IFRS 3 and Goodwill

This article of mine is published in December 2012 Journal of Institute of Chartered Accountants of India (ICAI).

http://220.227.161.86/28519cajournal_dec2012-19.pdf

Introduction:

With the introduction of revised schedule VI, India has shown its intent to Converge Indian Accounting Standards (Ind AS) with International Financial Reporting Standards (IFRS) read with 41 International Accounting Standards (IAS) and related interpretations.

Amongst the IFRSs, IFRS 3 i.e. Ind AS 103 – “Business Combination” is a standard that has very little similarity with existing Indian GAAP. IFRS 3 deals with accounting under various types of Business Combinations in the form of Acquisitions, Mergers, Reverse Mergers, etc.. Though Institute of Chartered Accountants of India (ICAI) has issued a standard to deal with Amalgamations and Mergers i.e. AS 14 – “Amalgamation”, the principles prescribed in IFRS 3 are more specific and stringent. Unlike AS 14 which has provided two options for accounting amalgamations viz. a) Purchase method and b) Pooling of Interest method, IFRS 3 only considers Purchase method of accounting.  Let us understand the accounting method under IFRS 3 and its related impacts under IAS 12 – “Income Taxes “and IAS 36 – “Impairment of Assets”

Purchase Method under IFRS 3 / Ind AS 103:

Purchase method requires the Acquiring Company to fair value all the identified assets and Liabilities and also recognize additional liabilities if any, at fair values on balance sheet.  It requires allocating the Purchase Price to all the items on the balance sheet and also off the balance sheet i.e. contingent liabilities.

Excerpt from Para 36 of IFRS 3

“The acquirer shall, at the acquisition date, allocate the cost of a business combination by recognizing the acquiree’s identifiable assets, liabilities and contingent liabilities that satisfy the recognition criteria, at their fair values at that date, except for noncurrent assets (or disposal groups) that are classified as held for sale in accordance with IFRS 5, Non-current Assets Held for Sale and Discontinued Operations, which shall be recognised at fair value less costs to sell.”

Note: Indian GAAP under purchase method does not require valuation of intangible assets, unless paid and contingent liabilities. Thus they do not appear on the balance sheet post acquisition.
Deferred tax:

While assigning fair values to assets and liabilities under IFRS 3, the difference between the respective book values and carrying values give rise to Temporary difference since these fair values are not considered for Tax reporting purposes. This difference in the nature of upward / downward fair valuation of assets and liabilities only in accounting books creates a temporary difference and thus deferred tax. Refer para 19 of IAS 12 below:

Para 19 of IAS 12
“The cost of a business combination is allocated by recognising the identifiable assets acquired and liabilities assumed at their fair values at the acquisition date. Temporary differences arise when the tax bases of the identifiable assets acquired and liabilities assumed are not affected by the business combination or are affected differently. For example, when the carrying amount of an asset is increased to fair value but the tax base of the asset remains at cost to the previous owner, a taxable temporary difference arises which results in a deferred tax liability. The resulting deferred tax liability affects goodwill.”

Goodwill on Business Combination:

If the acquirer’s interest in the net fair value of the identifiable assets, liabilities and contingent liabilities recognised is less than the cost of the business combination, it gives rise to Goodwill and if it is more, than it is a case of “Negative Goodwill”. Unlike Indian GAAP, Negative Goodwill i.e. Capital Reserve, where this gain is directly taken to equity, under IFRS 3, it is taken through profit and loss account.

It is pertinent to note that Ministry of Corporate Affairs has carved out the treatment of Negative Goodwill i.e. Capital reserve while converging Indian Standards towards IFRS 3. It will creates a GAAP difference in which Converged Indian Accounting Standard will take the Negative Goodwill directly to Reserves as against IFRS 3 which will consider this gain in the income statement.

Deferred tax on Goodwill under IAS 12:

“15. A deferred tax liability shall be recognised for all taxable temporary differences, except to the extent that the deferred tax liability arises from:

(a) the initial recognition of goodwill; or

(b) the initial recognition of an asset or liability in a transaction which:

(i) is not a business combination; and

(ii) at the time of the transaction, affects neither accounting profit nor taxable profit (tax loss).”

66. Temporary differences may arise in a business combination. In accordance with IFRS 3, Business Combinations, an entity recognises any resulting deferred tax assets or deferred tax liabilities as identifiable assets and liabilities at the acquisition date. Consequently, those deferred tax assets and liabilities affect goodwill or the amount of any excess of the acquirer’s interest in the net fair value of the acquiree’s identifiable assets, liabilities and contingent liabilities over the cost of the combination. However, in accordance with paragraphs 15(a), an entity does not recognise deferred tax liabilities arising from the initial recognition of goodwill. “

Thus Goodwill is the only asset under Business Combinations that is being exempted to create deferred tax. However it is interesting to note that when the rules of IFRS 3 and IAS 12 are applied for a Business Combination, then even if the deal is done at Arm’s Length Price, it will still lead to “Artificial Goodwill” generated ‘on account of deferred tax accounting’ as mentioned in para 19 of IAS 12 quoted above.

Let us appreciate the case with the help of a case study.

Case Study:

Company A is a Company involved in mining and manufacturing and has acquired a Company B who posses “Ore” reserves. While deciding the acquisition price for the B, Company A considered the future cost of extraction and long term selling price and thus arrived at present value of the net Cash flows on the Company at Rs 200 crores including some fixed assets amount to Rs 10 crores. Thus Rs 190 crores is paid for the future profit in today’s terms. The tax rate of Company A is 30%.

  Accounting treatment:

The acquisition falls under Business Combination governed by IFRS 3 which requires fair valuation of assets and liabilities.

Company A identified the Ore reserves as assets for fair valuation and for which such a consideration was paid.

Logically, when we follow the principles under para 15 of IFRS 3, we would expect that if we have paid for actual assets then this transaction should not have any Goodwill. However, it is just an illusion. The accounting of IAS 12 here generates artificial Goodwill which otherwise was non-existent.

