Accounting and Auditing Update - December 2013


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The December 2013 edition of the Accounting and Auditing Update casts its lens on the telecom sector and provides insights into accounting issues that are relevant to this sector. We also examine accounting implications of different types of outsourcing contracts. Continuing with our series of articles on the Companies Act, 2013, we have included in this issue an article highlighting the impact on mergers, acquisitions and restructurings.
This month, we also examine some accounting complications relating to a relatively common type of benefits/ compensation – car lease arrangements for employees. In addition, we have covered recent developments relating to the SEBI guidance on measures to ensure greater compliance with requirements of the Equity Listing Agreement and an overview of the key regulatory developments during the recent past.

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Accounting and Auditing Update - December 2013

  1. 1. ACCOUNTING AND AUDITING UPDATE December 2013 In this issue Accounting challenges in the telecommunication sector p01 The Companies Act, 2013 and the impact on M&A/ restructurings p6 Compliance with the Equity Listing Agreement: Scrutiny by stock exchanges p11 Accounting for outsourcing contracts p13 Employee Benefits: Car lease arrangements p17 Regulatory updates p19
  2. 2. Editorial The last couple of years have seen rapid growth and a number of regulatory changes in the telecom sector in India. This sector has emerged as a very important enabler of growth, tax revenue and employment. In many ways, telecom in India exemplifies how technology can be leveraged to allow an economy like ours to leapfrog many stages of evolution. This sector is our focus in this issue and our lead article examines some of the key accounting and reporting challenges that are specific to this industry. Outsourcing has been an integral component of the success of many telecom companies and in this issue, we also examine accounting implications of different types of outsourcing contracts. We continue our focus on the Companies Act 2013 and in this issue focus on the changes that this Act brings about with regard to mergers and acquisitions and restructurings and also highlight some areas where we believe additional clarity is required for consistent application. We also cast our lens on recent developments relating to the Securities and Exchange Board of India’s measures to ensure greater compliance with requirements of the Equity Listing Agreement and measures that will be undertaken in this regard. Finally, in addition to our round up of the key developments in the past month, we also highlight differences that we observe in practice of a relatively common type of transaction; car lease arrangements for employees. I hope you continue to find the Accounting and Auditing Update to be a good and informative read. In case you have any suggestions or inputs on topics we cover, we would be delighted to hear from you. Happy reading and best wishes for the festive season and the New Year! V. Venkataramanan Partner, KPMG in India
  3. 3. 1 This article aims to: • Highlight the challenges and emerging issues faced by the telecommunication sector in India • Accounting challenges in the telecommunication sector Explain accounting issues faced by the sector The Indian telecom story has seen its share of twists and turns in the past decade. From being the fastest growing sector in the country to the cancellation of licenses by the government and consequently investors exiting from the market, the sector has witnessed its share of highs and lows. The focus area of the sector in the recent past has been growing the data business more than the voice business. While India has witnessed significant growth in telephone connectivity over the last six years, with tele-density increasing from 17 per cent in December 20061 to .2 73.3 per cent in May 20132, the internet penetration level, however, remains at 12.6 internet users per 100 people3. The penetration levels of broadband are even lower. As per the World Bank estimates, a 10 per cent increase in broadband penetration would yield a 1.21 per cent increase in GDP growth on average for low/middle-income countries4 – higher than the impact of mobile penetration on GDP growth. The usage of data is fueled by the fact that smart-phones have become the next-generation choice and are increasingly taking over market share from basic mobile handsets. This is evident from the fact that out of the total internet subscribers of 164.81 million as on 31 March 2013, 143.20 million access the internet through wireless phones2. The accounting and financial reporting aspects that are specific to this sector are both capable of being complex and requiring the application of judgement. The telecom industry faces significant accounting challenges due to complexities in the schemes offered to customers, capacity transactions, accounting and amortisation for intangibles, etc. Although neither Indian GAAP nor IFRS provide any authoritative industry specific guidance, however, in December 2009, the research committee of the Institute of Chartered Accountants of India (ICAI) had issued an exposure draft of the ‘Technical Guide on Revenue Recognition for Telecommunication Operators’ with a view to provide guidance on peculiar revenue recognition issues in the industry which more or less mirrors the US GAAP requirements. However, the same has not been finalised as yet. The ICAI’s Expert Advisory Committee (EAC) has also issued some relevant guidance on the certain critical aspects of telecom industry. In this article we have highlighted certain significant accounting issues in the subsequent paragraphs which are relevant to the sector and the commentary also highlights with guidance on these accounting issues under Indian GAAP. 1. TRAI, The Indian Telecom Services Performance Indicators, published 7 April 2007 2. TRAI, The Indian Telecom Services Performance Indicators, published 1 August 2013 3. World Bank database 4. Broadband Commission for Digital Development Report
  4. 4. 2 Revenue Recognition Revenue recognition is a judgemental and complex area of accounting in the telecom sector. With telecom companies foraying into internet and television besides mobile, fixed line telephony and value added services, it has only added to the complexity due to vast arrays of constantly changing offers. Considering the different components of these schemes and offers to determine revenue recognition requires careful analysis of the business transaction together with the understanding of the accounting principles. Certain key aspects relating to revenue recognition which requires consideration are as follows: Bundled transactions Many operators have launched a range of bundled products as a package to customers incorporating elements like free minutes and messaging services, free internet services for a specific period, etc. These elements can lead to complexities in the accounting of these products/packages. Under Indian GAAP, there is no specific guidance available on the accounting of such incentives and accounting in such cases is driven mainly by the substance of each transaction entered into. In certain situations, it becomes necessary to apply the recognition criteria to each separately identifiable component of a single transaction in order to reflect the substance of the transaction. Accordingly, assessment should first be made to determine if any of transaction’s components need to be accounted separately or not. AS 7 Construction , Contracts provides guidance regarding combining and segmenting construction contracts and IFRS under IFRIC 18 provides the following guidance regarding separation of identifiable components: • the component has stand-alone value to the customer and • the fair value of the component can be measured reliably. In practical terms, the arrangements are complex and careful evaluation of facts of each case is needed. Further, the question arises on what is the overall consideration to the components. While Indian GAAP is silent on such accounting, however, reference can be drawn from IFRS under IFRIC 13 – customer loyalty programme. Under this interpretation, revenue could be allocated to each component either using the following method: a. Relative fair values or b. Fair value of the undelivered component (residual method). Using relative fair values, the total consideration is allocated to the different components based on the ratio of the fair values of the component relative to each other. Using residual method, the undelivered components are measured at fair value and the remainder of the consideration is allocated to the delivered component. The best evidence to measure the fair value of a component is to compare the component to an identical product or services sold on a standalone basis. If a telecom company is not able to establish fair values by reference to its own product or services, then the next most relevant reference point is the price of a similar product or service sold by the telecom or by a competitor, adjusted for significant differences between the products or services. Further, cost-plus-margin approach could also be applied in cases where there is a lack of market inputs. If no separable components are identified, then it may not be appropriate to recognise any revenue until completion (or acceptance) of the final deliverables. Free minutes to customers Certain telecom companies also provide incentives like free minutes or talk time to an existing customer based on their usage. As per current practices in Indian GAAP, billable minutes are recognised as revenue based on their usage after the free minutes are exhausted and the discount is often treated as marketing expense. However, under IFRS revenue to be measured at the fair value of the consideration received or receivable net of any trade discount or volume rebates. Revenue should be recognised on the basis of the substance of the transactions i.e., whether two or more transactions are linked such that the individual transactions have no separate or distinct commercial effect. The provision of free or discounted goods or services is also a form of identifiable benefit that is required to be identified as a separate component of the sales transaction. In such cases, revenue should be recognised and allocated to all goods or services, including those provided free of charge. For example, in an arrangement, say, where each tenth minute is free, revenue is recognised at nine-tenths of the standard rate. Inter-connect revenue For most operators, interconnect charges represent the largest single operating cost and the second largest source of revenue. Mobile operators enter into a number of interconnect agreements with other operators. These agreements allow them to terminate a particular call or transit the traffic on another operator’s network. This, essentially, uses network of contracting parties to facilitate and to provide the endto-end connections required by customers of agreeing parties. In certain cases, the rates may be regulated e.g., in India the rate is governed by the Interconnect Usage Charge (IUC) Guidelines issued by the Telecom Regulatory Authority of India (TRAI). Even though interconnect agreements usually allow operators to settle on a net basis, however as per market practices, interconnect revenues are accounted for on a gross basis since the operators are exposed to the gross risks of the transactions. For example, an operator may bear the gross credit risk for non-payment and be obliged to make payments under interconnect arrangements, irrespective of the level of reciprocal revenues due. In certain cases, accounting on gross basis may not be appropriate where net settlement and the legal right of offset exists between operators or when operators enter into an agreement where the rates and amount of traffic to be carried by each operator are agreed upfront. Thus, each arrangement needs to be evaluated on a case-to-case basis.
