Accounting and Auditing Update - January 2014


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The January 2014 edition of the Accounting and Auditing Update focuses on the pharmaceutical sector and provides insights into accounting issues relating to companies operating in the generics space. We also cover the complex area of hedge accounting with its accounting challenges and examine the IASB’s new hedge accounting rules (IFRS 9). Continuing with our series of articles on the Companies Act, 2013, we have included in this issue an article highlighting role and responsibilities for directors and those in positions of governance. The issue also highlights the implications of the U.K. Bribery Act.

This month, we also have covered some interesting practical aspects relating to the identification of and reporting obligations concerning related party transactions for Indian companies and an overview of the key regulatory developments during the recent past including the considering the practical application of an EAC opinion regarding the amortisation of ‘right of way’ intangible assets.

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Accounting and Auditing Update - January 2014

  1. 1. ACCOUNTING AND AUDITING UPDATE January 2014 In this issue The Generic Pharmaceutical Industry p01 Hedge accounting - Application challenges p07 New hedge accounting rules under IFRS 9 p11 The U.K. Bribery Act, 2010 p13 Identification of related parties p17 Enhanced responsibility for directors p21 Treatment of ‘right of way’ assets p24 Regulatory updates p25
  2. 2. Editorial Dear Readers, I hope the new year has begun well for you and you have had a chance to take some time off and recharge your batteries towards the end of the 2013. There has been a lot happening in the world of accounting and reporting, especially in the complex and often confusing area of hedge accounting. The International Accounting Standards Board (IASB) finally issued a much anticipated part of IFRS 9 that deals with hedge accounting, and the new standard has been broadly welcomed by most constituents. In this issue, we feature two articles on this subject by first examining why there was a need for change from the previous standard and then highlighting the key aspects that are changed under the new hedge accounting guidance in IFRS 9. Our sector focus for this month is the pharmaceutical sector and we highlight a number of the key industry drivers and resultant accounting and reporting issues for companies operating in the generics space. In this issue, we also examine the increased role and responsibilities for directors and those in positions of governance arising out the Companies Act, 2013. With a number of Indian companies having significant global operations, legislation in a foreign jurisdiction can have a material impact on them. This month, we highlight and examine the implications of the U.K. Bribery Act. Finally in addition to our round of regulatory developments, we also cast our lens on some interesting practical aspects relating to the identification of and reporting obligations concerning related party transactions for Indian companies. 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 the topics we cover, we would be delighted to hear from you. Happy reading and best wishes for the year ahead! V. Venkataramanan Partner, KPMG in India © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
  3. 3. 1 This article aims to: • Provide an overview of generic drug industry and related accounting issues • Explain the approval processes of generic manufacturers in the United States of America • Highlight the ‘era’ of opportunity for generic players • Discussion on the accounting considerations in relation to FTF’s The Generic Pharmaceutical Industry Few accounting considerations for First to Files (FTF’s) during the 180 days exclusivity period ‘The discussion below is particularly relevant in the circumstances where an Indian manufacturer is supplying generics to a subsidiary in the United States of America for sales to be made during the exclusivity period’ The Industry landscape The pharmaceutical industry develops, produces, and markets drugs for use as medications. To counter and cater to changing/emergence of new diseases, pharmaceutical companies continuously work on innovating new drugs, drug delivery systems, innovative processes, etc. Most branded or innovator pharmaceutical companies spend significant amount of money on research and development activities with generally low success rates which results in a significant business risk. Significant expense is usually incurred in the early phases of development of compounds that may not ultimately result in getting an approved drug. Further, the drugs produced by such companies are subject to a variety of laws and regulations regarding patenting, testing and ensuring safety, efficacy and marketing of drugs. This means that for a drug company to survive and thrive, it needs to discover a blockbuster (billion dollar drug) every few years. The products manufactured by pharmaceutical companies operating in this sector are generally identified as bulk drugs (active pharmaceutical ingredients - API) and dosage formulations (sold as syrups, injections, tablets and capsules). API manufacturing segment can be divided into two sectors innovative or branded and generic or unbranded. The risk undertaken by the innovator companies is rewarded through patent regime across the world whereby an innovator pharmaceutical company is granted a patent. A patent provides exclusive rights to sell that newly developed drug in that market typically for a period of about 20 years. Such patent is granted only after various phases of examination of applications by such companies to the relevant authorities. The United States of America (U.S.A.) has a strong patent protection system which is implemented through stringent patent laws. Being the largest drug market in the world, it is the most favoured target market of the pharmaceutical companies. In this article, we discuss FTF’s and certain related accounting considerations in the context of a drug which is patented and sold in the U.S.A. © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
  4. 4. 2 Recent events/developments has reiterated the world’s commitment towards reducing healthcare cost without impacting quality thereof and the promotion of increased use of generic drugs (due to its cost advantage compared to innovator) is currently recognised as an important step towards this direction. A generic drug product is one that is comparable to an innovator drug product of developing/manufacturing could be varied by a generic drug manufacturer. In developing generic drugs, the manufacturer needs to demonstrate the bioequivalence of its drug to the branded product, and that the manufacturing process produces acceptable purity and consistency. The development does not involve lengthy and costly clinical trials because generic manufacturers need to prove bioequivalence only. On an average, the development of the generic drugs takes only three years, in contrast to the six to seven years of development time spent on the branded drugs. The development and approval of generics is less expensive, allowing them to be sold at a lower price. Often the owner of the branded drug will introduce a generic version before the patent expires in order to get a head start in the generic market. The generic industry has grown significantly in the last few decades, driven by the patent expiration of products launched during the industry’s ‘golden era’ in the 1990s, followed by fewer subsequent launches of new blockbuster products to replace the lost revenues. in its dosage form, strength, route of administration, quality, performance characteristics and intended use. The underlying nature of a generic drug is that its process of developing/ manufacturing may vary but the patient should derive benefits comparable to those derived from an innovator product. A question arises that whether patent expiry means that there is no demand for that drug in the market? The answer is no. What it means is that now other companies can also sell this drug, provided necessary approvals have been received from the relevant authorities such as the U.S. Food and Drug Administration (FDA). Such product of another company is referred to as ‘generic drug’ in the pharmaceutical industry. When the patent protection for a drug expires, a generic drug is usually developed and sold by a competing company. A generic drug product is one that is comparable to an innovator drug product in dosage form, strength, route of administration, quality, performance characteristics and intended use. A generic drug must contain the same active ingredients as the original formulation. According to the FDA, generic drugs are identical (legal interpretation and not literal meaning) or within an acceptable bioequivalent range to the brand-name counterpart with respect to pharmacokinetic and pharmacodynamic properties. In simple words, the patient should be able to derive benefits comparable to those derived from an innovator product. However, the process Source: understandinggenericdrugs/ucm167991.htm A brief overview of the regulatory process currently applicable in the US In the United States, new pharmaceutical products must be approved by the FDA as being both safe and effective. This process generally involves submission of an Investigational New Drug (IND) filing with sufficient pre-clinical data to support proceeding with human trials. Following IND approval, three phases of progressively larger human clinical trials are required to be conducted. Phase I generally studies toxicity using healthy volunteers. Phase II includes pharmacokinetics and dosing in patients, and phase III is a very large study of efficacy in the intended patient population. Following the successful completion of phase III testing, a New Drug Application (NDA) is submitted to the FDA. The FDA reviews the data and if the product is seen as having a positive benefit-risk assessment, an approval to market the product in the US is granted. A fourth phase of post-approval surveillance study is often required due to the fact that even the largest clinical trials can not effectively predict the prevalence of rare side-effects. Post marketing surveillance ensures that after marketing, the safety of a drug is monitored closely. In certain instances, its indication may need to be limited to a particular patient group, and in others, the drug may be withdrawn from the market completely. Drug products approved on the basis of safety and effectiveness by the FDA under the Federal Food, Drug, and Cosmetic Act (the Act) are listed in the publication called ‘Approved Drug Products with Therapeutic Equivalence Evaluations’, the List, commonly known as the Orange Book. However, one will note that the process for a generic drug application as indicated below, is much simpler as compared to the process required to be followed by the innovator companies. © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