As part of fair valuation exercise, Company A carried out the fair valuation exercise using Discounted Cash Flow approach.

Business Combination note and Goodwill equation		Rs in Crores
Particulars	Carrying Value	FV Adj.	Fair Value with Def Tax	Fair Value without Def Tax
Purchase price			200	200
Less: Net Assets of the Company
Fixed assets	10	-	10	10
Mineral Reserves	-	190	190	190
Deferred tax liability @ 30%		-57	-57	0
Net assets of Company B	10	133	143	200
Goodwill			57	0
- On account of Deferred tax liability.			57	-
Total Assets			257	200

Since it is an acquisition of an entity, the acquiree entity (i.e. B) will continue to maintain its books at carrying value of Rs 10 and thus the tax books will also have Rs 10. When we fair value for acquirer’s (i.e. A) accounting under IFRS 3 for consolidating entity B, A will record assets at fair value and thus differ from the value in Tax books.  This will lead to a temporary difference which will reverse in the form of higher depreciation going forward.

 It can be seen from the above table that if we do not create deferred tax liability, there is no Goodwill.   If we create deferred tax liability then it gives rise to Goodwill. If Rs 200 is the price determined based on Discounted Cash Flow (DCF) of the business, we would expect  entity A should not have any Goodwill, however it is not so.   Under IFRS we will still have Goodwill on account of deferred tax implications and the total assets increase to Rs 257 as seen in the table above.

It is pertinent to note that this has a corresponding impact originating from IAS 36 on Impairment of assets. Under IAS 36, Goodwill has to be tested for Impairment atleast annually even if there are no triggers to suggest such. Goodwill is tested for impairment and justified to be on the balance sheet by supporting with Discounted Future Cash flows. In the current case scenario, the DCF of the business was only Rs 200, the Goodwill of Rs 57 will then to be impaired immediately.

Point that emerges:

a)      Does goodwill created purely on account of deferred tax need to be tested on the balance sheet date?

b)      Even if it has to be tested, does the Company need higher cashflows to justify Goodwill or rather compare Gross asset net of deferred tax liability with the same cash flow instead?  OR

c)       Test Goodwill related to deferred tax liability independently based on its reversal in future years in the form of deferred tax credit in Profit and Loss account?

Need to relook:

 The acquirer acquires the Company based on post tax discounted cash flows which we consider to be the best acquisition price.

If the acquisition is made at the above fair price based on DCF, then there should be no Goodwill since the acquirer has paid for its real value at par.

However under IFRS, when this Company does Purchase accounting, it will have to create a deferred tax liability and thus the mathematical equation will give rise to “Artificial Goodwill”.

Preferred Approach:

Goodwill arising on Deferred Tax liability should be tested independently based on its unwinding in the form of deferred tax credit in the P&L in future years.

In other words, such Goodwill should be tested for impairment based on its own reversal and not based on additional future cash flows.

Deduction:

It is understood from the preface by Standard setters in International Accounting Standards Board (IASB) that all the transactions should be accounted in substance at its true value. Thus recording the value of assets and liabilities of the Acquiree Company in the balance sheet that represents the actual purchase price is more logical accounting treatment.  However the area that needs deliberation is the creation of Goodwill on account of deferred tax and how it is to be tested for impairment.

CA. Sanjay Chauhan

Convergence to Ind AS 16 – Property, Plant & Equipment

My article Published in Bombay Chartered Accountant Journal October 2012 issue.

http://www.bcasonline.org/articles/artin.asp?1066

Introduction

India has principally agreed to converge to IFRS by implementing Revised Schedule VI, being the first constructive step in the journey. Let us appreciate the requirements of accounting for fixed assets, in specific under Ind AS (ie IFRS), in the light of the existing governing principles under Indian GAAP.

Ind AS 16, corresponding to International Accounting Standard (IAS), 16 governs the accounting, measurement and reporting for fixed assets. This means that it also governs the accounting for depreciation. Presently, two standards namely, AS 6 - Depreciation Accounting and AS 10 - Accounting for Fixed Assets govern the subject.

Following are the major points of differences between the two GAAPs that have wider industry impact:

a. Component approach for accounting of fixed assets

b. Depreciation provision

c. Revaluation of fixed assets

This article brings out the major differentiating characteristics under Indian GAAP including relevant governing provisions under the Statute and Ind AS, for accounting of fixed assets on above points. We later discuss the industry impact analysis and way forward.

Existing Governing Literature in India on Fixed Assets

AS 10 – Accounting for Fixed Assets

This standard governs the treatment of capital expenditure related to acquisition and construction of fixed assets. It introduces broad categories of assets as observed in many entities. These include land, buildings, plant and machinery, vehicles, furniture and fittings, goodwill, patents, trademarks and designs. The standard requires management to apply judgment to use the aggregation rule for individually insignificant items.

It encourages an improved accounting for an item of fixed asset, where the total expenditure thereon is allocated to its component parts, provided they are in practice separable, and estimate is made of the useful lives of these components. For example, rather than treat an aircraft and its engines as one unit, it may be better to treat the engines as a separate unit if it is likely that their useful life is shorter than that of the aircraft as a whole.

However, the entry in fixed asset register is made at a class of asset. For example, aircraft is capitalised as a single asset. This is because Schedule XIV prescribes a common rate for aeroplanes, aero engines, simulators, visual system and quick engine change equipment at 16.2% (WDV) and 5.6% (SLM).

In such a case, often, if the engine is replaced before it is fully depreciated, the balance WDV is charged off to Profit and Loss Account and the new engine is capitalised for being depreciated till the maximum life of its parent asset. This approach may lead to deferment of charge till the year of replacement.

Indian Companies Act, 1956

Schedule XIV plays a critical role in accounting for fixed assets under Indian GAAP, in recording of assets and depreciating it over its useful life.

Recording of assets: There are about 20 different rates of depreciation under Schedule XIV under single shift usage, which drive the allocation of cost of assets. The broad categories or class of assets include Land, Building, Plant & Machinery, Furniture & Fitting and Ships. Plant & Machinery is further subdivided into various sub-asset classes considering business specific allocations.

