services - KNAV.