  5. 5. 3 The generic approval process When applying to enter the market with a generic form of a reference product, the generic company files an Abbreviated New Drug Application (ANDA) and certifies against patents listed in the Orange Book. Unlike the innovator, a generic company is not required to carry out the detailed clinical trials for its drug. Through a bioequivalence study, the generic company has to prove that its generic drug would comparable to an innovator drug product and intended use. The certification states that either: • FDA should approve of its generic version after the date the last patent expires (a ‘Paragraph 3’ filing) • That its generic product does not infringe on the listed patents/that those patents are not enforceable (a ‘Paragraph 4’ filing or a Paragraph IV filing). If a generic company files an ANDA with a Paragraph IV certification, then the branded company is notified. After the notice, the branded company has 45 days to file a patent infringement action against the generic company. If a suit has been filed, the FDA can not approve the application until the generic company successfully defends the suit or until 30 months, whichever happens first. If the ANDA contains a paragraph IV certification and is for a drug for which a previous application has been submitted, the application shall be made effective not earlier than 180 days, after: i. the date the FDA receives notice from the applicant, under the previous ANDA of the first commercial marketing of the drug ii. the date of a decision of a court [in a patent infringement action] holding the patent which is the subject of the certification to be invalid or not infringed, whichever, is earlier. This means that, in certain circumstances, an ANDA applicant whose ANDA contains a paragraph IV certification is protected from competition from subsequent generic versions of the same drug product for 180 days, after either the first marketing of the first applicant’s drug or a decision of a court holding the patent that is the subject of the paragraph IV certification to be invalid or not infringed. This marketing protection is commonly known as ‘180-day exclusivity’ in the context of First to File or FTF . The ‘era’ of opportunity Majority of prescriptions filled in the United States are for generic drugs. The use of generic drugs is expected to grow over the next few years as it is expected that a number of popular drugs would come off patent by 2015. The Pharmaceutical industry is abuzz with the impact of the Affordable Care Act. However, it is still unclear what would be the long-term impact of the Obamacare on the industry in terms of drug spending. However, it is expected that generics share in the market will witness an increase. Indian pharmaceutical companies contribute significantly to the generic space in the United States and the next few years are likely to open the doors to even greater opportunity. The price competitiveness and experience of some of the big Indian pharmaceutical companies is expected to give them a considerable edge as compared to other pharmaceutical players in the world. However, recent FDA inspections and resulting actions in terms of warning letters/import alerts has once again raised a question mark on the current good manufacturing processes (cGMP) adherence by the Indian manufacturing companies. The Industry will thus have to raise the bar in terms of compliance if it intends to catapult its position as the leading manufacturers of generics drugs, given the opportunity that is expected to arise. First to file (FTFs) approvals are a key part of the strategy of a generic company, similar to innovating blockbuster drug for an innovator company. Due to size, amounts and uncertainties involved, accounting of certain specific elements of FTF’s monetisation (such as pre-launch shipment from parent to subsidiary, transfer pricing adjustments, price equalisation reserve, etc.) gain significant importance specially if an accounting/reporting period end is in between FTF period. © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
  6. 6. 4 The Accounting dilemma As mentioned above, a generic player has a six months exclusivity right to manufacture and sell its products in the United States. As the price difference between a branded prescription and a generic drug is significant, insurance companies also indirectly promote the sale of such generic drugs by agreeing to reimburse only the cost of generic drugs to patients covered under various healthcare programs. Thus, it is important for such generic players to make sure that the product is on the shelves of pharmacy the moment the approval is granted in order to capture maximum market share which can result into significant profits. More often than not, generic manufacturers in India enter into distribution arrangements with their subsidiary company in the United States which will sell the goods in the U.S. market. For the purpose of the discussion below, it has been assumed that such subsidiary is a limited risk distributor i.e., an entity which is permitted to earn a fixed margin on the sales made in the U.S.A. market. This leads to certain accounting issues in terms of sales made by the Indian manufacturer at various points of exclusivity period which has been discussed in the paragraphs below. It is also important to recognise that the accounting treatment would depend upon the exact commercial and economic substance of specific transaction in each instance. The discussion below is limited to an assessment of the treatment of prelaunch sales by an Indian manufacturer to its limited risk distributor subsidiary, related price equalisations and other adjustments in the context of sales of FTF’s from the Indian GAAP (Generally Accepted Accounting Principles in India) perspective. We have currently excluded an analysis on some of the other facets in the generic drug cycle such as the long process for development and therefore, treatment for R&D including filing fee/joint arrangement and exhibit batches, inventory valuation for pre-launch inventory, cost relating to patent infringement litigation including accounting policy for legal fee and accounting for aggressive launches and related consequences. Treatment of pre-launch sales made by the Indian company As explained above, in order to reap the benefits of sale during exclusivity, it makes commercial sense for a manufacturer in India to make certain pre-launch sales to the U.S. subsidiary which will enable the ultimate product to reach the shelves of a pharmacy immediately upon receiving the approval of six months exclusivity from the FDA. These sales are made at a base price as there is a significant amount of uncertainty on whether or not an approval by the FDA will be actually received. As such the sales price from the Indian manufacturer’s angle effectively comprises fixed price plus a contingent consideration that is linked to the following: i. The US subsidiary obtaining the FDA approval ii. The price of the final output. According to AS 9, Revenue Recognition in respect of sale of goods, the following three conditions are required to be met: i. the seller of goods has transferred to the buyer the property in the goods for a price, or all significant risks and rewards of ownership have been transferred to the buyer and the seller retains no effective control of the goods transferred to a degree usually associated with ownership ii. No significant uncertainty exists regarding the amount of the consideration that will be derived from the sale of the goods iii. It is not unreasonable to expect ultimate collection. The criteria for satisfying the first condition and the third condition would depend upon the evaluation in the facts and circumstances of each case. In this particular scenario, we are assuming that the transfer of the property in goods has taken place from the seller to the buyer and it is reasonable to expect ultimate collection. Thus, an issue arises in terms of whether or not any revenue should be recognised by the seller i.e., the Indian manufacturer, given the level of uncertainty regarding receipt of approval from the FDA. This is particularly important in order to satisfy the second condition of AS 9. It is important to consider that as far as the price is concerned, there are two elements. The first is a fixed price element. Generally, this price should be the equivalent price for same product sold in other markets where there is no exclusivity. Thus, if the product could be sold in 10 other markets (where there is no exclusivity); the price charged in those markets becomes the fixed price element (base) in invoicing of the supplies. To this extent, there is no price risk from the perspective of the seller (Indian manufacturer). The second element is the expected price that can be charged during the period of exclusivity. Till the time the approval is actually received, there is significant uncertainty as to whether the FDA would approve six months exclusivity period. Moreover, even in the event of such approval being granted, the price at which the US company would be able to sell the product would depend on the market forces. Generally, this price is expected to be quite high and consequently if the FDA approval is received, the realisation from the product is expected to be substantially higher than the upfront price charged by the Indian manufacturer. Thus, this differential price charged is an additional reward for both the Indian manufacturer and the US company. In this regard paragraph 9.2 of AS 9 states that where the ability to assess ultimate collection is lacking, revenue recognition is postponed to the extent of uncertainty involved. Accordingly, at present the Indian manufacturer should not recognise the possible higher amount that may be realisable till the significant uncertainty is resolved. However, the Indian manufacturer should recognise the price as per the invoice (fixed price) provided the transaction satisfies the recognition criteria in AS 9, even though the final approval for launch from the FDA, is pending to be received. © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
  7. 7. 5 Price adjustment on resolution of contingency Another, important consideration which is worth a discussion is whether an adjustment should be made to the period end financial statements in case the final price is determined after the balance sheet date, but before the date on which the financial statements are approved i.e., whether this would represent an adjusting event under AS 4, Contingencies and Events Occurring After the Balance Sheet Date. This issue would be relevant where sale has been recognised on the basis of the fixed price element. Paragraph 8.2 of AS 4 states that adjustments to assets and liabilities are required for events occurring after the balance sheet date that provide additional information, materially affecting the determination of the amounts relating to conditions existing at the balance sheet date. For example, an adjustment should be made for a loss on a trade receivable account which is confirmed by the insolvency of a customer which occurs after the balance sheet date. Accordingly, if the subsequent events provide additional information about the conditions existing as at the balance sheet date, then such subsequent events are considered as adjusting events, i.e., they cause adjustments to the carrying values of assets and liabilities as at the balance sheet date. In our discussion above, the condition as at the balance sheet date seems to be the uncertainty regarding the amount of balance consideration for goods in which the property has already passed to the buyer from the Indian manufacturer. Thus, the determination of final price (i.e., resolution of the above uncertainty) after the balance sheet date but before the approval of the financial statements represents an adjusting event in view of the authoritative guidance on this matter. © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