Consider ‘mines and quarries’ being one of the groups under ‘Plant & Machinery’ that attracts 13.91% rate of depreciation. It includes Surface and underground machinery, Head gears, Shafts, Tramways, etc. and all being depreciated at the same rate. In practical terms, all of them may have a different useful life.

Companies (Auditor’s Report) Order (2003) (CARO) requires every company to maintain proper records showing full particulars, including quantitative details and situation of fixed assets under para 4.1(a). Companies maintain minimum quantitative records for fixed assets that can be physically verified on an overall basis, in order to comply with CARO.

Depreciation: Section 205(2) of the Companies Act, 1956 (Act) provides that a company can declare or pay dividend only out of its profits. The profits for this purpose are to be arrived at after providing for depreciation as per section 350. If dividend is to be declared out of the profits of any earlier year or years, it is necessary that such profits should be arrived at after providing for depreciation for the respective years.

Section 350 of the Act requires a company to provide depreciation at the rates specified in Schedule XIV of the Act for arriving at net profit of the company for the purposes of section 205(2) and section 349 of the Act. There is no direct reference to useful life in the Act, but has indirect reference to it by prescribing depreciation rates for all types of assets for depreciation under the said Schedule. The rates prescribed under Schedule XIV are minimum rates (Circular No. 2/89, dated March 7, 1989 issued by Department of Company affairs).These are applicable for all the companies.

Thus, entities cannot depreciate the assets at a lower rate even if the technically established useful life of the asset is more than that derived from the rates specified under Schedule XIV, if they are governed by Companies Act. (In case of electricity companies, it is the Electricity Act that governs the minimum depreciation rates). There is also no provision of revisiting the rates at every year end.

AS 6 Depreciation Accounting

Para 5 of AS 6 requires assessment of depreciation based on historical or substituted historical cost, estimated useful life and residual value. U/s. 350 read with Circular. No. 2/89 as mentioned above, companies cannot estimate a useful life longer than that prescribed under Schedule XIV.

Companies exercise their judgement of useful life in the light of technical, commercial, accounting and legal requirements. It may periodically review the estimate and if it is considered that the original estimate of useful life of an asset requires any revision, the unamortised depreciable amount of the asset is charged to revenue over the revised remaining useful life. Companies can use a shorter useful life based on parameters stated above and disclose the fact by way of a note. However, there is no requirement to review residual value at periodic intervals.

AS 6 prescribes two methods of depreciation, namely, Straight line method (SLM) and Written down value method (WDV). The method of depreciation is applied consistently to provide comparability of the results of the operations of the enterprise from period to period.

A change from one method of providing depreciation to another is considered as a change in policy and is made only if the adoption of the new method is required by statute or for compliance with an accounting standard or for more appropriate presentation of financial statements. Change in accounting policy requires retrospective recomputation of depreciation as per the new policy i.e. new method of depreciation and adjustment in the accounts in the year of such change. Thus, the depreciation charge in subsequent years is not impacted with the change adjustment.

Ind AS 16: Property, plant and equipment (i.e. IAS 16)

Ind AS brings in a more stringent requirement to maintain component details of fixed assets, in terms of its Component Approach. Hence, it may increase the line items in fixed asset register and work of physical verification for each identifiable component.

The Standard does not prescribe the unit of measure for recognition. However, judgement is required in applying the recognition criteria to an entity’s specific circumstances. It may be appropriate to aggregate individually insignificant items, such as moulds, tools and dies, and to apply the criteria to the aggregate value. We will discuss the component approach is a separate section below.

Under AS 16, major overhauling expenses are capitalised with the asset line item and are depreciated till the next scheduled maintenance date unlike AS 10 that requires such costs to be expensed as incurred, unless it increases the future benefits from the existing asset beyond its previously assessed standard of performance and is included in the gross book value.

Elements of cost also include an initial estimate of the costs of dismantling and removing the item and restoring the site on which it is located, the obligation for which an entity incurs either when the item is acquired or as a consequence of having used the item during a particular period for purposes other than to produce inventories during that period. The value of such provisions is done based on discounted cash flow approach and depreciated over the useful life of the asset. Any change in estimate on account of principal amount would get adjusted in the cost of asset and any change on account of discount rate would be accounted in finance cost.

The major driving factor for component approach comes from the requirement to depreciate the asset over its own useful life. Though the useful life approach exists under Indian GAAP, the Companies Act has been considered more prominent since it forms part of the Statute.

As a convergence step towards IFRS, Revised Schedule VI has been helpful in addressing the conflict between erstwhile hierarchy of application between Schedule VI and Accounting Standards, by giving an upper hand to Accounting Standards. Ministry of Corporate Affairs (MCA) has so far notified Ind ASs, for which implementation date is still to be notified. One may look forward for similar clarification or convergence of Schedule XIV and/or of section 350 of the Act, with Ind AS 16 useful life approach, so that entities can in true spirit converge to Ind AS 16.

It is practically observed that steel plants of SAIL and Tata Steel are more than 30 to 40 years old. These plants require a regular maintenance and can continue longer. Similarly, many refineries in Europe and US are more than 30 years old as against the derived depreciation rates under Schedule XIV that work out to 18-20 years on SLM basis.

As a point of reference, British Petroleum Plc depreciates its refinery and petroleum assets over a period of upto 30 years. Corus Plc depreciates its steel making facilities upto 25 years under IFRS and Arcelor Mittal Plc has attributed upto 30 years of useful life for its plant & machinery. Both of them have a life more than what is prescribed under the Indian GAAP.

As a reverse impact, items where the useful life under Schedule XIV is likely to be more that its actual useable life, may include electrical machinery, X-ray and electrotherapeutic apparatus and its accessories, medical, diagnostic equipments, namely, cat-scan, ultrasound machines, ECG monitors, etc. that have 20% rate under WDV method and 7.07% under SLM for depreciation. This works out to around 13 years keeping 5% residual value. The actual life of these electronic equipments could be less considering the technology advances and consequential obsolescence.