  5. 5. 3 Capacity transactions Telecoms operate in a capital-intensive industry in which significant set-up costs are incurred in respect of the network infrastructure that is required to operate, for example, setting up of mobile towers and laying fiber optics. It makes commercial sense for such telecoms which own excess network capacity to enter into arrangements whereby they convey to another telecom the ‘right to use’ equipment, fiber or bandwidth (capacity) for an agreed period of time for an agreed payment. In respect to such capacity transaction, telecom could be seller, buyer or both/there could be capacity swaps. The excess capacity holder usually retains the ownership of the network asset and allows an ‘indefeasible right to use’ (IRU) to the customer. The basic accounting issue related to an IRU is when to recognise revenue. That determination can be quite complex, but can be boiled down to two basic questions: Is the IRU a lease or is it a service contract? Is there a lease? Yes No Apply lease accounting Operating lease Finance lease Apply revenue recognition principles. Sale of Service Sale of Goods Source: KPMG’s Accounting under IFRS: Telecoms (2010) Often the IRU contracts can be complex and lease arrangements are not explicitly mentioned in the contracts. Thus, one must evaluate the substance of the agreement to understand whether the arrangement contains a leasing arrangement or not. Other than AS 19, Leases, Indian GAAP does not have any specific guidance on evaluating whether an arrangement has a lease in it. However, under IFRS, IFRIC 4 Determining whether an arrangement contains a lease, mentions that the basic criteria for such an evaluation by evaluating two important aspects (a) does the provision of a service depend on the use of one or more specific assets?; and (b) does the arrangement convey the right to use? After applying the mentioned requirement, if an arrangement has been determined to embed a lease, the parties (provider/ receiver) to the arrangement would have to apply the requirements of AS 19 for the lease element of the arrangement and other applicable accounting literature determined, based on the nature of the other component in the arrangement. For the purpose of applying the requirements of AS 19, payments and other consideration required by the arrangement need to be separated at the inception of the arrangement from other elements on the basis of their relative fair values. However, if a purchaser concludes that it is impracticable to separate the payments reliably, it could: • In case of a finance lease - Recognise an asset and a liability at an amount equal to the fair value of the underlying asset that is subject of the lease. Subsequently the liability shall be reduced as payments are made and an imputed finance charge on the liability recognised using the purchaser’s incremental borrowing rate of interest. • In case of an operating lease - Treat all payments under the arrangement as lease payments. In other cases, revenue recognition as per AS 9 should be followed. Capacity Swaps Generally, telecom operators often exchange network cables or swap capacity based on the requirement, with or without any cash flows movement. There is no specific accounting guidance given for such swaps for telecom companies other than AS 10, Accounting for Fixed Assets. When a fixed asset is acquired in exchange or in part exchange for another asset, the cost of the asset acquired should be recorded either at fair market value or at the net book value of the asset given up, adjusted for any balancing payment, receipt of cash or other consideration. For these purposes, fair market value may be determined by reference either to the asset given up or to the asset acquired, whichever is more clearly evident. The key issues in respect of exchange transactions is to ensure there is an appropriate commercial basis for the transaction and to determine the relevant fair value at which to record the transaction. If there is no commercial rationale for the transactions, no accounting recognition should be given to the transaction.
  6. 6. 4 Fixed Assets Intangible assets – Regulatory licensees Telecom operators are required to acquire licenses to operate and access the parts of the spectrum to enable delivery of their services. The auction of 3G and Broadband Wireless Access (BWA) licensees in India by the Department of Telecommunications (DOT) is a recent example whereby many telecom operators had tendered their bids and were awarded the 3G/BWA spectrums, which involved significant costs. Hence, accounting for intangible assets becomes especially pertinent in the telecom sector. Under the Indian GAAP, AS 26, Intangible Assets deals with the accounting relating to intangible assets. The following aspects may be relevant in accounting of regulatory licensees: • Whether the licensees should be capitalised or not? If yes, what should be the amount of capitalisation? The intangible assets are recognised when they meet the conditions as to a) it is probable that future economic benefits that are attributable to the asset will flow to the entity and b) the cost of the asset can be measured reliably. Thus, considering this, the license fees should be capitalised as an intangible asset. The amount of other directly attributable expenses such as legal charges, tender fees, etc. should also be capitalised along with the amount of license fees paid. • Period of amortisation/useful life – Under Indian GAAP, AS 26 prescribes the period of amortisation of intangibles to be 10 years. However, the period of amortisation is rebuttable if more persuasive evidence is available for such extended useful life. The useful life of an intangible asset may be very long but it is always finite. In case of regulatory licensees the period of license allotted by the regulatory authority may be relevant for determining the period of amortisation. • When the licenses should be capitalised and commencement of amortisation? - The amortisation of license commences when they are available for use. Generally, the capitalisation and amortisation of the licenses coincides each other. However, there could be two different viewpoints about the date of commencement of amortisation. First, the licensees are capitalised and amortised from the date of allotment by the regulatory authority or second, the licensees are capitalised and amortised from the date when the network as a whole is ready to commence operations. The decision would be based on the circumstances in each case and one should evaluate the point of availability intangible for use to consider the starting point amortisation. Sometimes, the operators are allotted separate licenses for the geographical areas such as circles. In such cases, the commencement and amortisation needs to be evaluated for each such area for which the license is awarded and as they may be considered as separate licensees. • Method of amortisation – The intangibles are required to be amortised over the useful life using the method which reflects the pattern in which the asset’s economic benefits are consumed by the enterprise. This aspect requires consideration as the telecom companies pay high cost initially and the returns from such investment may not reflect the actual pattern of the utilisation of the asset. This is particularly relevant in the case of intangibles, where high license fees are paid and the capacity may not be fully utilised initially. Hence, deciding the method of amotisation is a matter of judgement and is determined based on facts and other relevant factors. A variety of amortisation methods can be used to allocate the depreciable amount of an asset on a systematic basis over its useful life. These methods include the straight-line method, the diminishing balance method and the unit of production method. The methods given are not exhaustive and may include any other method which appropriately reflects the expected pattern of consumption of the economic benefits which the company derives from the asset. In practice, typically telcom companies use the straight-line method of amortisation. Capitalisation of interest during preoperative period Telecom operators often construct networks from the borrowed funds for expansion or start up. The networks are generally constructed in phases one after another depending on the market demand, operational practicability, availability of the channel and environmental situation. Normally, there is a time lag between the availability of network and connecting the first customer. Irrespective of whether the customer is available or not, the interest liability starts when the company gets funds. During the start up there are operational hurdles and several test runs are required. Interest costs during the time, till sizeable customer base is created, is at times significant for the operators, hence, the question arises how and the period for which the pre-operative interest should be capitalised. The EAC of the ICAI has clarified the matter by way of opinion on capitalisation of interest during pre-operative period in the Cable and Telecommunication Industry. The committee mentioned that borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset are included in the cost of that asset and the capitalisation of borrowing cost shall cease when substantially all the activities necessary to prepare the qualifying asset for its intended use or sale are complete. Therefore, the interest shall be capitalised if it is directly related to the qualifying asset. The company may use weighted average cost formula to the extent that borrowed funds are used. Interest may be capitalised till the time the facility is technologically and commercially ready for distribution to the end-customers and not till the time customer base is created, as the subsequent activities do not add any value to the asset under consideration. Consolidation of business and getting sizeable number of customers is not a criterion for determining the commercial readiness to estimate the substantial period of time. Impairment of assets The significant technology innovations in the telecom sector from second generation to third generation (3G) and BWA required the telecom companies to invest significantly to deliver such products to the end customer. This investment is in the form of capital assets as well as intangibles. Impairment testing is required when there are indicators of impairment. In the scenario where the companies are investing heavily on the intangibles at extremely high prices, questions relating to the potential