  8. 8. 6 Price equalisations adjustment As the product nears the end of exclusivity, the management of the overseas limited distributor entity should make an estimate of inventory in the market on which it will be required to offer a price equalisation adjustments i.e., a difference between the current market price and the price at which the generic product will be sold at the end of exclusivity. Such arrangements are usually contained in the supply agreements considering the expectation of a significant drop in post exclusivity price of the generic drug also known as ‘price erosion’. The estimate of market inventory and the post exclusivity price involves a significant amount of judgement, and the management may use a variety of assumptions in order to arrive at a reasonable estimate. This is particularly challenging given the fact that no two generics are same. In these circumstances, the management usually estimates the inventory levels with the distributors and at the secondary market by analysing the purchase pattern and the re-order levels. Often the supply agreements also contain an element of overall limit of quantity which will be equalised post the exclusivity period which can give the management a reasonable estimate of the likely amount of market inventory. In terms of estimating the post exclusivity price, the company often compares the percentage of price fall in earlier FTF’s and also considers the number of players who are expected to launch an alternate generic variant post the exclusivity period and thus, eats into the market share currently enjoyed.Such an assessment involves significant amount of judgement and due caution should be exercised during the process of such estimation. Robust control environment including historical experience on such accruals is the key for mitigation of risk of material misstatement. Other adjustments As the generic company makes an estimate of price equalisation in relation to the market inventory, it must also, in accordance with AS 2, make an evaluation of the cost and the net realisable value of the inventory it physically holds given the fact that the post exclusivity prices are generally significantly lower as compared to the exclusivity price. Thus, an adjustment to bring the cost of inventory to its net realisable value may be required. Conclusion There are numerous accounting aspects in the pharmaceutical industry which are complex and difficult to tackle. A majority of these aspects are an outcome of complex contracts in relation to research and development, as well as the compliance with regulations in an era of patent protections. The accounting for FTF’s can be challenging given the level of judgement involved in estimating the future price as well as the market share. © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
  9. 9. 7 This article aims to: • Describe some of the limitation of the current hedge accounting model under IAS 39 / AS 30 • Explain some of the key drivers for revision of the hedge accounting model under IFRS 9 Hedge accounting – Application challenges Background and context While the recent weakening of the Indian Rupee could be a boon to the exporters, it has made life difficult for the importers, as falling rupee is making imports dearer. In any case, the profit and loss account of both importers and exporters has been volatile one way or the other. Many of these companies use a variety of derivatives to hedge their economic exposure, including the exposure arising due to currency movements. Some of these companies have been able to insulate their profit and loss by applying accounting choices and parking markto-market (MTM) movement in such derivative instruments temporarily into reserves while some others have taken the volatility into the profit and loss. The focus of this article is to highlight the available choices of accounting for derivatives under Indian GAAP and to also talk about the practical challenges faced by some of the companies that have adopted the hedge accounting model. This article also puts a lens on some of the limitations of the current hedge accounting model. The current accounting guidance under Indian GAAP for derivative instruments is limited and is restricted to, AS 11, The Effect of Changes in Foreign Exchange Rates, and the guidance of the Institute of Chartered Accountants of India (ICAI) of 2008 which applies to all derivative contracts other than those covered by AS 11. However, a comprehensive guidance for derivative accounting is covered in AS 30, Financial Instruments: Recognition and Measurement, albeit AS 30 is neither mandatory nor recommendatory at this point in time. In the ICAI’s words, “the preparers of the financial statements are encouraged to follow the principles enunciated in the accounting treatments contained in AS 30”. AS 11 only applies to foreign exchange forward contracts used to hedge existing assets or liabilities and it requires amortisation of the premium or discount arising at the inception of such forward exchange contracts as an expense or income over the life of the contract. Further, the standard requires all spot exchange differences on such contracts to be recognised in the profit and loss statement to offset the opposite movement in exchange differences of the underlying assets or liabilities. The ICAI’s announcement of 2008 requires companies to reflect MTM losses (on derivatives not covered by AS 11) at each reporting date in their profit or loss statement, using the principle of prudence. Recognition of MTM gains, on the other hand, are prohibited by the same guidance. This announcement made it almost mandatory for companies to recognise all MTM losses on derivatives to the profit and loss statement in case if these companies did not apply hedge accounting. Hence, for derivatives that are not covered by AS 11, the preparers have a difficult choice between the complexity of applying the hedge accounting model under AS 30 or living with the volatility (at least to the extent of recognising the MTM losses) coming into the profit and loss statement. In practice, many large Indian companies, especially those that deal with derivative contracts on a routine basis, have taken a route of following hedge accounting by applying the principles of AS 30, which are consistent with those in IAS 39, Financial Instruments: Recognition and Measurement. Simply put, hedge accounting is a method that enables companies to match the profit and loss impact of hedging instruments (generally derivative contracts) with hedged items (e.g., future forecasted sales in foreign currency). A common example in the Indian context is when an organisation uses foreign exchange forward contracts to lock in rupee receipts on forecasted export sales. In such scenarios, hedge accounting defers any MTM movements on the hedging instrument until the forecasted sale impacts earnings. The highly complex and arcane nature of hedge accounting rules, coupled with diverse level of disclosures on hedging activities made by Indian companies, has not helped the users comprehend in entirety, the risk management practices of the reporting companies. On the other hand, the preparers have found the provisions of hedge accounting highly complex, rule based and sometimes not portraying the true risk management objectives. From their perspective, there have been many limitations of the current hedging rules and challenges in implementation, some of these key limitations and challenges have been highlighted in this article. © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
  10. 10. 8 Contemporaneous documentation requirements At the inception of the hedge, AS 30 requires formal designation and documentation of the hedging relationship and the entity’s risk management objective and strategy for undertaking the hedge. Formal hedge documentation supporting a hedging relationship should include: • the entity’s risk management objective and strategy for undertaking the hedge • the nature of the risk being hedged • the hedged item • the hedging instrument • how the entity will assess the hedging instrument’s effectiveness in offsetting the exposure to changes in the hedged item’s fair value or cash flows attributable to the hedged risk. AS 30 does not mandate any standard format for documenting the hedging relationship and, therefore, in practice, the nature and style of the documentation may vary from entity to entity. The important thing being the documentation must include all of the basic information as highlighted above and must be in place at the inception of the hedge. Since there must be a formal designation and documentation of the hedging relationship at the inception of the hedge, a hedge relationship can not be designated retrospectively. In our experience, many Indian companies have struggled with this onerous requirement of detailed documentation for hedge accounting programme. This is in many cases seen as an afterthought and occasionally is not formally maintained to the level anticipated by the standard. Meeting ‘highly probable’ criterion for future forecasted transactions For achieving hedge accounting for the forecast transactions, AS 30 requires that the transactions should be highly probable and should present an exposure to variations in cash flows that could ultimately affect the profit or loss. Generally, for a forecast transaction to be considered highly probable, there should be at least a 90 per cent probability of the transaction occurring. In assessing whether a transaction is highly probable, consideration should be given to: • the quality of the budgeting processes • the extent and frequency of similar transactions in the past cent of the anticipated sales will be made. However, if the hedged item is designated as 100 of anticipated sales of 100 in March 2014, then it is unlikely that the highly probable criterion will be met. An important consideration in applying the above criteria of hedge accounting for highly probable forecast transactions is the hedging time horizon. Other factors being equal, the more distant a forecast transaction is, the less likely it is that the transaction would be regarded as highly probable and the stronger the evidence that would be required to support the assertion of highly probable. In our experience, many Indian entities have traditionally hedged for time periods longer than what would generally qualify for the purpose of determining ‘highly probable’. These risk management interventions have benefited entities in recent times of currency volatility but also potentially expose companies to considerably larger accounting volatility than what they have an appetite for. • whether previous similar expected cash flows actually occurred • the availability of adequate resources to finish the transaction • the impact on operations if the transaction does not occur • the possibility of different transactions being used to achieve the same purpose • how far into the future the transaction is expected to occur • the quantity of anticipated transactions. Normally, it is possible to meet the highly probable criterion if significant similar transactions are expected and hedge accounting is limited to a percentage of these forecast transactions. For example, the hedged item may be designated as the first 80 of anticipated sales of approximately 100 expected in March 2014, since it is highly probable that 80 per © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
