Accounting for rate-regulated activities

In February 2012, the Institute of Chartered Accountants of India issued a new Guidance Note on Accounting for rate-regulated activities which deals with the accounting for assets and liabilities under Indian GAAP arising from future changes in permitted tariffs for industries which are subject to rate regulation; for example, electricity distribution. In particular, it focuses on industries where tariffs charged to customers are based on the relevant costs incurred, plus a fair return.

Currently under Indian GAAP, companies subjected to rate regulation tend to already recognise an asset or liability based on recovery or refund of costs through future changes in customer tariffs.

So, from an Indian GAAP perspective this appears to be no more than a housekeeping exercise. The larger concern is that under both Ind-AS and IFRS, regulatory assets and liabilities cannot currently be recognised, which would lead to large losses being recognised for those groups in India carrying significant regulatory assets.

While the Guidance Note has been based on an Exposure Draft issued by the International Accounting Standards Board (IASB), this project has come to a standstill, with no clear indication that hints at if and when it will be concluded. The focus should therefore be on how to resolve the potential issues under Ind-AS, with no clear lead from the IASB, rather than housing keeping under Indian GAAP.

Accounting for infra assets

Whilst the implementation date of Ind-AS 11 on “Construction Contracts” is yet to be announced by the Ministry of Corporate Affairs, companies should evaluate the impact that arises due to the changes proposed in Ind AS 11. In the case of infra projects which provide a public service, the accounting under Ind-AS will be significantly different than Indian GAAP.

While infrastructure assets constructed are recognised as fixed assets under Indian GAAP and the revenue recognised over the course of the contract on an accruals basis, under Ind-AS, the fixed assets will become intangible assets or financial assets or a combination of both. Furthermore, the timing of revenue of profit may be accelerated, compared with the related cash flows.

The de-recognition of fixed assets and apparent mismatch between revenue and cash will mean that institutions providing the project finance will need to revisit how they assess such projects.

The financing KPIs will need to move away from fixed assets and revenue, with a greater focus on cash generation. Infrastructure groups should engage early with their financial backers to ensure that they clearly understand the impacts of these accounting changes.

Protect yourself from investment risk

Conducting a thorough forensic due diligence helps the acquirer (or investor) in arriving at fair valuation and mitigating the unknown post investment risk. By applying forensic accounting techniques, fraud examiners can help investors quickly identify any significant black holes that may exist in the target's books. In order to protect themselves and their investments, investors should thoroughly evaluate the potential impact of all forensic due diligence findings and, where required, also build suitable safeguards in the investment agreement.

Red flags to watch out for

Revenue growth and operating margins significantly different than normal industry trends without significant difference in business model;

Weak corporate governance structure with limited or no independent review and approval for transactions related to promoters;

Frequent changes in key management personnel, specially, the CFO;

Frequent changes in MIS/other information shared during due diligence process;

Failure to rectify repeated weaknesses in controls captured in internal audit reports;

Various internal frauds reported were not acted upon;

Large number of related party transactions;

Evasive or inconsistent responses to questions raised/information sought by investors/advisors;

Absence of independent whistle-blowing reporting mechanism;

Multiple instances of regulatory violations;

Absence of an ethical culture at the target due to which corruption and bribery is highly prevalent;

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