  7. 7. 5 impairment of existing assets could frequently arise. The important aspect to consider in evaluating the impairment of a telecom company is to ascertain the cash generating unit (CGU). AS 28, Impairment of Assets defines cash generating unit as the smallest identifiable group of assets that generates cash inflows from continuing use that are largely independent of the cash inflows from other assets or groups of assets. A CGU should be identified consistently unless a change is justified. In identifying whether cash inflows from assets or CGUs are largely independent of the cash inflows from other assets or CGU’s, various factors, including the manner in which management monitors operations and makes decisions about continuing or disposing of assets and/ or operations, should be considered. However, the identification of independent cash inflows is the key consideration. For telecom companies identifying CGUs is further complicated in the current environment of network convergence and stiff competition, as a result of which telecom companies are increasingly providing bundled products and services. Many telecom companies operate on the basis of type of customer i.e., enterprise or retail customers as opposed to type of network e.g., wire-line or wireless. This interdependency of the revenue stream has the effect of increasing the size of CGU because the assets at lower level do not generate largely independent cash inflows. In practice, if more than half of the cash inflows are generated independently from other operations, then the operations are likely to be separate CGU. A telecom company’s network is often common across many of its products lines or business, the network may need to be viewed on a geographic country or regional basis e.g., circle. Monitoring and management of the business may be on a product basis e.g., distinct billing for distinct range of products, however, the product will use the same underlying network. While the use of network is monitored, independent cash inflows may not be identifiable for individual parts of the physical network. Asset retirement obligation Telecom operators often construct assets to build their networks for their mobile and fixed line operations. The land or premises on which such networks as assets are constructed are generally taken on lease, whereby the operators are obligated (under many lease agreements) to reinstate the land or premises at the end of the agreed term of its original state or condition. The provision for such costs is required under India GAAP as per AS 29, Provisions, Contingent Liabilities and Contingent Assets as asset retirement obligations (AROs). The provision for ARO is made at the estimate of the costs involved in dismantling the network assets and re-instating the land or premises on which the networks are built and reviewed at every reporting date till the time the obligations are met. The complexity involved in accounting for AROs is that often it may not be evident from the contractual terms that a legally enforceable obligation exists. It may also be that the contract is unclear or silent on restoration requirements at the end of a contracted period. Even in such cases, entities would need to make their ‘best estimate’ of the cost involved based on past experience. Conclusion There are numerous accounting aspects in the telecom industry that are complex and difficult to tackle. While some of these are contributed by the high level of competition and product innovation, others are a function of the pace of technology change and market landscape.
  8. 8. 6 The Companies Act, 2013 and the impact on M&A/restructurings This article aims to: • Summarise the mergers and acquisitions/restructuring requirements of the Companies Act, 2013 and the draft rules • Provide our observations on the new requirements With the President’s assent on 29 August 2013, the Companies Act, 2013 (the New Act or New Provisions) achieved finality. The Ministry of Corporate Affairs (MCA) has notified 98 sections of the New Act to be operative wholly or in part and the rest are expected to be notified by 1 April 2014. As the heading suggests, this article deals with: Particulars New Provisions Existing Provisions S. 230-234 S. 391-394 S. 236 S. 395 S. 68-70 S. 77A Differential voting rights S. 43 S. 86 Loans to directors, etc. S. 185 S. 295 Loans and investment by company S. 186 S. 372A Arrangements/amalgamations/demergers (Restructuring) Minority buy-out Buy-back of shares Restructuring Brief overview Overall restructuring process format under the New Act continues to be similar as under the Companies Act, 1956 (Existing Act or Existing Provisions), except for the following major changes: • Approvals from statutory authorities enhanced, however, the same is made time bound. • National Company Law Tribunal (NCLT) to assume jurisdiction of the High Court as sanctioning authority in relation to restructuring. • Concept of fast track restructuring, without NCLT approval, introduced. • Amalgamation of/demerger from foreign company into Indian company made restrictive. However, amalgamation of/demerger from Indian company into foreign company is introduced. • There are bound to be significant differences in prescribed procedural formats, statutory approval requirement and mainly the style of functioning of the High Court and NCLT. The MCA may remove some of the transitional difficulties by issuing Rules. However, till such time uncertainty and consequential ambiguity would continue. It is important to note that Rules are subordinate legislation and can provide clarity regarding the provisions or set out operational processes etc. However, the Rules can not deal with issues which may require amendment to New Provisions. Such issues may require amendment to the New Act which may prolong continuation of some of the ambiguity for a longer time. Some general concerns • Practical difficulties in the absence of detailed transitional provisions • The MCA may issue Rules for removing such difficulties.
  9. 9. 7 Arrangements with shareholders/ creditors Basic format of process continues to be same under the New Act. However, certain disclosure/approval requirements have been enhanced and certain conceptual changes brought in as under: • The concept of restructuring to be a single window clearance under the Existing Act is diluted to some extent and New Provisions require that if arrangement involves buy-back of shares or variation of rights, the restructuring scheme should comply with the provisions applicable to buyback or variation of rights. • Increased disclosure requirements in the notice to members/creditors in a bid to boost transparency and keeping all stakeholders well informed. In addition following significant changes are made in the amalgamation process: • Creation of treasury stock pursuant to amalgamation/demerger. Cross holding of shares resulting in creation of treasury stock should be cancelled and no shares should be issued against the same. • Yearly statement confirming implementation of the scheme, to be in accordance with the Order, is required to be submitted till completion of the scheme. Fast track amalgamations/demergers • The New Act has introduced a simplified procedure for merger and amalgamation between: i. holding company and its wholly owned subsidiary ii. two or more ‘small companies’ or iii. uch other prescribed classes of s companies. Any such merger can be given effect to without the approval of the NCLT, subject to compliance with certain other procedures. • To encourage maximum participation from members, postal ballot has been made compulsory and combined results of voting by members present at the meeting and by postal ballot needs to be considered. • Arrangement can be objected only by a person holding at least 10 per cent shareholding or owning five per cent debt. This will avoid all superfluous objection and litigations. • Notice of compromise or arrangement to be given to the Central Government (CG), Income tax, Reserve Bank of India (RBI), Securities and Exchange Board of India (SEBI), Stock exchanges, Registrar of Companies (ROC), Official Liquidator (OL), Competition Commission of India (CCI), and other sector regulators/ authorities as necessary. The authorities • In the case of amalgamation of a listed transferor company into an unlisted transferee company, the New Act allows unlisted company to remain unlisted by giving exit option to the dissenting shareholders. This provision seems to suggest automatic delisting even without complying with the SEBI Delisting Guidelines. • The New Act provides that ‘free reserve’ should not include any change in carrying amount of an asset or of a liability recognised in equity. Therefore, the reserve generated from recording assets at fair value under purchase • Small company is defined as follows: –– A non-public company –– Not being a holding/subsidiary company, a company for charitable purposes or a company established under a special Act –– Having paid-up capital less than INR 5 million (the amount can be prescribed up to INR 50 million) or turnover less than INR 20 million (the amount can be prescribed up to INR 200 million) as per the last audited financials. Thus, a company not meeting either criterion should remain a small company. are allowed a period of 30 days from receipt of the notice to respond and if no response is received within such time, it is presumed that they have no representation. –– This would effectively act as a pre- approval and make the process time bound • The most important change is the requirement to furnish auditor’s certificate to the effect that the accounting treatment specified in the scheme is in conformity with the prescribed Accounting Standard in all cases. Currently, such certificate was required only in relation to listed companies per listing agreement with stock exchanges. method of accounting may not be considered as free reserve and may not be available for declaration of dividend, issue of bonus shares, buyback of shares, etc. Scheme of amalgamation/ demerger – Key issues • Lack of clarity on treasury shares already held by companies. • Lack of clarity about time till which yearly statement about implementation of scheme is required to be filed. Fast track mergers – Key issues • Practical difficulties in obtaining approval of the CG vis-à-vis NCLT • Power of the CG to transfer the scheme to NCLT for application of normal amalgamation provisions which are more onerous. • Positive confirmation required from shareholders and creditors holding 90 per cent in value.