  11. 11. 9 Frequency and methods of assessing hedge effectiveness To qualify for hedge accounting in accordance with AS 30, a hedge has to be highly effective, both prospectively and retrospectively. Consequently, an entity has to perform two effectiveness assessments for each hedging relationship. The prospective assessment supporting the expectation that the hedging relationship would be effective in future and the retrospective assessment determining that the hedging relationship had been effective in the reporting period. All retrospective assessments are required to be performed using quantitative methods. However, AS 30 does not specify a particular method for testing hedge effectiveness. guidance in the standard for undertaking the effectiveness exercise. The requirement to assess hedge effectiveness is extremely important for a hedge transaction to qualify for hedge accounting. This particular requirement is also the most burdensome of the hedge accounting criteria because of the time, cost and effort that it entails. Assessing the degree or the extent to which such offset will be effective for hedge accounting purposes is by no means an easy task. The difficulty is also exacerbated by the lack of practical This aspect of implementing hedge accounting has been by far the most challenging from the perspective of Indian companies since it not only requires knowledge of the hedge accounting principles, but also requires domain knowledge of complex statistical techniques. Further, the outputs of statistical technique are also difficult to comprehend by most accountants. Hence, most companies end up outsourcing this part of the overall exercise. Arbitrary 80-125 rule of measuring highly effective hedging relationship As discussed above, to qualify for hedge accounting in accordance with AS 30, a hedge has to be highly effective. The term ‘highly effective’ refers to the degree to which the hedging relationship achieves offsetting between changes in the fair value or cash flows of the hedging instrument and changes in the fair value or cash flows of the hedged item attributable to the hedged risk during the hedge period. In accordance with AS 30, a hedge is regarded as highly effective if the offset was within the range of 80–125 per cent. If at any stage during the hedging relationship, either the prospective or retrospective test fails the 80-125 bracket, the hedge accounting will need to be terminated even though the risk management objectives of the entity are still being met. In our experience, this arbitrary and onerous ‘bright-line’ approach to assess whether the hedge is highly effective has been a key area of concern for many Indian companies. Some of these companies have been vocal in supporting proposals to amend the hedge accounting norms under AS 30 and to do away with the effectiveness testing criteria whilst continuing to recognise ineffectiveness in the profit and loss statement. Hedging specific components of non-financial items The current AS 30 rules prevent entities hedging specific components of nonfinancial items. An example is where a metal company manufactures and sells aluminium cans from the aluminium sheets. It intends to use aluminium futures to hedge its exposure to changes in the aluminium can inventory in a fair value hedging relationship. Although, the aluminium metal is a key component of the final product, it is not considered as an acceptable hedged item because, under the existing rules, an entity can hedge either the full price of the product itself or the foreign currency risk. As discussed above, risk components of non-financial items, even when they are contractually specified, are not eligible risk components in accordance with AS 30. Consequently, other than for foreign currency risk, a non-financial item was required to be designated as the hedged item for all risks. The rationale for including this restriction in AS 30 was that permitting risk components (portions) of non-financial assets and non-financial liabilities to be designated as the hedged item for a risk other than foreign currency risk would compromise both the principles of identification of the hedged item and effectiveness testing because the portion could be designated so that no ineffectiveness would ever arise. The hedge accounting model in AS 30 used the entire item as the default unit of account and then provided rules to govern what risk components of that entire item were available for separate designation in hedging relationships. This has resulted in the hedge accounting requirements being misaligned with many risk management strategies, and the outcome is that the normal approach for risk management purposes is treated as the exception by the hedge accounting requirements. © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
  12. 12. 10 Hedging group of hedged items AS 30 restricts the application of hedge accounting for groups of items. For example, hedged items that together constitute an overall net position of assets and liabilities can not be designated into a hedging relationship with that net position as the hedged item. Other groups are eligible to be designated as being hedged if the individual items within that group have similar risk characteristics and share the risk exposure. Furthermore, the change in the fair value attributable to the hedged risk for each individual item in the group has to be approximately proportional to the overall change in the fair value of the group for the hedged risk. The effect of those restrictions is that a group would generally qualify as a hedged item only if all the items in that group would qualify for hedge accounting for the same hedged risk on an individual basis (i.e., each item is an individual hedged item). The restrictions in AS 30 prevent an entity that hedges on a group or net basis from presenting its activities in a manner that is consistent with its risk management practice. For example, an entity may hedge the net (i.e., residual) foreign currency risk from a sequence of sales and expenses that arise over several reporting periods (say, two years) using a single foreign currency derivative. Such an entity can not designate the net position of sales and expenses as the hedged item. Instead, if it wants to apply hedge accounting, it has to designate a gross position that best matches its hedging instrument. Discontinuation of hedging accounting In accordance with AS 30, an entity has to discontinue hedge accounting when the hedging relationship ceases to meet the qualifying criteria (including when the hedging instrument no longer existed or is sold). However, in accordance with AS 30, an entity also has a free choice to voluntarily discontinue hedge accounting by simply revoking the designation of the hedging relationship (i.e., irrespective of any reason). This voluntary choice of de-designation is an area of hedge accounting that has been subjected to some degree of misuse. For example, entities revoke the designation of a hedging relationship and re-designate it as a new hedging relationship in order to apply a different method of assessing hedge ineffectiveness from the method originally documented (expecting that the new method would be a better fit). Another area of big concern of the current hedge accounting rules is that sometimes a hedging relationship was discontinued because of a decrease in the hedged quantities of forecast transactions (i.e., the volume that remains highly probable of occurring falls or is expected to fall below the volume designated as the hedged item). Under AS 30, this results in discontinuation of hedge accounting for the hedging relationship as designated, i.e., the volume designated as the hedged item in its entirety. Complex calculations and measurements requiring the need for sophisticated IT systems and processes As discussed above, applying hedge accounting would mean that the company would not only need to deal with the accounting part, but also the effectiveness testing and measurement of ineffectiveness through statistical techniques. Depending on the size of the hedging programme and the types of hedging instruments that an entity trades in, it can be challenging to deal with the computations and measurements through simple spreadsheets. The companies may necessarily need to invest in sophisticated IT solutions for implementing hedge accounting and the cost of the IT systems and processes may need to be factored in the eventual cost benefit analysis. The above limitations and complexity in AS 30 or IAS 39 and resulting inability of users to understand the true risk management objectives of an organisation led preparers and users of financial statements globally to ask the International Accounting Standard Board (IASB) to develop a model that instead of reporting the results of an accounting-centric exercise, would report the performance of an entity’s hedging activities in the financial statements on a basis that is consistent with the entity’s risk management activities. Accordingly, in November 2013, the IASB released the revised rules on hedge accounting through a new chapter on general hedge accounting under IFRS 9, Financial Instruments. The revised principles of hedge accounting under IFRS 9 are expected to address many of the issues highlighted above. © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
  13. 13. 11 This article aims to: • summarise the requirements of the IASB’s revised hedge accounting model • discuss its application in India New hedge accounting rules under IFRS 9 The revised hedge accounting model introduced in IFRS 9, Financial Instruments in November 2013 represents a significant change from the current practice and many of the issues and challenges faced by the preparers while applying hedge accounting under AS 30/IAS 39 (Financial Instruments: Recognition and Measurement), discussed in the previous article have been addressed by the recently announced hedge accounting rules. The new hedge accounting requirements in IFRS 9 seek to deliver a principles-based standard that aligns hedge accounting more closely with risk management resulting in useful information to the users of the financial statements. Net positions and layer components may be hedged items If the components that make up the aggregated exposure are already designated in a hedging relationship, then an entity will account for the second hedging relationship without having to terminate and restart the initial hedging relationship. The new standard does not fundamentally change the types of hedging relationships or the requirement to measure and recognise ineffectiveness; however, under the new standard more hedging strategies that are used for risk management will qualify for hedge accounting. New potential hedging strategies Risk components of non-financial items and non-contractually specified inflation may be hedged items Separately identifiable and reliably measurable components, of both financial and non-financial items, may be hedged items. This single change is a significant change, and a relaxation of accounting rules for a number of companies that hedge commodity price risks and for whom the current (IAS 39 or AS 30) model of hedge accounting was difficult and challenging to apply. A non-contractually specified inflation component may qualify as a hedged item; however, the standard contains a ‘rebuttable presumption’ that unless inflation is contractually specified, it is not separately identifiable and reliably measurable. A group of items – including a group of items that constitute a net position – may be a hedged item only if: • it consists of items that are eligible hedged items • the items in the group are managed together on a group basis for risk management purposes • in the case of a cash flow hedge of items with offsetting risk positions, it is a hedge of foreign currency risk and the designation specifies certain details about the forecast transactions. An aggregated exposure may be a hedged item An aggregated exposure (a combination of a derivative and a non-derivative exposure) that is managed together for risk management purposes may be designated as the hedged item in a hedging relationship. Equity investments at FVOCI may be hedged items An entity may, at initial recognition, make an irrevocable election to present subsequent changes in the fair value of some investments in equity instruments in other comprehensive income (OCI). Under the new standard, an entity may hedge the foreign exchange risk exposure or equity price risk exposure of equity investments at fair value through OCI (FVOCI), with any hedge ineffectiveness recognised in OCI. Hedge effectiveness IFRS 9 does not specify a method for assessing whether a hedging relationship meets the hedge effectiveness requirements. However, an entity © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