Assuming Ind AS 16 will get an upper hand in terms of accounting of Fixed assets, it may be expected that the entities could benefit from lower provision for depreciation based on more realistic estimate of useful life of the assets such as power plants, refineries, smelters, etc.

Another point of difference comes from para 51 and para 61 of Ind AS 16, which provide that the residual value, useful life of an asset as well as the depreciation method shall be reviewed at least at each financial year-end. Such changes are to be accounted for as a change in an accounting estimate in accordance with Ind AS 8 Accounting Policies, Changes in Accounting Estimates and Errors. Ind AS 8 requires such changes in estimates to be accounted prospectively.

Point to note that change in method and rates of depreciation are a change in estimate with prospective application under Ind AS 16 whereas, under AS 6 it is a change in policy that needs retrospective application.

Ind AS 16 is self contained, in the sense that it also prescribes the depreciation guidelines on fixed assets unlike the current environment where it is governed by AS 10, AS 6, Schedule XIV and Guidance notes. One may note that, exposure draft of AS 10 (Revised) issued by ICAI before notifying Ind ASs, was also in line with Ind AS 16, and included component approach and provided for calculating depreciation based on estimated useful life.

Component approach

Is component approach of assets required?

Yes, when it is significant. Ind AS 16 does not prescribe a unit measure. However, it requires that each part of an item of property, plant and equipment which has a probability of future economic benefits associated with the item will flow to the entity and the cost of the item can be measured reliably and is significant in relation to the cost of the item shall be depreciated separately. Implicitly, component approach is required under para 43 of Ind AS 16 which requires each significant part of the total asset to be depreciated separately.

How to determine components?

The determination of whether an item is significant requires a careful assessment of the facts and circumstances.

These assessments would include, at a minimum:

i. comparison of the cost allocated to the component to the total cost of the property, plant and equipment; and

ii. effect on depreciation expense between component approach and clubbing approach.

Following factors may broadly assist in arriving at component identification:

• Shut down or major repairs and maintenance. Shutdown costs are made of replacement of an item and labour cost. Thus, items that require replacement on a regular basis can be identified as separate components. For example, a furnace may require relining after a specified number of hours of use, or aircraft interiors such as seats and galleys may require replacement several times during the life of the airframe.
• Useful life estimates of major components at the acquisition date. Example; it may be appropriate to depreciate separately the airframe and engines of an aircraft.
• Technical knowhow and obsolescence may be considered in case of information technology (IT) and electronic equipment. With respect to IT, hardware has a different useful life as compared to software.

Revaluation model

Under Ind AS 16, there are two models of accounting fixed assets, namely ‘Historical Cost’ model and ‘Revaluation’ model.

Under AS 10, revaluation of fixed assets is considered as substitution for historical costs and depreciation is calculated accordingly. However, under Ind AS, it is a separate model of accounting. Once an entity chooses ‘Revaluation model’, it will be considered as its accounting policy to an entire class of property, plant and equipment. Revaluation is required to be made with sufficient regularity to ensure that the carrying amount does not differ materially from that which would be determined using fair value at the balance sheet date.

The base fundamental of Ind AS 16 and AS 10 remain the same, i.e. revaluation does not affect the Income Statement, and valuation difference is recognised in reserves, unless the revaluation adjustment decreases the value of asset below its original cost. In such a situation, it would result in a change in profit and loss account which is indirectly an impairment of asset.

However, there is a difference in amortisation impact when it comes to Ind AS 16. The depreciation is calculated on the fair value of the asset and is amortised over the useful life by debiting profit & loss account without taking any credit from the revaluation reserve. It is pertinent to note that, under the present Indian GAAP, the entities plough back the reserves in income statement to the extent of additional depreciation and balance if any, at the time of disposal in line with paragraph 11 of the Guidance note as stated below; and thus the debit in profit & loss account is reduced to that extent.

“The Revaluation Reserve is not available for payment of dividends. This view is also supported by the Companies (Declaration of Dividend out of Reserves) Rules, 1975. Similarly, accumulated losses or arrears of depreciation should not be set off against Revaluation Reserve. However, the revaluation reserve can be utilised for adjustment of the additional depreciation on the increased amount due to revaluation from year to year or on the retirement of the relevant fixed assets.” (Paragraph 11 from Guidance note on treatment of reserve created on revaluation of fixed assets, issued 1982)

This guidance note will not be applicable once Ind AS is implemented and thus the depreciation charge will increase for the entities that follow Revaluation approach. Additionally, the existing unutilised reserve will get transferred directly to retained earnings instead of being routed through the profit and loss account.

Note: Under Ind AS 12, deferred tax is calculated on all temporary differences. The revaluation adjustment will be considered as a temporary difference and hence the amount that will flow to equity will be net of deferred tax.

Industry Impact Analysis – Ind AS 16 Property Plant & Equipment:

Industry will be impacted due to Component Approach in Ind AS 16. Since the Schedule XIV rates are not split into various parts of heavy duty machinery, companies will have to go through a detailed exercise of breaking down its fixed asset line item into various components and assess each item's independent useful life.

Mining and Construction

Assets in Mining and Construction industry include heavy duty trucks, vehicles, dozers, excavators, loaders & unloaders, tunnelling machinery, etc. These heavy duty machineries are made up of various assembled parts which are high in value and also have a different useful life as compared to the other parts such as chassis, rollers, body, electrical systems, etc. These items will have to be broken in to their components.

Entities will also have to estimate mine restoration liabilities and capitalise with the initial cost of the mine.

Excerpts from Mining major, Xstrata Plc’s Annual Report 2011:

“Where parts of an asset have different useful lives, depreciation is calculated on each separate part. Each asset or part’s estimated useful life has due regard to both its own physical life limitations and the present assessment of economically recoverable reserves of the mine property at which the item is located, and to possible future variations in those assessments. Plant & equipment have useful lives from 4-30 years.”