  10. 10. 8 • Transferor and transferee companies need to file declaration of solvency. –– Prima facie companies with negative networth can not use fast track route. • CG may, if it is of the opinion that scheme is not in public interest or in interest of creditors, instead of approving the scheme, may refer the scheme to the NCLT. In such a case, the NCLT may direct that process under S. 232 should be carried out. This will result in duplication of efforts and taking away all benefits of fast track. tax, etc. (as required in normal amalgamation/demerger process). • If the process is completed as fast track –– Auditor’s certificate of compliance without the NCLT order, beneficial rates of stamp duty provided in certain states may not be available. • Significant benefits of fast track are: –– Approval of NCLT is not required. with applicable accounting standards is not required. –– All the above will result in reduction in burden of administration, compliances, timelines and costs. –– Notice is not required to be given to various authorities like Income- Foreign company amalgamation/ demerger (Cross border merger) • The New Act has enabling provisions for cross border mergers subject to: –– eligible jurisdictions being notified by CG –– rules prescribed by CG in this respect –– approval of RBI. Purchase of minority shareholding – S 236 • The New Provisions allow any person or group of persons holding 90 per cent or more of the issued equity capital of a company to purchase the remaining equity shares of the company from minority shareholders at a price determined by a registered valuer. • Although this provision applies to all companies, it may prove beneficial to delisted companies with minority shareholding and enable the majority shareholder to buy-out minority shareholder at a fair price. Key issues • Doubts are raised as to whether offer from majority is binding on minority. • Timeline and other procedures for offer from minority is not clearly specified. • Similarly, the minority shareholders of the company may also offer to the majority shareholders to purchase their shareholding. • Mechanism for higher price sharing with minority shareholders is not clear. Power of company to purchase its own securities – S 68 to 70 Process of buy-back continues to be same as u/s.77A of the Existing Act, except for the following significant changes: • The New Act prescribes minimum gap of one year between two buy-backs, i.e., a gap of one year from end of first buy-back till commencement of next buy-back. Multiple buy-backs within a year should not be possible under the New Act. • Under the New Act, a company which has defaulted in repayment of deposits, redemption of debentures, etc. is not allowed to buy-back for a further period of 3 years after the default is remedied. Existing Act prohibited buy-back only till such default was remedied. • The New Act has added compliance with provisions relating to declaration of dividend as an eligibility condition for buy-back. Key issues • Multiple buy-back in a year not allowed • Prohibition of 3 years post remedy of defaults, may impact many buy-back plans
  11. 11. 9 Equity shares with differential voting rights (DVRs) – S 43 • DVR provisions made applicable even to private limited companies. • Issue of DVRs subject to following key conditions (prescribed as per Draft rules) for any company, private or public: –– DVRs can not exceed 25 per cent of post issue paid up equity share capital –– Track record of dividend payment of at least 10 per cent in preceding 3 financial years as against requirement of 3 years profit track record under the Existing Act. –– Existing equity shares with voting rights can not be converted into shares with DVRs and vice-versa. –– No subsisting default (dividend payment, deposits, redemption of preference shares, repayment of loan, etc.). Key issues • DVR provisions made applicable to even private companies. • Lack of clarity on treatment under the New Act of existing DVRs issued by companies. –– Company is not convicted of any offence under the RBI Act, SEBI Act, SCRA, FEMA or any other special Acts. –– Onerous disclosure requirements. Loan to directors – S 185 –– S. 295 of the Existing Act provided for approval of CG for directly or indirectly granting any loan/giving guarantee/ providing security to its directors and other specified persons (specified loan). However, it exempted from its purview a private company or such loan/guarantee/ security by a holding company to its subsidiary company. –– The New Act provides that a company can not provide loans/guarantee/ security to directors or to any other person in whom the director is interested. The expression ‘to any other person in whom director is interested’ includes any body corporate, the Board of Directors, managing director or manager who is accustomed to act in accordance with the directions or instructions of the Board, or of any director or directors, of the lending company. Exemptions are removed and consequently, the New Provisions are applicable to private companies and also appear to aply to loan from a holding company to a subsidiary company or group companies where directors are common or interested. There is no clarity whether, in view of exemption u/s.372A of the Existing Act, a holding company can give loan to its subsidiary even if the same is prohibited u/s. 185. The MCA has recently issued a circular clarifying that S.372A of the Existing Act is still in operation until Section 186 of New Act is notified. However, that also does not fully clarify above conflict. • Further, the New Provisions are not applicable to: –– Loan to managing director/whole time director as a part of contract of services extended to all its employees or pursuant to scheme approved by members by special resolution –– A company which in the ordinary course of its business provides loan, guarantee or security for due repayment of any loan and charges interest thereon being not less than bank rate declared by the RBI. • This provision has virtually brought intra- group loans and inter-company group borrowings to a standstill. Loan to directors – Key issues • Different views about whether section provides for a blanket prohibition or it is subject to other provisions of the New Act. • No clarity on reconciliation between Section 185 of the New Act and Section 372A of the Existing Act.
  12. 12. 10 Loan and investment by company – S 186 Investment through not more than two layers • An Indian company is allowed to make investments through maximum of two Investment Companies between the holding company and the operating company. Exceptions are overseas acquisition and multi-layering mandated under any law. • The provisions are applicable to investments by a company. Therefore, two layers need to be determined in relation to an investing company and not the ultimate holding company of that investing company. Loans by company • Scope of section is enlarged to include loans to persons other than body corporate • The rate of interest on the loan is now linked to the prevailing yield on approved Government Security closest to the tenor of the loan. • No company shall give any loan or make any acquisition if there is any subsisting default on repayment of any deposits or interest thereon. Loan and investment by company – Key issues • Lack of clarity on ‘two layers of investment companies’ before an operating company in the structure – would it mean an overall restriction of not more than two investment companies vis-à-vis the entire structure or with respect to each individual operating company in the structure Conclusion Since a new legislation is replacing halfa-century old corporate law in a phased manner and envisages some forwardlooking provisions, there are obvious teething troubles. Many of the privileges and exemptions enjoyed by private companies under the Existing Act stand withdrawn under the New Act leading to stricter compliance and disclosure requirements for private companies. This in turn would require revamping and scaling up internal processes by the private companies. The long term objective appears to be boosting standards of corporate governance in private companies. Further, ambiguities arising on account of partial notification of provisions of New Act vis-à-vis active provisions of the Existing Act would also need to be addressed. Schemes of restructuring would still require 75 per cent approval from shareholders. There are transitional overlaps vis-à-vis NCLT and the courts which are yet to be reconciled. Similarly, the new concept of short form merger, chiefly introduced with the objective of saving time on internal group restructurings, would also need to be fine-tuned to address practical challenges and difficulties in order to serve its purpose. While the Existing Act permitted merger of foreign company with Indian company, the converse was not possible. A fresh concept of cross border merger has now been introduced under New Act governing both the situations (i.e., inbound as well as outbound mergers). However, there is a need to bring about corresponding amendments in tax and regulatory regime in order to avoid overlaps/ unintended consequences or hardships and facilitate seamless cross border mergers. The draft Rules to the New Act are already out in public domain for consultations and the same are expected to be finalised before end of the financial year. While some of the ambiguities may be addressed through the Rules, the rest may require suitable amendments to the New Act.