  14. 14. 12 shall use a method that captures the relevant characteristics of the hedging relationship including the sources of hedge ineffectiveness. Depending on those factors, the method can be qualitative or quantitative. Accordingly, more judgement will be required to assess the effectiveness of a hedging relationship under the new standard. Frequency of assessing whether the hedge effectiveness requirements are met An entity shall assess at the inception of the hedging relationship, and on an ongoing basis, whether a hedging relationship meets the hedge effectiveness requirements. At a minimum, an entity shall perform the ongoing assessment at each reporting date or upon a significant change in the circumstances affecting the hedge effectiveness requirements, whichever comes first. Termination of hedging relationship An entity will not be allowed to voluntarily terminate a hedging relationship that continues to meet its risk management objective and all other qualifying criteria. An entity may be required to rebalance hedging relationships that are not behaving in the expected manner, by adjusting the quantities of the hedged item or the hedging instrument, to maintain a hedge ratio that complies with the hedge effectiveness requirements. Documentation The new model also enables an entity to use information produced internally for risk management purposes as a basis for hedge accounting. Currently it is necessary to exhibit eligibility and compliance with the requirements in IAS 39 using metrics that are designed solely for accounting purposes. The new model also includes eligibility criteria but these are based on an economic assessment of the strength of the hedging relationship. This can be determined using risk management data and should reduce the costs of implementation compared with those for IAS 39 hedge accounting because it reduces the amount of analysis that is required to be undertaken only for accounting purposes. Effective date and transition The mandatory effective date of 1 January 2015 has been deferred and is expected to be notified when the final version of IFRS 9 which will include all the phases: Classification and Measurement, Impairment and Hedge Accounting. In the interim, IFRS 9 continues to be available if entities choose to early apply it. Entities may apply: • only the portion of IFRS 9 that deals with the treatment of measurement of own credit risk • apply all the other parts of IFRS 9 that have been issued till date • apply all the parts of IFRS 9 except the hedge accounting section. The entities can continue to apply the guidance under IAS 39 (till the finalisation of the macro hedge accounting proposals that the IASB is currently considering). Application in India An important question is whether companies in India that have opted for hedge accounting principles under AS 30 will have a choice to adopt the revised general hedge accounting guidance under IFRS 9. Given that the principles under AS 30 had originated from IAS 39 and given the ‘non mandatory and non recommendatory’ status of AS 30 in India, it may be possible for Indian companies to adopt the revised principles prospectively. This area could be of interest to a number of companies especially ones that have large hedging programmes and would be a topic worthy of discussion and debate in the weeks to come. © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
  15. 15. 13 This article aims to: • discusses the key provisions of the U.K. Bribery Act, 2010 • highlight its impact on business operated by a multinational in India or elsewhere except the U.K. The U.K. Bribery Act, 2010 Regulators across the globe are attempting to re-orient ethical and competitive business practices with newer and stringent anti corruption regulations. Many countries have implemented the programme of Organisation for Economic Cooperation and Development’s (OECD) Convention on Combating Bribery of Foreign Public Officials. The absence of a specific law in the U.K. made it difficult to evaluate how effectively the system works. In order to deal effectively with bribery of all kinds and to provide the basis for a modern, clear and consolidated law that complements and supported the U.K.’s international efforts and equips the U.K. courts and prosecutors to deal with it, wherever it occurs, the U.K. Bribery Act 2010 (the Act) came into effect. The Act which came into force on 1 July 2011 is a stringent law that has significantly changed British law on bribery. In addition to the Act, the Ministry of Justice in the U.K. has issued guidance about procedures which relevant commercial organisations can put into place to prevent persons associated with them from bribing. While one would, prima facie, think that the U.K. Act would not have any impact on how the business is operated by a multinational in India or elsewhere except the U.K., but the Act is not as benign as it sounds. It has extra-territorial jurisdiction which makes it imperative for the multinationals to appreciate the provisions/requirements of the Act so as to not invite any penal consequences under the Act. Coupled with the fact that there is no gentle run-up to the implementation of the regime for corporate entering business in U.K., ignoring the Act, could be a a recipe for greater inconveniences/penalties. Offences relating to bribery The Act treats bribery as a criminal offence and covers bribing another, being bribed, bribing a foreign official, and, for commercial organisations, failing to prevent bribery. Some of the salient features of the Act that makes it stringent and unique include: • The Act covers commercial bribery, bribery of public officials and prohibits facilitation payments • Receipt and payment of a bribe will be considered illegal and both parties can be prosecuted • Corporate offence of ‘failing to prevent bribery’. The onus will be on the company to prove that it had undertaken ‘adequate measures/procedures’ to prevent such non compliance • Permitting the U.K. authorities to prosecute British nationals, companies and residents regardless of the place(s) of offense • Severe penalties including unlimited fines for companies and imprisonment up to 10 years for individuals. The Act empowers the U.K. courts to have jurisdiction over the offences committed within and outside U.K., where the person committing them has a ‘close connection’ with U.K. which includes being a British national or an ordinarily resident in the U.K., a body incorporated in the U.K. or a Scottish partnership. However, the requirement of a close connection does not apply to commercial organisations failing to prevent bribery (Section 7) under the Act. Where the organisation is incorporated or formed in the U.K., where the organisation carries on a business or part of a business in the U.K. (irrespective of place of incorporation or formation), U.K. courts will have jurisdiction. © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
  16. 16. 14 Having said that, it is not expected, for example, the mere fact that a company’s securities have been admitted to the U.K. Listing Authority’s Official List and therefore, admitted to trading on the London Stock Exchange, in itself, to qualify that company is carrying on a business or part of a business in the U.K. and therefore, falling within the definition of a ‘relevant commercial organisation’ for the purposes of section 7 Likewise, . having a U.K. subsidiary will not, in itself, mean that a parent company is carrying on a business in the U.K., since a subsidiary may act independently of its parent or other group companies. Adequate procedures The Act states that a relevant commercial organisation is guilty of offence under the Act if a person associated with the organisation bribes another person intending to obtain or retain business for organisation/to obtain or retain an advantage in the conduct of business of the organisation. However, it is a defense for the organisation to prove that it had in place ‘adequate procedures’ designed to prevent persons associated with the organisation from undertaking such conduct. The Guidance suggests that the procedures put in place by commercial organisations wishing to prevent bribery being committed on their behalf should be informed by six principles. These principles are not prescriptive. They are intended to be flexible and outcome focused, allowing for the huge variety of circumstances that commercial organisations find themselves in. The six principles1 suggested by the guidance are as under: 1. Proportionate procedures: A commercial organisation’s procedures to prevent bribery by persons associated with it are proportionate to the bribery risks it faces and to the nature, scale and complexity of the commercial organisation’s activities. They are also clear, practical, accessible, effectively implemented and enforced. 2. Top-level commitment: The toplevel management of a commercial organisation (be it a board of directors, the owners or any other equivalent body or person) are committed to preventing bribery by persons associated with it. They foster a culture within the organisation in which bribery is never acceptable. 3. Risk assessment: The commercial organisation assesses the nature and extent of its exposure to potential external and internal risks of bribery on its behalf by persons associated with it. The assessment is periodic, informed and documented. 4. Due diligence: The commercial organisation applies due diligence procedures, taking a proportionate and risk based approach, in respect of persons who perform or will perform services for or on behalf of the organisation, in order to mitigate identified bribery risks. 5. Communication (including training): The commercial organisation seeks to ensure that its bribery prevention policies and procedures are embedded and understood throughout the organisation through internal and external communication, including training that is proportionate to the risks it faces. 6. Monitoring and review: The commercial organisation monitors and reviews procedures designed to prevent bribery by persons associated with it and makes improvements, where necessary. Once the prosecution has charged that a bribe was paid or offered for the benefit of the company, the onus will lie with the company to demonstrate ‘adequate procedures’. This makes it far easier to obtain convictions as the test of ‘proof beyond reasonable doubt’ is replaced by an assessment of guilt ‘on the balance of probabilities’ 1. U.K.’s Ministry of Justice The Bribery Act 2010 Guidance © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