“Provision is made for close down, restoration and environmental rehabilitation costs.. ….At the time of establishing the provision, a corresponding asset is capitalised, where it gives rise to a future benefit, and depreciated over future production from the operations to which it relates”.

Commodity manufacturing Industry – Crude, Ore, Power

These industries include oil and ore refineries, smelters that are used to melt the ore, and power plants among others. These plants carry huge investments with complex designs and take years to build. They are made of various facilities that can be identified as first level components such as Water treatment, Gas tapping, Conveyors, Turbines, Rooters, Shafts, Grids, Tankages, Ovens, Casters, Moulds, Furnaces, Rolling mills, etc.. More often one component that is left out in the analysis is the Pipelines, which have material value and different useful life.

Second level components will need a detailed analysis of each identified first level component with their individually assessed useful lives. Each unit will need separate line items for identification.

Entities will need to estimate its asset retirement obligations at the time of initial capitalisation.

A Nuclear Power Plant will have to estimate its related decommissioning liabilities and capitalise with power plants.

Another impact will be on account of capital repairs that are incurred during shut down, cell realignment, etc. This will be capitalised under fixed assets and amortised till the next overhauling date.

By virtue of assessment of useful life, entities get a chance to increase the useful life for depreciating the assets to its true useful lives.

Shipping

Main parts of a ship include hull and engine. Further, hull is made up of deck, chassis, propeller, funnel, stern and super structure. A modern ship includes a fair component of electronic and automatic control systems. Entities will have to carry out a detailed exercise and use its judgement for capitalising each component.

Dry dock expenses in shipping industry which carried out periodically will need capitalisation and amortisation.

Similar to the commodity industry, entities will get a chance to increase the useful life for depreciating the assets to its true useful lives. International peers such as B+H Ocean Carrier Plc have estimated useful life of 30 years for its vessels from the date of construction and capital improvements are amortised over a period of five years.

Major differences between AS and Ind AS on Accounting of Fixed Assets:

Ind AS 16	AS 10 & AS 6
Component approach IAS 16 mandates component accounting. Each major part of an item of property plant and equipment with a cost that is significant in relation to the total cost of the item is depreciated separately.	Component approach is present but is more of recommendatory.
Cost & Revaluation Historical cost or revalued amounts are used. Regular valuations of entire classes of assets are required when revaluation option is chosen.	Historical cost or revalued amounts are used. No specific requirements on frequency of revaluation. Revaluation for the whole class of assets is not required.
Depreciation on Revaluation Depreciation on revalued portion is debited to income statement without recouping out of revaluation reserve.	Depreciation on revalued portion may be recouped out of revaluation reserve, thus reserve reduces over the period and depreciation charge represent the original cost
Revaluation Reserve Revaluation Reserve is directly transferred to retained earnings on derecognition.	Revaluation Reserve is transferred to Income Statement on derecognition.
Useful Life of PPE Depreciation to be calculated based on useful life.	Depreciation amount is based on useful life of the assets or Schedule XIV rates, whichever is higher.
Major overhauling or Shut down Cost Cost of major inspections and overhauls are recognised in the carrying amount of property, plant & equipment and amortised till next major maintenance date.	Costs of major repairs are expensed when incurred.
Review of Useful Life, Residual Value, Depreciation Method IAS 16 mandates review of useful life, residual value and depreciation method at each year end. It is an estimate and any change is accounted prospectively.	Depreciation method is a policy decision, which can be reviewed only if certain criteria are met. Any change is to be accounted retrospectively.

Hotel Industry

A restaurant maintains a minimum stock of silverware and dishes. Some entities treat cutlery, crockery, linen, etc, as stores and spares and group them under inventory. Any increase or decrease is accounted as consumption in profit and loss account. Moreover, Schedule XIV does not lay down any rate for depreciating such items and hence companies in India adopt inventory and consumption approach to account these items.

For a restaurant, cutlery is similar to a plant, without which it cannot operate. Under Ind AS 6, these items fall into the definition of tangible assets and hence need to be capitalised as such and depreciated based on its useful life. Considering the nature of these assets, the estimation of their useful life may involve a significant amount of judgment. The management should consider factors such as physical wear and tear, commercial obsolescence, asset management policy of an entity that may involve replacement of such assets after a specified period, etc for such assessment. John Keels Hotels Plc, depreciates its Cutlery, Crockery, Glassware & Linen in a period of three years, as per its 2010 annual report.

Way forward:

(i) It is advisable to start updating the fixed asset records in SAP or any other ERP with major component details. This can be done by opening various sub group codes for the master asset.

(ii) Any new capitalisation should be based on component approach assessing specific useful life of each component and then applying the aggregate rule.

(iii) Expect changes or clarifications for section 350 or Schedule XIV or both to avoid conflict with depreciation principles under Ind AS 16.

(iv) Assessment of useful life and residual value will have to be done by the management on a regular basis.

(v) Estimate dismantling, decommissioning, restoration liabilities valued at discounted cash flow basis at the beginning and continue to reassess on a regular basis.

(vi) Entities following revaluation approach for accounting fixed assets, will be impacted more, as Ind AS 16 does not allow an entity to plough back the reserve in profit and loss account to match the additional depreciation on revaluation. Ind AS 16 will come with first time exemptions under Ind AS 101 and hence entities may decide an appropriate policy when they adopt Ind AS, for the first time.

CA. Sanjay Chauhan 

Ind AS: Functional Currency and Consequential Impact on Deferred Tax

http://www.bcasonline.org/articles/artin.asp?1059

My article was published in Bombay Chartered Accountants Journal - August 2012 issue

Executive Summary

This article covers the ‘Functional Currency’ aspect differentiating with ‘Presentation Currency’ as laid in Ind AS 21, which will be a new concept when India converges to IFRS.

It also highlights the consequential impact of having two sets of functional currencies (one for GAAP reporting and other Tax submissions) on deferred tax computation under Ind AS 12, which again is based on a new approach i.e. ‘Temporary difference’ as against ‘Timing difference’ under existing AS 22.