  13. 13. 11 This article aims to: • Summarises the key measures taken by the SEBI to ensure compliance by the issuers with the reporting requirements Compliance with the Equity Listing Agreement: Scrutiny by stock exchanges The Equity Listing Agreement (ELA) is an agreement entered between a listed company and a stock exchange where its shares are listed. The ELA is one of the forms through which corporate governance is enforced in India by which listed companies are directed and controlled by their respective stock exchanges. It is aimed at rationalising disclosures made by the listed companies such that the investors can take timely and informed decisions. For example, inter-alia: • Under clause 35 of the ELA, a listed company is required to file its shareholding pattern with the stock exchange • Under clause 36 of the ELA, a listed company is required to immediately inform the stock exchange of any event that has taken place such as sale of business or merger of a company, litigation with a material impact, disruption of operations due to natural calamity, etc., which will have a bearing on the performance or operations of the company as well as price sensitive information • Under clause 41 of the ELA, a listed company is required to file quarterly and yearly financial results with the stock exchange • Under clause 49, a listed company is required to file corporate governance report annually along with quarterly compliance report with the stock exchange. 1. International Organisation of Securities Commissions Listed companies are required to adhere to the conditions prescribed by the ELA failing which the company may face penal actions. Recently, in September 2013, the Securities and Exchange Board of India (SEBI) had prescribed procedures for imposition of fines on the non-compliant listed companies and had also laid down ‘Standard Operating Procedure’ for suspension and revocation of suspension of trading in the shares of such listed companies. The procedures aim to bring consistency and uniformity of approach undertaken by the stock exchanges for taking action against the non-compliant listed companies. A recent report ‘India: Financial Sector Assessment ProgramDetailed Assessments Report on IOSCO1 Objectives and Principles of Securities Regulation’ released by the International Monetary Fund had pointed out certain deficiencies in the current supervisory framework and has suggested that the stock exchanges should act more vigorously to ensure compliance. SEBI has thus directed stock exchanges to design appropriate framework in order to strengthen the supervision approach including improvement of mechanisms, to ensure compliance by the issuers with the reporting requirements. SEBI has suggested that such improvements should include: • Comparison of current filings made by the listed companies with that of the previous quarter. For example, in case of the submissions made under clause 35 of the ELA, this comparison should include identifying changes, if any, in the names of the promoters, their shareholding, encumbered shares, persons holding more than the required percentage in public category and to ensure whether the requisite disclosures have been made in compliance with SEBI (Prohibition of Insider Trading) Regulations, 1992, SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 and
  14. 14. 12 any other applicable laws, rules and regulations. • Similarly, people in the supervisory role from various stock exchanges should keep themselves informed about major events in relation to a company, through various channels such as print and mass media, to ensure meaningful scrutiny under clause 36 of the ELA • Filings under clauses 41 and 49 of the ELA should be monitored for quality and substantive compliance • It is further suggested that a framework to ensure compliance with the provisions of the Securities Contracts (Regulation) Act, 1956, the Securities and Exchange Board of India Act, 1992, the Rules and Regulations made there under and any other applicable laws, should be devised. This framework should put in place an appropriate mechanism for handling complaints related to inadequate and inaccurate disclosures and non-compliances • Submit an ‘exception report’ in addition the existing reporting requirements, with details of companies which do not respond to the clarifications sought by the stock exchanges and/or where the response submitted by the company is not satisfactory in the opinion of the stock exchange • Obtain the details of the promoters/ directors and/or Key Managerial Personnel of the listed companies who shall be responsible for ensuring compliance with the provisions of the listing agreement and in case of defaults, disclose such details on its website • Procedural efficiency suggestions: –– Timely dissemination of information received by the stock exchanges –– In case any clarification is required, the stock exchanges should seek such information from the company within 2 days from the date of the disclosure –– Listed company should submit requisite information within the timeframe specified by the stock exchange which should not exceed 5 days from the date the information was sought by the stock exchange –– Unsatisfactory information received by the company should be treated as non-compliance of the respective clause of the ELA against which necessary action will be taken. Date of non-compliance in these cases will be deemed as date of last communication received by the company. The stock exchanges should send exception report to the SEBI within 45 days from the end of the quarter with respect to clauses 35, 41 and 49 and on a weekly basis with respect to clause 36. In order to ensure compliance with the conditions as stated above, the SEBI has directed the stock exchanges to carry out a review of disclosures made by the top 500 listed companies (by market capitalisation as on 31 March 2013) for the quarter ending 31 December 2013 with respect to clauses 35, 36, 41 and 49 of the ELA. Good corporate governance, effective enforcement of unfair trading practices such as market manipulation and insider trading and building a robust market surveillance system has been a priority of the SEBI. The above measures are further steps taken by the SEBI in this direction.
  15. 15. 13 This article aims to: • Explain the types of outsourcing contracts in India • Accounting for outsourcing contracts Explain the accounting application issues Businesses are increasingly seeking for cost arbitrage, aiming to concentrate on their core competencies, leverage technology for enhanced customer benefits in order to stay and grow profitable and importantly to remain highly competitive in this fast -changing business environment. The impact of technology to all the key business processes has facilitated effective business functioning and drawn managements to focus on optimising their IT infrastructure and other associated activities as a significant growth driver. Managing IT infrastructure efficiently has become critical for enterprises to preserve the IT assets to deliver and sustain the high performance. Increasingly, Indian IT and ITeS companies are entering into total IT infrastructure outsourcing contracts wherein they offer end-to-end IT solutions, IT infrastructure management strategies including transfer of existing assets, employees and IT systems of the customer to the vendor. The aforesaid outsourcing services are generally rendered by delivery centers using remote infrastructure management platforms in accordance with service level arrangements and applicable quality and security standards. In this article, we will examine some of the key accounting aspects relating to outsourcing contracts primarily under IFRS and Indian GAAP. Nature of outsourcing contracts Application maintenance Application management activities relates to managing a range of legacy, hosted and proprietary systems (such as ERP, payroll, asset management, inventory modules, supply chain/distribution network management applications, etc.) within an organisation. The application systems undergo changes once moved into production owing to business/user needs. Maintenance activities relate to providing support services, optimising the processes/activities within the process and making enhancements as required. Application support services also entail increasing overall productivity as well improving the quality of services. Services rendered as part of the application maintenance includes major/minor enhancements to the system, support services (i.e., L1/L2/L3 support activities), ticket and issue resolution, bug fixes, etc. Infrastructure management Infrastructure management is the remote management of the IT infrastructure/ facilities of a company which typically includes workstations (i.e., laptops, notebooks, mobile devices, tablets), datacenter management (such as servers, hosting and storage devices), network management (managing network equipment such as switches, router, firewall, hub, Virtual Private Network (VPN), etc.) and application support services (help desk services, Level 1/Level 2 support, IT environment management). Business process management It refers to the set of activities which facilitate effective and efficient functioning of the organisation. These activities enable organisation to respond to changing business environment by aligning the business processes and related activities. Business process management generally is part of the overall infrastructure management within an organisation. Business process management aims at increasing the flexibility and functioning of existing infrastructure and data in order to support key business objectives of the stakeholders. Scope of services included in business process management includes business activity monitoring, process mining, process optimisation, business process re-engineering, etc.