  17. 17. 15 What the Act means to the business The intention and ability of Indian companies to expand globally has led to a significant increase in the number of cross-border transactions and foreign investments. The implications of the extra-territorial reach of foreign anticorruption legislations in such scenarios are significant and must be given due consideration, so that adequate compliance measures are implemented. The U.K.’s Bribery Act 2010 is being hailed as one of the ‘toughest anti-corruption laws’ in the world. In the U.S.A., the Foreign Corrupt Practices Act (FCPA) 1977 (as amended in 1988) deals with anticorruption. Both these legislations have a broad reach extending to companies and persons outside the territorial jurisdictions of their respective countries, and have significant implications for Indian companies. Indian corporates which that have already adopted FCPA-compliance programmes and best practices, would have to relook at those procedures to comply with those compliances under the U.K. Bribery Act, 2010. The Prevention of Corruption Act, 1988 (PCA) of India provides a framework for enforcing penalties against bribery. However, the PCA has not been updated ever since. Facilitation payments Increased business complexity and globalisation has required corporates to enter and operate in newer geographies. This has resulted in numerous challenges that deal primarily with the nature of the business culture and practices adopted within that geography. Often, businesses and investors across the globe are skeptical about adopting or not adopting certain practices, which may make them non-compliant with certain global laws or possibly reduce their competitive ability in such geographies. ‘Facilitation payments’ has been one such topic of much discussion in the recent years. The Act adopts a ‘Zero Tolerance’ approach and provides no specific defense for facilitation payments. Anti-bribery and Corruption (AB&C) policies 2. KPMG Publication – Doing business under the UK Bribery Act – Survey 2012 The existence of AB&C policies is imperative. The starting point for a strong AB&C framework is a policy statement that provides guidance to the organisation and its stakeholders. Areas which may not have been clearly defined by the law such as gifts and hospitality, definitely pose a challenge for organisations. ‘Better practices’ for compliance are still evolving and businesses are attempting to adopt such practices2. Adequate heed needs to be given to not just the depth and breadth of the policies but also the sufficiency of the communication and training to the stakeholders. Dealing with third parties Risk resulting from relationships with third parties and their conduct can be significant and difficult to control. The Act specifically defines ‘associated’ persons and indicates that a commercial organisation is liable under the Act if a person ‘associated’ with it, bribes another person, intending to obtain/retain business or a business advantage for the organisation. The definition of ‘associated’ person is wide enough to include contractors, business partners, suppliers of services, joint ventures partners, associates and agents. With the expanse of the law having introduced the ‘relevant commercial organisation’ which could mean as covering entities located, organised or conducting ‘all or part of their business’ in the U.K. as well as Indian companies with operations in the U.K., one needs to monitor their own business as well as subsidiaries/third parties that act on their behalf. Businesses are exposed to a greater risk due to the limited ability to influence the acts and business practices of the third parties. It is pertinent to note that adequate due diligence on third parties is one of the key principles of the ‘adequate procedures’. Risk assessment In order to implement a fool proof AB&C compliance programme, risk assessments play an important role. They identify timely, in-depth, specific and actionable information regarding the level of AB&C compliance risk across the organisation which allows management to design and tailor its AB&C program in alignment with the organisation’s risk management strategies. © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
  18. 18. 16 Dealing with the provision of the Act3 Following the advent of the Act, multinational companies have taken note of the Act seriously. Most of the companies have appointed legal advisors in the U.K. and have already included the necessary components and processes in their risk and compliance structures. Many companies have also adopted a Zero Tolerance attitude to corruption where business deals are not considered if there is any aspect of bribery or corruption involved. Measures for implementing the guidance could inlcude restricting cash transactions to a nominal amount, which discourages the payment of bribes as the transactions above the nominal amount are on record. However, numerous difficulties exist in complying with the Act, particularly, in terms of the need to be aware of the actions of the company, its employees and business associates. Organisations need to adopt an integrated and holistic process that encourages stringent compliance and enforcement so as to detect and prevent bribery and corruption. The approach could, thus, broadly cover the following: • Having written AB&C policies and procedures (including distribution of the same to agents, distributors, vendors, brokers, joint venture partners, and or suppliers) in place • Drawing up a comprehensive code of conduct across all group companies, which is continually monitored and revised that communicates the organisation’s ‘Zero Tolerance’ towards corruption • A structured whistle blowing mechanism (i.e., compliance or ombudsman hotline) to report potential bribery/corruption issues • Regular communication and training programmes (extending the participation beyond only employees, etc. to include third party representatives) • Relook at the contracts with third parties and exercise of the ‘right to audit clauses’ • Periodic compliance certifications from agents, distributors, vendors, brokers, joint venture partners, or suppliers. • A comprehensive and periodic risk assessment mechanism alongside a concurrent monitoring mechanism (and internal audit protocols), including third party audits with specific reference to corruption related risks 3. KPMG’s publication - Doing business under the UK Bribery Act – Survey 2012 © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
  19. 19. 17 This article aims to: • highlight challenges faced in application of the requirements of the standard especially in complex structure of companies Identification of related parties In recent times, there has been a considerable increase in the number of business combinations and acquisitions of interests by one entity in another. Such combinations give rise to complexities in identifying and tracking transactions of the related parties. The objective of the related party disclosures in the financial statements of an entity is to draw attention to the possibility that its financial position and profit or loss statement may have been affected by the existence of related parties and by transactions with such parties. Under Indian GAAP, related party disclosures in financial statements are governed by AS 18, Related Party Disclosures (the standard). In this article, we aim to highlight challenges faced while applying the requirements of the standard especially in a complex structure of companies. Challenges in identification of related parties Identification of related party transactions are complex where • arrangements where control or significant influence may not be apparent from the group structure and which are highlighted through detailed shareholders’ agreements or • arrangements where the group structure involves multiple chain of holdings are situations which make identification of related parties more complex. In this article, such structures are explained with examples. Example 1 – Relationships not apparent from group structure One of the key related party relationship is where an individual or an entity is able to control another entity. Sometimes owing to complex group structures, the control evaluation may be cumbersome. For example, cases where a private equity investor holds only the preference share capital of the company but has such participative rights that give it control/joint control over the entity. the investee are indicative of participative rights. While examples of protective rights are amendments to an entity’s constitution, the pricing of related party transactions, the liquidation of the entity or launching bankruptcy proceedings and share issues or repurchases. Protective rights would not in isolation overcome a presumption of control by the majority holder of voting power. Participative rights include right to appoint and remove governing body members, including setting their remuneration and making operating and capital decisions, including approving budgets, in the ordinary course of operations, etc. Similarly, the ability of the minority shareholders to liquidate the entity and any ‘kick-out rights’ that could force the majority shareholder to sell its interest in We should look at this aspect closely as this requires judgement in evaluating rights of the shareholders whether they are participative or protective. Therefore, before embarking on identification of related parties, first step in the analysis is to identify the party/ies that control or has significant influence over an entity. © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