Temporary difference is essentially arrived at by comparing the balance sheet under tax books with financial books. This approach is also known as ‘Balance Sheet approach’ and the approach in AS 22 is termed as “P&L approach” .

Introduction

India has laid down the convergence plan of ‘Indian Accounting Standards’ (AS) with ‘International Financial Reporting Standards’ i.e. IFRS in a phased manner. The first phase implementation was expected to begin from April 1, 2011 but due to practical challenges, the implementation is delayed.  ICAI, as part of convergence approach, has come out with 35 Ind AS which are same as IFRS except for the carve outs. Ministry of Corporate Affairs (MCA) has notified 35 Ind ASs on February 25, 2011.

Amongst these standards, there is one standard that has the potential to entirely turn the Indian financial statements topsy turvy and that is IAS 21 i.e. Ind AS 21.The consequential impact of this standard on Deferred taxes, is not part of the carve outs and hence would need due care while the standard is implemented in India.

Currency for accounting and presentation

While all Indian entities prepare our books of accounts in Indian Rupees, we have never thought of preparing our books in any other currency. There may be some who did wish of using currency other than Indian Rupee (INR) on account of huge foreign exchange exposures but they did not have any guidance or literature to support them.  The spot will now be addressed in “Ind AS 21 - The Effects of Changes in Foreign Exchange Rates”

Once India starts converging to Ind AS, we will have this standard on effects of exchange fluctuations, which has considered the aspect of huge volatility and exposures to operations due foreign currency (i.e. other than INR). It requires the managements of companies to adopt a suitable currency for maintaining their accounts. Since the entities may vary their exposures to currency in different years, the standard has mandated the assessment of such book keeping currency every year.

If any other currency, say USD is considered as the currency that influences the primary economic environment, managements will have to prepare themselves to consider INR as foreign currency exposure and mark to market all INR monetary assets and liability at each balance sheet date.

Ind AS 21 – ‘The Effects of Changes in Foreign Exchange Rates’ is a standard that brings a new dimension to the financial statements prepared in India. Now, the book keeping currency i.e. Functional currency will no more be optional or default INR, it will be governed by specific principles laid down under the standard and functional currency can be different than the presentation currency.

Functional Currency:

Let us appreciate the governing principles of functional currency under Ind AS 21:

“Functional currency is the currency of the primary economic environment in which the entity operates.” (para 7)

“The primary economic environment in which an entity operates is normally the one in which it primarily generates and expends cash. An entity considers the following factors in determining its functional currency:

(a)   the currency:

(i) that mainly influences sales prices for goods and services (this will often be the currency in which sales prices for its goods and services are denominated and settled); and

(ii) of the country whose competitive forces and regulations mainly determine the sales prices of its goods and services.

(b)   the currency that mainly influences labour, material and other costs of providing goods or
 services (this will often be the currency in which such costs are denominated and settled).” (para 8)

Ind AS 21 defines the Functional Currency and differentiates it from the Presentation Currency. The primary factor that drives the choice of currency is influenced by stream of revenue and operating costs. Additional factors that the standard requires to examine are the currency of loan obligations.

“Many reporting entities comprise a number of individual entities (e.g. A group is made up of a parent and one or more subsidiaries). Various types of entities, whether members of a group or otherwise, may have investments in associates or joint ventures. They may also have branches. It is necessary for the results and financial position of each individual entity included in the reporting entity to be translated into the currency in which the reporting entity presents its financial statements. This Standard permits the presentation currency of a reporting entity to be any currency (or currencies). The results and financial position of any individual entity within the reporting entity whose functional currency differs from the presentation currency are translated in accordance with paragraphs 38–50.” (para 10)

Under existing AS 11 definitions, foreign currency is a currency other than the reporting currency, and reporting currency is the currency used for reporting financial statements. The rules of translating the subsidiary accounts into reporting currency are similar to those under Ind AS 21, which prescribes using closing rate for Balance sheet items and transaction rate or average rate for income statement items (para 38-50).

Point of difference:
 Under Indian GAAP, a currency used for  preparing as well as reporting  .i.e. presenting financial statements to regulatory authorities, lenders, investors, etc is foreign currency is no other than INR. There is no concept ofhaving the currency to report financial statements (presentation currency) different from the currency in which books of accounts are to be maintained (functional currency).

Functional Currency: Industry perspective

Under Indian GAAP there is no concept of functional currency identification. It however has reference to ‘Reporting Currency’, which is expected to be the same currency of the country in which it is domiciled.

The definition of functional currency in Ind AS will encompass all the companies whose primary economic environment is not the Indian economy.

The impact of this standard will be more evident on commodity market linked companies engaged in mining, refining, and trading products, whose primary revenue is governed by international commodity prices prevailing on London Metal Exchange in US Dollars. Another industry that may be impacted by the implementation of Ind AS will be Business Process Outsourcing Companies and Software Companies whose primary revenue is again governed in terms of Dollars and Euros. Oil and Gas companies are also prone to get functional currency assessment and application in India since the oil prices are quoted in USD per barrel globally.

It will also be impacting the bullion companies that are listed on Indian stock exchanges and others that are planning to list soon on Indian and international bourses. The revenues of these companies are always traded in USD in India and internationally.

Domestic prices for sales within India, of these companies though in INR, are arrived at by first considering the respective International prices in USD and then making certain adjustments such as duty differentials, domestic market premium, freight differentials, competitive discounts, etc which in industry terms is called as ‘Shadow Gap’ pricing.

Each company will have to apply its own judgment and access all the criteria of primary environment and other additional factors that influence the choice of its functional currency.

 Challenges on adoption of functional currency other than INR in India:

1.       If the accounting records of these Indian Companies are to be prepared under Ind AS then the financial statements will altogether give a different picture. Since currency fluctuation on say USD may now sit in transaction amounts and change company’s profitability.