  16. 16. 14 Accounting matters Outsourcing contracts in practice contain a variety of different features. The arrangements can have significant accounting implications in respect of revenue recognition, accounting for business combinations, accounting for assets (including intangible assets) acquired, recognition of leases from both the service provider and customer perspective, etc.. For example, service provider M enters into a ten-year contract with manufacturing company P to outsource and run P’s IT platform/IT infrastructure. As part of the outsourcing contract, all of P’s existing IT hardware (computers, servers, laptops) will be acquired by M and the personnel in P’s IT department will be taken over as employees of M. In order to determine the accounting treatment for outsourcing contracts, the starting point for a service provider would be to consider the substance of the contract: Revenue recognition considerations for the vendor Outsourcing contracts that are service arrangements are accounted for under IAS 18, Revenue and AS 9, Revenue Recognition . In the example above, this means that M’s running of P’s IT platform should be accounted for as revenue as the services are rendered. In order to determine the amount of revenue earned it will be necessary to assess the most appropriate measure of performance, although in some cases this could be complex because of the mix of services provided. In some cases, an outputbased measure of performance will be appropriate, for example the number of transactions processed, tickets resolved, calls handled, etc. In other cases, when services are performed through an indefinite number of acts over a specific period, it may be appropriate to recognise revenue on a straight-line basis over that period. In the above example, revenue from the continuous maintenance of the IT platform might be recognised on a straight-line basis. Multiple element arrangements – How should they be segregated? Acquisition of people and assets from customer – a business combination The service providers may offer multiple solutions to the customers as part of outsourcing arrangement. Those solutions may result in the delivery or performance of multiple products and services including rights to use assets/ platform, and performance obligation may occur at different period of time. In certain cases, the arrangements include initial knowledge acquisition/transition phase coupled with steady state involving consideration in the form of a fixed fee or a fixed fee coupled with a continuing payment stream. The continuing payment stream generally corresponds to the continuing performance, and the amount of the payments may be fixed, variable based on future performance, or a combination of fixed and variable payment terms. Certain outsourcing contracts require vendors to perform an integrated set of activities and may also require the vendor to takeover certain assets of the customer at the onset. In the above example, the acquisition of P’s IT personnel and IT hardware might indicate that an integrated set of activities and assets are acquired by M. Under IFRS, an entity would need to assess if the outsourcing contract falls within the scope of IFRS 3, Business Combinations. When the contract is deemed to be a business combination, under IFRS, the contract would be accounted for in accordance with IFRS 3 by applying what is often referred to as the purchase method of accounting. Under Indian GAAP, the assets acquired under above transaction will be recorded under AS 10, Accounting for Fixed Assets wherein the assets will be recorded at fair value and excess of consideration, if any, over the fair value will be recognised as goodwill. Further, the employee obligations acquired shall be recognised in accordance with AS 15, Employee Benefits. The steps involved in revenue recognition in respect of multiple element arrangements are set out below: STEP 1 Identify components - Revenue arrangements with multiple deliverables/elements should be divided into separate identifiable components Contract for provision of services or usage of assets – Is there an embedded leasing arrangement? As in this example, often outsourcing contracts include assets (e.g., an IT platform or other IT hardware) and an entity should determine whether the arrangement would be classified as a lease under AS 19, Leases. Under IFRS, an entity would consider the guidance in IFRIC 4, Determining Whether an Arrangement Contains a Lease as well. If it is determined that the outsourcing contract contains leased assets, then the asset should be accounted for in accordance with IAS 17 Leases. Equally , relevant is considering whether the asset is property, plant or equipment of the service provider. STEP 2 Allocate consideration - Arrangement consideration to be allocated among the separate identifiable components based on their relative fair values or by application of the residual method, as considered appropriate STEP 3 Recognise revenue - Revenue is recognised when general recognition tests are fulfilled
  17. 17. 15 Each of the steps above has been briefly explained below: Step 1: A service provider should evaluate all separately identifiable components in an arrangement. That evaluation must be performed at the inception of the arrangement. This process also involves identifying the relevant standards and/or interpretations that apply. In order to identify separate components in an arrangement, the following criteria should be met: • The delivered item has a stand-alone value to the customer and • the fair value of the components can be measured reliably. Stand-alone value would mean either that • item could be sold separately by the vendor or the customer could resell the delivered item on a standalone basis or • the customer derives value from that item that is not dependent on receiving other deliverables under the same arrangement. Step 2: When a contract or agreement includes more than one component, the second step in recognising revenue is to allocate the overall consideration to the different components. The consideration may be allocated to the elements of the arrangement based on relative fair value method or the residual method as described below: Relative fair value method-Using relative fair values, the total consideration is allocated to the different components based on the ratio of the fair values of the components relative to each other. For example, assume a transaction comprises two components i.e. maintenance of two IT platforms - X and Y. If the fair value of component X is 100 and of component Y is 50, then two thirds of the total consideration would be allocated to component X. If the total consideration is 120, then revenue of 80 would be allocated to component X and 40 to Y. Residual fair value method – Using the residual method, the undelivered components are measured at fair value, and the remainder of the consideration is allocated to the delivered component. For example, assume a transaction consists of two components, X and Y; at the reporting date only component X has been delivered. If the fair value of component Y is 100 and the total consideration is 120, then revenue of 20 would be allocated to component X and 100 to Y. • The transition services include specific Step 3: • The consideration in respect of The allocated fair value would be recognised as revenue when the identified components comprising products or services are rendered/delivered when the revenue recognition criteria are satisfied. Specific application issues Accounting for one-time costs to acquire the contracts Certain contracts involve one-time payment to employees (such as severance pay), retention charges to the employees acquired, early cancellation charges, if any, to the existing vendor, etc. Service providers generally seek to include such charges while determining the pricing of the entire arrangement and also protective terms including right to recover unamortised costs. Such directly attributable charges linked to the acquisition of contract require careful evaluation whether they can be deferred over the period of the contract if the future revenue flow from the contract entails recovery of aforesaid amounts and the costs can be recovered in the event of foreclosure of the contract. Accounting for transition revenue The outsourcing contracts generally involve efforts on the part of service providers in respect of service initiation planning, knowledge acquisition of existing set-up/facility, documentation of business processes, performing shadow support, etc. The transition activity is followed by steady state. In respect of these arrangements, it is essential to determine whether the initial fees for transition services needs to be recognised upfront as a separate element or should be deferred and recognised systematically over the period the steady services are rendered. Transition services can be considered as a separate element and associated revenues and costs are recorded based on the terms of the arrangement in the following cases: • The transition services are not entered into at the same time or as part of and in contemplation of steady state services • Transition services have a standalone value to the customer and are executed as a separate project. deliverables at the end of the transition activity (such as business process documents, knowledge mapping, etc.). transition phase is not contingent upon the service provider’s failure to fulfil its obligation under the steady state. • On conclusion of transition phase, other service providers have the ability to provide steady state services. If the above conditions are not fulfilled, consideration in respect of transition activity and steady state services would be recognised on a straight line basis over the contract period even though transition fee may be non-refundable in certain instances. Productivity gains Generally, the outsourcing contracts are long-term and usually for a period exceeding three years. Certain outsourcing contracts may contain lower billing in later years owing to productivity gains arising to the customer as a result of process proficiency and efficiency factors. In this scenario total fees receivables under the contract is recognised on a straight line basis over the period of the term of the contract. There may be scenarios wherein the amount to be received is lower in the earlier year and higher in the later years. In these cases in the event of termination for convenience, if the vendor cannot recover the unbilled amount (i.e. amount based on straight line over the amount mentioned in the contract), only the contractual amount would be recorded as revenue owing to lack of price protection for unbilled in the event of early contract termination. Certain outsourcing contracts include termination charges in the event of early termination of the contracts. In such scenario, unbilled revenue can be recognised, subject to the termination charges payable by the customer at reporting date. Accounting for service level credits Service level refers to quantitative/ qualitative performance standards set out in the outsourcing contract that customer requires and expects, and which the service provider is committed to provide. The outsourcing contracts typically include assured service levels and the service rendered are compared with the agreed service levels. Service level
  18. 18. 16 credit is the monetary amount that the service provider is obligated to pay to the customer with respect to failure to fulfil service levels. Service level credits are recognised in accordance with the applicable rate in case the service levels can be reliably measured. These service level credits are recorded in the same period in which the corresponding revenue is recognised and shown as revenue reduction in the books. Accounting for incentives to service provider In outsourcing contracts in certain cases there will be incentives which shall be linked to innovation, service value, performance testing, etc. in respect of services delivered. Incentives for these services would be usually recognised on completion of the performance of relevant activities. Accounting for volume discounts The customers increasingly seek to reduce the cost in an outsourcing arrangement. Resultantly, the customer aims at increasing productivity gains due to achievement of higher volumes of transactions/processes outsourced. The contracts or arrangements with the customers generally include a clause wherein the service provider agrees for slab based discounts linked to achievement of volumes. • bears credit risk for loss of collection In respect of such discounts, the service provider needs to estimate the most likely cumulative revenue outcome for the reporting period and record the appropriate discount. Discount thus recognised should be reduced from revenue. • other risks such as general inventory Reporting of reimbursement of costs from customers In the outsourcing arrangements, the terms of the contracts include reimbursement of certain expenses such as travel cost, communication and network related expenses, software/ hardware purchased, etc. The service provider needs to consider the following indicators in order to determine whether these reimbursement needs to be reported on a gross or net basis: Indicators of gross reporting in the financial statements of service provider when it: • is responsible for buying goods and services from vendors (such as airlines/travel agents, service providers, software vendors, etc.) and takes the title to the goods • has discretion in selecting the supplier used to fulfil the customer order and establishing prices and risk, transit risk, etc. An indicator that the service provider is acting an agent is that it performs services for compensation on a commission or fee basis, which is fixed in terms of either an amount of currency or a percentage of the value of the underlying services provided by the principal. Conclusion A number of factors have contributed to the increased outsourcing of IT infrastructure and related services to service providers. The underlying arrangements can be complex from an accounting perspective as they often involve multiple elements, varied pattern of performance/ payment, and service level agreement driven engagement models which needs to be carefully evaluated and analysed from the financial reporting perspective.