  20. 20. 18 Example 2 – Involvement of multiple entities in shareholding on an entity In a multiple chain of shareholding, it becomes complex and difficult to identify related party relationship. To illustrate let us take the following example: In the above structure, there are multiple entities that are related to each other. In this example, X Ltd. is the reporting entity and as per AS 18 X Ltd. should identify its related parties. In order to simplify the example, we have assumed that there is no separate agreement between the shareholders and there are no key management persons. A Ltd. and X Ltd.: A Ltd. holds 45 per cent shareholding in X Ltd. Thus, by virtue of its shareholding, A Ltd. exerts significant influence over X Ltd. Thus, as per para 3(b) of AS 18, A Ltd. and X Ltd. are related parties. V Ltd. and X Ltd.: V Ltd. holds interest in X Ltd. indirectly through A Ltd. A Ltd. is an associate of V Ltd. As per the guidance on AS 18, significant influence may be gained directly or indirectly through intermediaries. Intermediaries have been defined as subsidiary enterprises. Thus, an associate of an associate can not be regarded as a related party. Thus, V Ltd. and X Ltd. are not related parties. C Ltd. and X Ltd.: C Ltd. holds interest in X Ltd. indirectly through A Ltd. A Ltd. is an associate of C Ltd. As per the guidance on AS 18, significant influence may be gained directly or indirectly through intermediaries. Intermediaries have been defined as subsidiary enterprises. Thus, an associate of an associate can not be regarded as a related party. Thus, C Ltd. and X Ltd. are not related parties. S Ltd. and X Ltd.: S Ltd. holds interest in X Ltd. indirectly through A Ltd. S Ltd. holds only 5.31 per cent in A Ltd. and thus by virtue of its shareholding is not a related party of A Ltd. and also X Ltd. K Ltd. and X Ltd.: K Ltd. holds interest in X Ltd. through S Ltd. and A Ltd. S Ltd. seems to be a joint venture of K Ltd. However, since S Ltd. is not related to X Ltd. so K Ltd. does not become related to X Ltd. Q Ltd. and X Ltd.: Q Ltd. holds interests indirectly in X Ltd., but the indirect interests are through associates. This is so because although Q Ltd. controls V Ltd. and C Ltd., but since V Ltd. and C Ltd. are able to exert only significant influence over A Ltd. Therefore, Q Ltd. has significant influence over A Ltd. A Ltd. has significant influence over X Ltd. Thus, from the above structure A Ltd. is an associate of Q Ltd. and X Ltd. is an associate of A Ltd. Since the indirect holding should be through intermediaries which is defined as subsidiaries, X Ltd. and Q Ltd. are not related parties. Thus, in a complex structure involving multiple entities that hold shareholding in a reporting entity, care should be exercised to establish related party relationships. It may initially seem that the parties are related, but a detailed understanding of shareholding pattern may lead to a different conclusion. Following is the summary of the related party relationships between entities in the above example: Whether related party Relationship between Nature of relationship A Ltd. and X Ltd. Associate with 45 per cent shareholding Yes C Ltd. and X Ltd. Associate of an associate No V Ltd. and X Ltd. Associate of an associate No S Ltd. and X Ltd. Does not control nor does it have significant influence No K Ltd. and X Ltd. Does not control nor does it have significant influence No Q Ltd. and X Ltd. Does not control nor does it have significant influence No © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
  21. 21. 19 Example 3 – Whether only material related party transactions need to be disclosed: It is the nature of related party relationships and transactions with such parties rather than merely the size of related party transactions that determines the materiality of related party disclosures. For example, in case of transactions with key management personnel, materiality considerations can not be used to override the explicit requirements for the disclosure of remuneration and borrowings to key management personnel as required by the standard. The nature of the key management personnel compensation is likely to be qualitatively material. Example 4 – Other challenges Entities would need to exercise judgement and understand facts and circumstances of the related party transactions in order to provide disclosures under AS 18. Following are some of the examples of related party transactions which may pose challenges to identify existence and disclosure of such transactions. • Non-recognition of revenue since the contract not finalised: It may be possible that the subsidiary provides certain services/sells goods to the holding entity. However, since the contract is not finalised, subsidiary may not have recognised revenue due to uncertainty of prices or the final arrangement. Explanation about these transactions must also be highlighted as related party transactions. Further, agreements for the provision of services to certain parties under terms and conditions that are prejudicial to the entity may indicate existence of related party relationship and thus, need disclosure in the financial statements. Companies Act, 2013 (the Act) mandates every listed company and every other company with paid-up share capital of INR 50 million or more to appoint a whole time Chief Financial Officer (CFO) through a Board resolution. The Act further specifies that such a CFO would be a KMP and a ‘related party’ of the company. • Cost of services rendered/received free of cost, for example, rent free premises – This may be the case where the subsidiary is operating in premises of the holding entity for which no rent is charged by the holding entity and there is no lease agreement between the companies. Thus, this transaction needs to be disclosed both in the books of the holding entity and subsidiary entity. In order to comply with the related party disclosure requirements, it is important to obtain a clear understanding of the group structure. Additionally, it is important to have a clear understanding about the legislative requirements. For example, the © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
  22. 22. 20 The related party relationships covered by the standard [para 3 (a) to (e)] are as following: a. enterprises that directly, or indirectly through one or more intermediaries, control, or are controlled by, or are under common control with, the reporting enterprise (this includes holding companies, subsidiaries and fellow subsidiaries) b. associates and joint ventures of the reporting enterprise and the investing party or venturer in respect of which the reporting enterprise is an associate or a joint venture c. individuals owning, directly or indirectly, an interest in the voting power of the reporting enterprise that gives them control or significant influence over the enterprise, and relatives of any such individual d. key management personnel and relatives of such personnel e. enterprises over which any person described in (c) or (d) is able to exercise significant influence. This includes enterprises owned by directors or major shareholders of the reporting enterprise and enterprises that have a member of key management in common with the reporting enterprise. AS 18 states that an intermediary means a subsidiary as defined in AS 21, Consolidated Financial Statements. AS 21 defines a subsidiary as an enterprise that is controlled by another enterprise (known as the parent). Control is defined as per AS 21, Consolidated Financial Statements, as under: a. the ownership, directly or indirectly through subsidiary(ies), of more than one half of the voting power of an enterprise b. control of the composition of the board of directors in the case of a company or of the composition of the corresponding governing body in case of any other enterprise so as to obtain economic benefits from its activities. Similarly, associates and joint ventures are defined by AS 23, Accounting for Investments in Associates in Consolidated Financial Statements and AS 27 Financial Reporting of Interests in , Joint Ventures, respectively as under: AS 23 defines an associate as “an enterprise in which the investor has significant influence and which is neither a subsidiary nor a joint venture of the investor” It further defines Significant influence as “the power to participate in the financial and/ or operating policy decisions of the investee but not control over those policies” AS 27 defines Joint control as the , contractually agreed sharing of control over an economic activity. © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
  23. 23. 21 This article aims to: • highlight the wider responsibility of directors and management placed by the new Act • explain our observations regarding these changes Enhanced responsibility for directors The level of change and the complexities associated with implementing the changes introduced by the Companies Act, 2013 (2013 Act) are likely to be significant and pervasive for many companies. The effects of these changes would be felt notably by Directors, Audit Committee and Key Managerial Personnel. Mandatory director appointment Appointment of directors • In keeping with the theme of raising the bar on governance, the 2013 Act increases the maximum number of directors from 12 at present to 15. Further, the Central Government’s approval is not required for enhancement of this limit of 15; the maximum number can be increased by a special resolution. This could help companies in engaging directors with varied skill sets thereby, improving the quality of oversight on the affairs of the company. • All companies are required to have at least one director who is an Indian resident i.e., having spent at least 182 days in India. This requirement might pose some challenges for foreign companies who have limited operations in the country but who have to comply with the requirements of the new Act because of the wider definition of foreign companies. • All listed companies and unlisted public companies with a share capital of INR 1 billion or more or turnover of INR 3 billion or more are required to have at least 1 woman director, thus paving way for gender diversity in the governing body of companies. The draft Rules provide a transition period of 1 to 3 years to companies for appointing women directors. • Public companies with share capital of INR 1 billion or more, turnover of INR 3 billion or more, or with loans/ debentures/deposits of more than INR 2 billion are required to have at least one-third of the Board of Directors as Independent Directors. This requirement will impact unlisted public companies but is unlikely to impact listed companies because of the pre-existing requirements to appoint independent directors under the listing requirements issued by SEBI. • The 2013 Act requires Independent Directors to be persons who possess relevant expertise and experience and the Directors or their relatives should have no pecuniary relationship with the company, its holding, subsidiary or associate company, or their promoters, or directors, during the two immediately preceding financial years or during the current financial year. • No person is permitted to act as a director or alternate director in more than 20 companies at the same time and of which the maximum number of public companies in which a person can be appointed as a director is 10. • The Directors intending to be appointed as Independent Directors should also not have been an employee, proprietor, a partner of the firm of auditors, company secretaries, cost auditors, consultants or legal advisors, in any of the three financial years immediately proceeding the financial year in which the director is proposed to be appointed. © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