2.       Change in mindset and budgets required.

3.       Will lead to difficulty in decision making processes by Indian Managements specifically in assessing its foreign exchange exposure which so far was on currencies other than INR.

4.       Continuing a parallel accounting system for Income Tax submission since Direct tax Code does not provide for similar changes.

5.       Updation / modification to ERP solutions. It is also worth noting that accounting softwares such as SAP have a functionality to address the dual currency accounting which can take care of both Tax reporting using INR as functional currency and IFRS reporting using any other currency.

6.       Accounting for Deferred tax and unwanted volatility in income statement.

Indian Industry including Managements, Lenders, Investors, Analysts of financial statements will have to prepare for seeing a currency different than INR as accounting currency in annual financial statements. Many companies internationally have adopted this standard which aligned their accounting currency i.e. functional currency in line with their respective primary economic environments.

In the international markets most of the transactions happen in US dollars and India is now a part of a global economic platform and thus is very much influenced by USD in its financial statements. The impact is more evident in industries that are primarily dependent on USD and whose profitability is affected by any change in USD: INR exchange rate such as Mining & Metals, Oil & Gas, Software exports and Business Processing Operations among others.

Let us now appreciate the challenge in point 6 above, on how deferred tax is impacted by change in functional currency from INR
Ind AS 12: Income Taxes

A deferred tax asset or liability shall be recognised for all taxable temporary differences.

‘Temporary differences’ are differences between the carrying amount of an asset or liability in the balance sheet and its tax base. The ‘tax base’ of an asset or liability is the amount attributed to that asset or liability for tax purposes.

The primary approach of accounting of deferred tax under Ind AS is using the balance sheet approach. For example, revaluation of fixed assets under Indian the GAAP with no corresponding revaluation in Tax books i.e. Tax base has no impact on deferred tax computation under AS 22 since the revaluation impact is only a balance sheet adjustment with corresponding impact directly in reserves.

Under Ind AS 12, even though the revaluation does not impact the income statement, there is a need to adjust the deferred tax and post the net impact in revaluation reserve. This is because this originates a temporary difference on comparison between the balance sheet value of asset and tax base for that particular asset. This is true for all such differences between the balance sheet value and tax base, that have a potential of reversal either in Tax books such as 43B items or financial books itself such as Revaluation adjustments.

While comparing the balance sheet values and tax base, the following paragraph of Ind AS 12 brings out the impact of functional currency on deferred tax computation.

“The non-monetary assets and liabilities of an entity are measured in its functional currency (see Ind AS 21 The Effects of Changes in Foreign Exchange Rates). If the entity’s taxable profit or tax loss (and, hence, the tax base of its non-monetary assets and liabilities) is determined in a different currency, changes in the exchange rate give rise to temporary differences that result in a recognized deferred tax liability or (subject to paragraph 24) asset. The resulting deferred tax is charged or credited to profit or loss.” (Para 41)

The application of this paragraph will not trigger if the currency in which the company maintains its books of accounts i.e. functional currency and the ones used for calculating taxable profit under tax laws is the same i.e. INR for India. It is pertinent to note that choosing a different currency for presentation of financial statements to stock market, lender, investors, etc, will not attract application of paragraph 41 of Ind AS 12.

However, with the change in accounting standard wherein the accounting records may have to be made under say USD (considering primary economic environment criteria under Ind AS 21) and taxable profit or loss is to be calculated under INR, this may cause the temporary difference if the USD: INR exchange rates changes at every balance sheet date.

We will take an example to understand the implications of functional currency on deferred tax.

1. Entity A has INR as Tax Currency and USD as functional Currency

2. The value of non monetary assets as maintained for tax books in INR is Rs 3,150 and as maintained with USD as functional currency stood at $77.73.

The transactions under both sets of books were accounted at respective historical exchange rates and thus the INR numbers of tax books when divided by USD numbers of Financial books, will give historical transaction rates, thus different from the Closing rate.

3. The original and subsequent cost under tax base for the assets are the same as that in financials books, with the exception to the difference that originates due to application of para 41 of Ind AS 12.

4. Example considers only non monetary assets assuming monetary assets are valued at closing rate and thus would not lead to any difference while comparing the tax base using translation rate.  5. The exchange rate at March 31 is 1 USD = Rs 50 and tax rate is 33.99%

Closing deferred tax status of deferred tax liability as on March 31, XXXX of Entity A is as shown in Table 1:

Table 1

	Particulars	March 31 – XXXX		Equivalent	Diff	Tax	Def tax
	Non monetary assets	INR - Tax	USD - A/c	USD - Tax	INR	Rate	USD
		A	B	C=A/50	D=B-C	E	F=D*E
	Property, plant and equipment	2,500.00	62.50	50.00	12.50	33.99%	4.25
	Intangible assets	200.00	5.00	4.00	1.00	33.99%	0.34
	Other assets	150.00	3.41	3.00	0.41	33.99%	0.14
	Inventories	300.00	6.82	6.00	0.82	33.99%	0.28
	Total	3,150.00	77.73	63.00	14.73		5.01
Deferred Taxe under Ind AS will be calculated as follows:
Under Ind AS, the deferred taxes are measured in the functional currency
Carrying value in the functional currency: $77.73
Tax base translated in functional currency i.e. USD at the rate on closing date is USD = Rs 3,150 / 50 = $ 63.
Temporary difference: $14.73 ($77.73-$63.00)
Tax Rate        33.99%
Deferred tax expense $ 5.01
As can be seen from the above calculation, the translation of tax base using closing rate has lead to a difference of $14.73. It is pertinent to note that this difference is only for deferred tax computation and not for accounting in the financial books. The notional comparison has reduced the tax base in USD by 14.73 and this leads to creation of a deferred tax liability with a corresponding deferred tax expense in the income statement. The impact of $ 5.01 over net assets of $ 63 will be a material impact on the profits of the company. It will vary depending upon the value of non monetary assets as on the reporting date and movement of exchange rates during the period. There would not have been any temporary difference in the above example if the functional   currency was INR since tax base and book base would have been same.

