Goodbye to off-balance sheet transactions

Indian Accounting Standards (Ind AS) is going to significantly change the accounting and reporting of transactions by corporate India. But what is even more important is that Ind AS will bring on to the books many fundamental transactions which escaped Indian GAAP (generally accepted accounting principles).

Ind AS provides a single model for control, the definition of which is quite broad. It requires evaluation of power of an entity over another entity, exposure to variable returns (positive or negative), and ability to use the power to affect the returns of that other entity.

Simply put, one has to evaluate (1) how an entity is involved with another entity; (2) exposure to the risks and rewards of the other entity; and (3) the ability to make decisions over the other entity. An entity could also control another holding even less than majority ownership of equity or voting interest when the remaining shareholding is scattered. These circumstances could result in consolidating more subsidiaries, thereby increasing consolidated assets and liabilities under Ind AS.

Under Indian GAAP, related party transactions are generally recorded based on the amounts mentioned in the contracts or agreements with disclosures to be made. Some transactions may not get accounted in the financial statements due to lack of mandatory guidance.

For example where a parent entity has provided a long tenure interest free loan to its subsidiary, the subsidiary would generally record such borrowing at face value without interest expense.

Under Ind AS, the subsidiary will account such borrowing from the parent at fair value (which would be lower than the face value of the loan). The difference between the fair value and the amount of borrowings received representing a financing benefit provided by the parent shareholder to its subsidiary will get credited to equity in the subsidiary’s financial statements.

Subsequently, the subsidiary will record interest expense through the repayment date. By doing this, the subsidiary effectively reflects the borrowing expense similar to what it would have reported if the loan was taken from an unrelated third party. So this will increase the reported interest expense of companies which may have such transactions.

Share-based transactions with employees are another classic example. Many times, the parent company provides its shares or options as a form of incentive to the employees of its subsidiary.

Under the current Indian GAAP, the subsidiary entity may not have recorded any stock compensation expense in the absence of mandatory guidance. Under Ind AS, such subsidiaries will have to record the stock compensation expense for the share awards granted by the parent company to the subsidiary’s employees.

Further, entities will no longer be able to use the intrinsic value method for recording stock compensation expense. Instead entities will have to record the fair value of the share based awards as an expense in the financial statements.

Derivatives and leases Upon adoption of Ind AS, all derivatives will necessarily have to be recorded at fair value on the balance sheet. In addition to the more common foreign exchange, commodity, interest rate linked derivative instruments, others such as call and put options to acquire a company’s own shares or shares of subsidiaries will also get accounted in the financial statements.

Ind AS also has explicit guidance on arrangements in the nature of leases — often referred to as embedded leases. Contracts which may not have been legally termed as leases will now get accounted as leases.

Take, for example, an auto manufacturing company that sources its components from an ancillary component manufacturing unit under long-term non-cancellable supply agreement.

Under the arrangement, generally all the output of the component manufacturer is supplied to the auto manufacturer and the fees charged for manufacturing service includes operating cost, recovery of amortised cost of machinery and profit margin.

Has the auto component manufacturer leased the right to use its fixed assets (machinery, etc) to the auto manufacturer? Accordingly, subject to certain conditions, though the fixed assets are legally owned by the auto component manufacturer, it is the auto manufacturer that may have to record the assets and corresponding lease liabilities on its books.

If this is done, it will increase the reported amount of assets and liabilities of the auto manufacturers. In summary, many transactions which were previously not recorded in the financial statements under Indian GAAP will get included in the Ind AS financial statements. The users of financial statements, investors and other stakeholders will have to get familiar with thr new information which could be quite different and important from what they have been historically used to.

Therefore adoption of Ind AS calls for proactive planning and early communication with stakeholders on the implications of Ind AS relevant to their companies.

(The writer is a partner at Price Waterhouse. The views are personal)

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