  24. 24. 22 Reporting on internal financial controls For the first time, the 2013 Act requires directors of the listed companies to provide assurance on adequacy and effectiveness of internal financial controls. The term internal financial control is defined in the 2013 Act to mean inter alia orderly and efficient conduct of business, and prevention and detection of frauds and errors. This is an onerous requirement. In order to provide assurance on internal financial controls, companies will have to document and test controls every year. The directors would then have to rely on the management’s evaluation of adequacy and operating effectiveness of such control. The term internal financial control as defined in the 2013 Act is wider in coverage even when compared to the requirements of the Sarbanes Oxley Act which includes internal control over financial reporting. We expect that the regulators and rule makers will provide additional guidance to companies on how these internal financial controls are required to be tested in order to provide this level of assurance. Duties of directors The 2013 Act lays down specific and inclusive duties of directors: • acting in good faith in order to promote the objects of the company for the benefit of its members as a whole, and in the best interests of the company, the shareholders and other stakeholders • exercising duties with due and reasonable care, skill and diligence and exercising independent judgement • not being involved in a situation in which there may be a direct or indirect interest that conflicts, or possibly may conflict, with the interest of the company • not achieving or attempting to achieve any undue gain or advantage either to himself or to his relatives, partners, or associates. In addition to enunciation of best practices, the Act also enables easier prosecution of delinquent directors. Additional responsibility on independent directors The 2013 Act clarifies that the independent directors are liable only for acts or omissions which occurred with their knowledge, attributable through the Board processes, and with their consent, connivance or when they had not acted diligently. Independent directors are not entitled to any remuneration, other than sitting fee, reimbursement of expenses and any profit related commission as approved by the members. Stock options are specifically prohibited. Code for independent directors Schedule IV of the Companies Act, 2013 includes a code for independent directors that lays down specific guidelines for professional conduct, roles and functions, duties, manner of appointment/ reappointment/resignation and an evaluation mechanism. Independent directors will need to conduct at least one meeting in a year of all independent directors without the attendance of non-independent directors and members of management to review performance of non-independent directors, chairperson of the company and also assess the quality, quantity and timeliness of flow of information between the company management and the Board that is necessary for the Board to effectively and reasonably perform their duties. The independent directors have been entrusted with an important task to evaluate the performance of the Board of Directors. Conversely, the performance evaluation of independent directors shall be done by the entire Board of Directors, excluding the director being evaluated. Mandatory independent director rotation The Act also contains restrictions on reappointment of independent directors. Tenure of independent directors is limited to maximum of two consecutive tenures of five consecutive years with a cooling off period of three years thereafter. During the cooling-off period, such a person can not be inducted in any capacity in the company either directly or indirectly. For this purpose, tenure shall be computed prospectively from the commencement of the 2013 Act. © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
  25. 25. 23 Audit committee All listed companies and public companies with paid-up capital of INR 1 billion or more, debt /debentures/deposits more than INR 2 billion are required to constitute an Audit Committee of minimum three directors, with independent directors in majority. The role of the committee has sharpened with specific responsibilities including recommending appointment of auditors and monitoring their independence and performance, approval of related party transactions, scrutiny of inter-corporate loans and investments, valuation of undertaking/assets, etc. The audit committee is contemplated as a major vehicle for ensuring controls, sound financial reporting and overall good corporate governance. There appears to be an increased focus on the audit committee especially to protect the interests of other stakeholders by bringing into the committee’s purview, a requirement to review/ approve transactions with related parties and enhanced financial reporting requirements. Remuneration of directors No change in overall/individual limits on managerial remuneration in public companies. Maximum limit of managerial remuneration retained at 11 per cent (of net profits). Accountability of directors for CSR compliance As per Section 135 of the 2013 Act, companies with a specified net worth, turnover or net profit are required to mandatorily spend two per cent of its average net profit towards specified CSR activities. Every qualifying company needs to constitute a CSR committee of the Board consisting of three or more directors. Though the CSR provisions under the 2013 Act required minimum 3 directors for constitution of CSR committee, the issue that needs to be clarified is whether qualifying private companies (which requires minimum two directors only) would be required to appoint one more independent director only to constitute CSR committee and comply with the CSR provisions. © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
  26. 26. 24 This article aims to: • summarise the EAC opinion regarding ‘Amortisation of Land Right of Way’ • highlight the varied practices followed by the companies Treatment of ‘right of way’ assets Companies engaged in refining of crude oil and marketing of petroleum products acquire right to use land not owned by them for the purpose of laying down underground pipelines for movement of petroleum products from one location to another. Though the land on which the pipelines would be laid down does not belong to the company, the company normally acquires ‘right of way’ i.e., right of use in land (ROU) under which such pipeline is to be laid. The right is acquired under the Petroleum and Mineral Pipelines (Acquisition of Right of User in Land) Act, 1962. Such rights vest with the company free from all encumbrances. The company acquires perpetual and absolute right to access the land under which pipeline has been laid for the purpose of maintaining, examining, repairing, altering or removing any such pipeline or for doing any other acts necessary for any of the aforesaid purposes or for the utilisation of such pipeline. The land owner can not construct any permanent structure or plant any tree having deep roots on the specified piece of land, though crops can be raised on such land. Such rights to use are capitalised by various companies as intangible assets. AS 26, Intangible Assets states that the depreciable amount of an intangible asset should be allocated on a systematic basis over the best estimate of its useful life. It further states that the useful life of an intangible asset may be very long but it is always finite. Uncertainty justifies estimating the useful life of an intangible asset on a prudent basis, but it does not justify choosing a life that is unrealistically short. Expert Advisory Committee Opinion In September 2013, the Expert Advisory Committee (‘EAC’ or ‘the Committee’) of the Institute of Chartered Accountants of India (ICAI) issued an opinion on ‘Amortisation of Land Right of Way’. This opinion, considering the specific facts and circumstances of a company, took the view that paragraph 68 of AS 26 specifically envisages that the useful life of an intangible asset is always finite, howsoever long and indefinite it may be. AS 26 does not justify non amortisation; it only requires disclosures where the useful life is considered more than 10 years. It stipulates that the life has to be determined on a prudent and rational basis. The Committee opined that the useful life of the land right of way may be determined considering various technical, legal and economic factors, such as, useful life of petroleum reserves from which the petroleum products are being produced and then transported, technological changes in the transportation modes, alternative resources of energy, etc. Further, the Committee also opined that the useful life of the land right of way may be indefinite but it is not infinite and, accordingly, the depreciable amount should be allocated on a systematic basis over the best estimate of its useful life. The practice of not amortising the land right of way is not correct. If the useful life of an intangible asset is determined to exceed more than 10 years, the company should provide reasons for such presumption. Industry practice It is worthwhile to note that the above EAC opinion is based on the specific facts and circumstances of a company and may not be applicable for all the companies having such rights, where the facts may be different. However, it appears that there are varied practices being followed by the companies. Certain companies treat such right of way as perpetual in nature and do not amortise it. However, other companies treat it as an intangible asset with a defined useful life and amortise it over its useful life. © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
  27. 27. 25 Regulatory updates Extension of time line for alignment of existing employee benefit schemes with SEBI (ESOS and ESPS) Guidelines, 1999 The SEBI (ESOS and ESPS) Guidelines, 1999 were amended in January 2013, to prohibit listed companies from setting up any Employee Stock Option Scheme (ESOS) or Employee Stock Purchase Scheme (ESPS) which involves acquisition of shares from secondary market. Accordingly, the companies that had schemes which allowed acquisition of own securities from secondary market were required to align such schemes as per the amended guidelines by 30 June 2013 which was later extended up to 31 December 2013. However, on 20 November 2013, the SEBI issued a discussion paper to review the guidelines governing employee benefit schemes. According to the discussion paper, companies may be allowed to purchase its shares from the secondary market subject to shareholder’s approval. Considering review of proposals enunciated by the discussion paper, the SEBI has further extended the timeline for alignment of existing employee benefit schemes with the SEBI (ESOS and ESPS) Guidelines, 1999 up to 30 June 2014. The discussion paper, inter-alia, considers factors such as: • Minimum holding period for such bought back shares to ensure it is for long term and for the benefit of employees • Sale of shares by trust • Administration of schemes set up by the trust like appointment of independent trustee • Classification of such shares as promoter shareholding • Disclosure requirements, etc. • Ceiling on the number of shares that can be bought back • Limit on funding provided by the company to the trust for such proposed secondary market acquisition Source: CIR/CFD/POLICYCELL/14/2013 dated 29 November 2013; PR No. 109/2013 dated 20 November 2013 Illustrative format of Statement of Assets and Liabilities in offer document revised The SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009 (regulations), require an issuer to disclose its statement of assets and liabilities in the offer document. An illustrative format of statement of assets and liabilities was included in the said regulations which was based on pre-revised format of Schedule VI of the Companies Act, 1956. The SEBI has revised the illustrative format of the statement of assets and liabilities to bring it in line with the revised schedule VI of the Companies Act, 1956 and which is also in line with schedule III of the Companies Act, 2013. The revised format is applicable for draft/ final offer documents filed with the SEBI on or after 3 December 2013. Source CIR/CFD/DIL/15/2013 dated 3 December 2013 © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.