  19. 19. 17 This article aims to: • Summarise typical car lease arrangements • Highlight the divergence in practice Employee Benefits: Car lease arrangements As a part of employee benefits, companies often provide a car on lease to their employees. These cars may be owned by the company or taken on lease from a finance company. While these arrangements may take various forms in view of tax and other considerations, a typical arrangement is structured as follows: • The employer (company) enters into a lease arrangement with a finance company and takes a car on lease. • The employer enters into an arrangement with the employee and provides the car to the employee. These back-to-back arrangements may be in the form of separate agreements or a part of the general employee compensation policies. • The lease rentals are paid by the company to the finance company and form part of the overall ‘cost to company’ (CTC) of the employees. For accounting purposes, there are two arrangements, which need to be analysed, viz., (i) arrangement between the employer and the finance company, and (ii) arrangement between the employer and the employee. Accounting for the arrangement between an employer and a finance company The first arrangement between the finance company and an employer may be an operating lease or a finance lease arrangement based on the terms and conditions of the arrangement. For this purpose, all terms and conditions need to be carefully analysed considering the requirements of AS 19, Leases. This evaluation involves judgement and analysis of the substance of the arrangement. In case, the arrangement is concluded to be an operating lease, the lease rentals are recognised in the statement of profit and loss of the employer as an expense. However, in case the arrangement is concluded to be a finance lease, an asset is capitalised in the books of account of the employer with a corresponding finance lease payable. In the statement of profit and loss, depreciation and interest expenses is recognised instead of lease rentals. The accounting is significantly different depending whether the arrangement is an operating lease or a finance lease. Accounting for the arrangement between an employer and an employee While the accounting for the arrangement between the finance company and the employer may be a relatively straight forward assessement to make, the accounting for the arrangement between the employer and the employee may pose more significant challenges. In some cases, there may not be a separate lease arrangement and the terms and conditions may be a part of a general employee compensation policy manual. Further, in some cases, while the lease rent payments may be a part of overall CTC, there may not be an explicit deduction from the gross salary for lease rentals. Instead, the CTC may be adjusted to the extent of lease rental payments. In these cases, the car provided by the company may appear to be a non-monetary benefit; however, in substance, it may not be the case. To illustrate, suppose the CTC of an employee is INR 1,500,000 per annum and entire amount is paid as a part of payroll cost. As per the employee
  20. 20. 18 compensation policy, an employee is eligible to take a car on lease from the company. For this purpose, the company obtains the car from a finance company on an operating lease and pays INR 200,000 per annum as lease rental to the finance company for four years. This amount so paid is recovered from the employee as a deduction from his CTC. In such a case, INR 1,300,000 per annum is paid to the employee as a part of payroll cost and INR 200,000 per annum is paid as lease rental to the finance company. In this example, in the absence of any specific documentation, the gross salary of the employee may appear to be INR 1,300,000 per annum and the car provided by the company may appear to be a non-monetary benefit. However, in substance, there is no change in the CTC and the lease rental is being paid by the company to the finance company on behalf of the employee. The accounting for these arrangements poses a challenge and there are divergent practices to account for such arrangement. Some of the companies recognise the operating lease rentals paid to finance companies as a part of the rent expense and the employee cost is recognised at a reduced amount (INR 1,300,000 in the above example). Since the provision of cars to employees is in consideration of services rendered by employees, the other practice may be to recognise the employee cost on a gross basis (INR 1,500,000 in the above example). Considering the substance of the transaction, it could be argued that that the cost of providing the cars on operating lease (operating lease rentals) should be recognised as a part of employee costs but no definitive guidance exists currently in India on this subject. The accounting analysis can become more complex when the lease from the finance company is classified as a finance lease by the employer. In such a case, based on the terms of the arrangement between the employer and the employee, it needs to be evaluated whether the arrangement should be considered as a sub-lease of the car to the employee. To illustrate, assume that a company takes cars on lease from a finance company. As per the terms and conditions of the arrangement, the lease is classified as a finance lease in the books of the company as per the requirements of AS 19. Accordingly, the company recognised a fixed asset (car), with corresponding finance lease payables. An employee can opt to be provided a leased car in lieu of car allowance. In the case where employees opt for a company car, the company enters into a back to back arrangement with such employees, which has the following key terms and conditions: asset (the car) have been transferred to the employee and whether the employee controls the asset or the company. It could be concluded that the company’s control is not over the car, but over the stream of deductions that it is authorised to make from the employee’s remuneration package, the asset from the company’s angle is not the car but the amount recoverable from the employee. • The employee shall pay all taxes, In the above case, both the company and the employee are bound to have the ownership of the car transferred in the name of the employee at the expiry of the specified period (or earlier). As such, control as well as risks and rewards incident to the ownership of the car appear to rest with the employee. The situation is, thus, effectively that of a finance lease wherein, instead of making a direct payment for the leased car to the company, the employee is making an indirect payment in the form of deduction from his remuneration package. It may be appropriate that the arrangement is considered as a sub-lease to the employee. The asset (the car) would be derecognised from the books of the company and, there would be an asset in the form of recoverable from employees. registration fees, insurance premium and other dues as may be applicable in respect of the vehicle, to the Government or any other agency. • The employee shall not during the tenure of the arrangement sell, transfer or hypothecate the vehicle, unless the permission is taken from the company. • In the event of cessation of the employment of the employee from the company, the employee undertakes to pay directly to the finance company all the monthly lease payments for the remaining period of lease and assume all the liabilities of the company. In cases where an employee leaves the services of the company (as above) or the agreement is foreclosed due to other specified reasons such as transfer, retirement, etc. prior to the expiry of the lease period, the ownership of the car shall be transferred to the employee at no cost to the company. • On expiry of the tenure of the arrangement, i.e., four years, the employee must purchase the vehicle at a residual value and get the title transferred in its name. • The company is and shall remain the absolute legal owner of vehicle, unless the title is transferred in the name of the employee on foreclosure or expiry of the lease term. • The monthly lease rentals for the car will be paid by the company and adjusted towards the total remuneration package of the employee. In the above case, it needs to be evaluated whether the arrangement between the company and the employee should be considered as a sub-lease by the company to its employee. This requires a careful evaluation of all the terms and conditions of the arrangement to conclude whether substantially all the risk and rewards associated with the Further, as discussed earlier, since the provision of cars to employees as per the car policy is in consideration of services rendered by employees, the cost of providing the cars should be recognised as part of the employee costs over the period of related employee services. It may, however, be noted that the accounting treatment and determination whether there is a sublease arrangement would depend on the terms and conditions of a specific arrangement. The primary consideration is whether substantially all the risks and rewards incidental to the ownership of the assets are transferred and effectively, who controls the asset. It may be noted that under Indian GAAP, the classification of lease is determined based on the substance of the transaction, and not upon certain quantitative/rule-based criteria. The fact that this analysis can result in quite different accounting/ reporting possibilities increases the onus on preparers of financial statements and auditors to carefully consider all facts to arrive at an appropriate accounting conclusion.