Impact of accounting of Deferred Tax such functional currency difference

1.       The accounting for deferred tax on account of such notional differences creates high volatility in the income statement.

2.       The gain/loss on account of such treatment has no corresponding charge/income in the income statement. It is accounted based on pure out of books comparison of exchange rates on non monetary items.  ($14.05 is notional only for comparison but tax of $ 5.01 is real for accounting)

3.       This item has no bearing to operations or profit; instead it pulls down/up financial results from operations due to tax provision and thus calls for suitable disclosures in financial statements to explain the earnings per share to investors, analysts, etc .

It is pertinent to note that i.e. US GAAP, Financial Accounting Standard (FAS) 109 prohibits recognition of a deferred tax liability or asset for differences related to assets and liabilities that, under FASB Statement No. 52, Foreign Currency Translation, are re-measured from the local currency into the functional currency using historical exchange rates and that result from (a) changes in exchange rates or (b) indexing for tax purposes.

On one hand Ind AS 21 aims to reduce the volatility in results on account of currency exposure and on the other hand Ind AS 12 brings in volatility in income taxes on account of notional difference created on account of comparing the balance sheet value and tax base in functional currency at the closing date.

 Thus, choice of functional currency other than that used for Tax reporting will lead to such temporary differences and will continue to exist until book currency and tax currency are aligned.

Change in Functional Currency

“When there is a change in an entity’s functional currency, the entity shall apply the translation procedures applicable to the new functional currency prospectively from the date of the change”

The entity will have to assess the criteria for deciding the functional currency year and apply the accounting impacts for change prospectively. Here the country’s policies also would influence the decision such as restrictions on holding foreign currency and INR being the only legal tender in India.

The entity will also have to explain in notes to financial statement as to why it considers such change in its functional currency.

Presentation currency

Ind AS 21 allows the entity to present its financial statements in any currency and does not restrict any one currency. However, considering the Indian requirements for ROC filing, tax submission, Stock exchange filings, etc the presentation currency will be preferred to be INR.

INR as the presentation currency in Indian market will also be preferred currency for reporting to facilitate easy comparability with its peer group.  This can be achieved by either following the rules of translation (using average rate for income statement and closing rate of balance sheet) which will give rise to translation reserve or convenient translation using a single rate for all the items in the balance sheet and income statement. 

International Precedence

In order to relate to the new concept, financial statements of some international companies who have gone through the change in functional currency may be referred. Following relevant excerpts are for reference:

“StatoilHydro (OSE:STL; NYSE:STO) changed the company structure as per 1 January 2009. The parent company, StatoilHydro ASA, and two subsidiaries, consequently changed their functional currencies to USD from the same date.

The accounts for these companies are therefore now recorded in USD, while the presentation currency for the Group remains NOK. The changes in functional currencies have no cash impact.

The companies changing functional currency will no longer have currency exchange effects, deriving from USD denominated monetary assets and liabilities, related to the “Net financial items”. Conversely, monetary assets and liabilities, denominated in other currencies than USD, may now generate such currency effects.” 

Radiance Electronics Limited, Singapore

“Certain subsidiaries of the Group have changed their functional currency from SGD and RMB to USD in FY2008A. Revenue for these subsidiaries is mainly denominated in USD while purchases are mostly made in USD. Administrative expenses are denominated based on their country of domicile and are mainly in SGD and RMB.

While the factors used to determine its functional currencies are mixed, the Company is of the opinion that USD best reflects the economic substance of the underlying transactions and circumstances relevant to the foregoing subsidiaries. Accordingly, the subsidiaries adopt USD as its functional currency with effect from the current financial year ended 31 December 2008. This change shall be applied retrospectively to the prior years.

The Company and the Group continues to present its financial statements in SGD consistent with prior years.”

For deferred tax implications under IFRS Tenaris S.A.’s annual financial statements may be referred. It carries a note in its financial statements under ‘Tax reconciliation note’ to explain the investors and readers on the volatility caused due to tax accounting.

Tax note from Tenaris S.A 2008 financial statements–

“Tenaris applies the liability method to recognize deferred income tax expense on temporary differences between the tax bases of assets and their carrying amounts in the financial statements. By application of this method, Tenaris recognizes gains and losses on deferred income tax due to the effect of the change in the value of the Argentine peso on the tax bases of the fixed assets of its Argentine subsidiaries, which have the U.S. dollar as their functional currency. These gains and losses are required by IFRS even though the devalued tax basis of the relevant assets will result in a reduced dollar value of amortization deductions for tax purposes in future periods throughout the useful life of those assets. As a result, the resulting deferred income tax charge does not represent a separate obligation of Tenaris that is due and payable in any of the relevant periods.”

Internationally it was easier for companies to adopt a change in currency of accounting since these are fully convertible economies i.e. they can operate bank accounts in foreign currency. Thus the change in mindset was comparatively easier, however the common challenge was again ERP which had to be equipped with dual currency reporting for tax purposes.

With respect to deferred taxes, we can see that note in financial statements was given to explain notional volatility to guide the analysts and readers of financial statements.

Forward Path

It will be a challenging journey for Indian corporates who will adopt Converged IFRS i.e. “Ind AS” and will have to consider the implications of these standards on its accounting and reporting requirements.

From stability of profitability and ultimately EPS perspective, the companies may avoid the volatility of currency exposure but may not escape the volatility created by foreign exchange rates in computing deferred taxes. In order to explain the volatility on deferred tax front, companies may prefer to give note disclosures as given by international peers.

Alternative approach: Ind AS 12 ‘Income Taxes’

Considering the amount of volatility of foreign exchange rates with INR and its notional impact on financial statements, Institute of Chartered Accounts of India can consider  a “Carve-out” while converging to IAS 12 or represent to International Accounting Standards Board for granting an exemption under IAS 12 which will flow in Ind AS 12. This is keeping in mind the deferment of Ind AS implementation in India and practical hardships that will be faced by Indian Multinational Congloromates. 

 CA. Sanjay Chauhan