  21. 21. 19 Regulatory updates Revised norms for primary issuance of debt securities In a move to develop the corporate bond market, the Securities and Exchange Board of India (SEBI) announced the following measures pertaining to primary issuance of debt securities: 1. Disclosure of cash flows – Cash flows that will emanate from interest payments and redemption of debt securities shall be disclosed by way of an illustration in the offer document. This provision is applicable for debt securities issued on or after 1 December 2013. 2. Payment of Interest and repayment of principal of the debt securities – In order to standardise the payment of interest and repayment of principal of the debt securities, it has been decided that if the date of interest payment falls on a Sunday or a holiday, the payment shall be made on the next working day. However, in case the redemption date falls on a Sunday or on a holiday, the redemption proceeds shall be paid on the previous working day. This provision is applicable for debt securities issued on or after 1 December 2013. 3. Allotment date – Allotment should be made on the basis of date of upload of each application into the electronic book of the stock exchange. However, on the date of oversubscription, the allotments should be made to the applicants on a proportionate basis. This provision is applicable for those draft offer document that have been filed with the designated stock exchange on or after 1 November 2013 for issuance of debt securities. 4. Unaudited financials for stub period – In the cases, where listed issuers (i.e., whose either equity shares or debentures are listed) and who are in compliance with the listing agreement, may disclose unaudited financials with the limited review report (as filed with the stock exchanges in accordance with the listing agreement), instead of audited financials, for the stub period along with necessary disclosures including risk factors. This provision is applicable for those draft offer document that have been filed with the designated stock exchange on or after 1 November 2013 for issuance of debt securities. 5. Debenture Trustees – Further, it has now been mandated to disclose the details of debenture trustees (name and contact details) in the Annual Report along with disclosure on the company’s website. This provision is applicable from 1 December 2013. Source: CIR/IMD/DF/18/2013 dated 29 October 2013 Framework for setting up Wholly Owned Subsidiaries (WOS) by foreign banks in India The Government of Indian had liberalised Foreign Direct Investment (FDI) in the private sector banks to 74 per cent in 2004. Several roadmaps were issued in the past to operationalise these FDI guidelines. However, due to the lack of incentives in earlier roadmaps, the response by foreign banks had been sluggish. A new framework has been introduced to attract FDI in the private sector banks in India which will give a ‘near national treatment’ to the WOS set up by the foreign banks. Following are the key features: 1. WOS or branches • Banks with complex structures, banks that do not provide adequate disclosure in their home jurisdiction, banks that are not widely held, banks from jurisdictions having legislation giving a preferential claim to depositors of home country in a winding up proceedings, etc. would be mandated entry into India only in the WOS mode. • Foreign banks in whose case the above restrictions do not apply may opt for either branch or WOS mode. However, such banks shall convert their branches into a WOS as soon as the above restrictions become applicable to it or they become systematically important on account of their balance sheet size in India. • Foreign banks which commenced business in India before August 2010 have the option to continue their banking business through the branch mode. 2. Initial minimum paid up capital – The initial minimum paid-up voting equity capital for a WOS should be INR 5,000 million. Existing branches of foreign banks desiring to convert into WOS should have a minimum net worth of INR 5,000 million. 3. Letter of comfort – The parent of the WOS is required to issue a letter of comfort to the RBI for meeting the liabilities of their WOS 4. Curbing domination by foreign banks – Foreign banks will be restrained from infusing further capital in existing WOS or from opening new WOS, when the capital and reserves of
  22. 22. 20 the WOSs and the branches of foreign banks in India exceed 20 per cent of the capital and reserves of the banking system. This measure is undertaken to check domination by foreign banks. 5. Corporate governance - Following are the corporate governance conditions that need to be complied with by the WOS: • Not less than two-third of the directors should be non-executive directors • A minimum of one-third of directors should be independent of the management of the subsidiary in India, its parent or associates • At least fifty per cent of the directors should be Indian nationals/NRIs/PIOs subject to the condition that not less than one-third of the directors are Indian nationals resident in India. 6. Expansion – The WOS of foreign banks will be able to expand their business in India by opening new branches. However, the WOS will require prior approval of the RBI for opening branches in areas sensitive from the perspective of national security. 7. Priority sector lending – Similar to domestic scheduled commercial banks, priority sector lending will be 40 per cent for the WOS like domestic scheduled commercial banks with adequate transition period for existing foreign bank branches converting into WOS. 8. Dilution of stake – WOS may dilute their stake to 74 per cent or less as per existing FDI policy. In the event of dilution, they will have to list themselves. 9. Operation: On an arm’s length basis, WOS would be permitted to use parental guarantee/credit rating only for the purposes of providing custodial services and for their international operations. However, WOS should not provide counter guarantee to its parent for such support. The RBI would consider at a later stage the issue of permitting WOS to enter into merger and acquisition transactions with any private sector bank in India. The RBI’s decision would depend on the extent of penetration of foreign investment in Indian banks and functioning of foreign banks (branch mode and WOS). Source: Press Release 2013-2014/936 issued by the Reserve Bank of India dated 6 November 2013 FDI guidelines - Definition of Group Company For the purposes of Foreign Direct Investment (FDI) in India, the RBI has incorporated the definition of ‘group company’ and amended the FDI guidelines as under: ‘Group company’ means “two or more enterprises which, directly or indirectly, are in position to (i) exercise twentysix per cent, or more of voting rights in other enterprise or (ii) appoint more than fifty per cent, of members of board of directors in the other enterprise. ” The definition is applicable retrospectively from 3 June 2013. However, it is clarified that no person will be adversely affected as a result of retrospective effect of amended guidelines. Source: RBI/2013-14/356, A.P. (DIR Series) Circular No.68, dated 1 November 2013; Notification No.FEMA.292/2013RB dated 4 October 2013 Pilot scheme to allow unlisted Indian companies to list and raise capital abroad – date notified November 2013 issue of the Accounting and Auditing Update elaborated on the pilot scheme announced by the Ministry of Finance (MoF). Under this scheme unlisted companies may be allowed to list and raise capital abroad without the requirement of prior or simultaneous listing in India. This scheme was to be applicable from the date of its notification. Ministry of Finance has now published the notification. The date of notification is 11 October 2013, from which date the pilot scheme is applicable. It is further clarified that such unlisted company must be compliant with the prevailing Foreign Direct Investment (FDI) policy and all other relevant guidelines and regulations issued by the Reserve Bank of India (including under Foreign Exchange Management Act (FEMA)), Securities and Exchange Board of India (SEBI) and MoF from time to time. Source: RBI/2013-14/363 A.P. (DIR Series) Circular No. 69, dated 8 November 2013 Update on Companies Act, 2013 The Ministry of Corporate Affairs (MCA) has released the fifth and sixth tranche of draft rules to the Companies Act, 2013 relating to winding up and cost audit respectively. The last date for submission of comments for the fifth tranche of draft rules is 19 December 2013 and for the sixth tranche of draft rules is 6 December 2013. Further, the MCA has clarified that section 372 A, Inter-corporate loans and investments of the Companies Act, 1956 will remain applicable till the time section 186, Loan and investment by company of the Companies Act, 2013 is notified. Source: MCA website:; Circular 18/2013 date19 November 2013 released by the MCA
  23. 23. 21 Missed an issue of Accounting and Auditing Update? The November 2013 edition of the Accounting and Auditing Update casts its lens on the healthcare sector and provides insights into emerging issues and internal control considerations that are relevant to this sector. We also cover US GAAP developments and focus on the proposals of the Private Company Council relating to intangibles acquired in a business combination, goodwill and accounting of certain derivatives swap contracts. We have included two articles highlighting the impact of the Companies Act, 2013 – Corporate Social Responsibility and auditor appointment and reporting requirements. In this issue, we also discuss the EAC opinion on ‘Disclosure in the cash flow statement of borrowings and related payments in the case of a financial institution’. In addition, we have covered recent developments relating to the SEBI guidance on acceptability of certain pre-emptive rights in shareholder agreements including an overview of the key regulatory developments. The October 2013 edition of the Accounting and Auditing Update discusses the key areas of focus when conducting impairment testing under Indian GAAP. We also examine some considerations from an accounting perspective of Corporate Debt Restructuring. We also cast our lens on the IASB’s proposals on Insurance accounting. In this issue we also explain the accounting for employee share based payments under Indian GAAP. In addition, we have covered an overview of the key changes being proposed to the format and content of the auditors’ report internationally. The issue also highlights the accounting practices by entities in India relating to transaction costs associated with lending/financing and provides an overview of the key regulatory developments including a snap shot view of the key regulatory developments relating to the Companies Act, 2013. Back issues are available to download from:
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