Adoption of Ind AS and Impact on Corporate Performance

The adoption of IFRS-converged Indian Accounting Standards, being a reality after almost a-decade-long deliberations and a mega-failed attempt in 2011, is seen to be posing a different kind of challenge to the markets. The quarter ending June 30, 2016 will be the first quarter of Ind AS compliant financial statement reporting for corporate and a steamy results season is expected to be forthcoming.

How should the results as appeared in Ind AS statements be compared vis-a-vis the statements as per earlier Indian GAAP, especially when the comparison period spread across more than two years? As, as per Ind AS, companies need to report the Ind AS compliant statements for current FY and one previous FY. It’s a strange situation where corporate publishing the results may have done better than their previous quarters, still might end-up delivering a lower than expected results.

Even if any investor-friendly companies were to report for the previous five years, how to establish authenticity, as no re-audit is required. While it is universally agreed that said adoption is a momentous step in the corporate regulation, the transitional phase quandaries are bound to bring some tremors in the near future. Let’s also not miss noting the point that this movement is filling several gaps that exist today in accounting framework and reporting. We discuss certain potential issues that need attention of investors in understanding the new financial statements. (Also the list of issues is not exhaustive, but, definitely not of least importance).

The timeline of for adoption of standards given by the Board is as below:

The Ind AS mandated to be complied with, with effect from April-2016 is expected to impact a wide array of sectors including pharma, IT, Infra, and more importantly banking, for Ind AS is more prescriptive than current standards and also more elaborative. A fair amount of subjectivity is involved in readying the financial statements, especially when recording the value of assets and liabilities. Consider the below examples:

Revenue Recognition

Unlike Indian GAAP, Ind AS 115 provides a higher scope for judgments when it comes to reporting useful information about the amount, timing and uncertainty of revenue and cash flows arising from contracts. As per Ind AS, irrespective of the unrelated party status, the transfer of goods or services must be recognized in an amount that reflects the consideration that it expects to be entitled to in a similar exchange transaction. Revenue is recognized when a customer obtains control of the good or service, unlike previous Indian GAAP (AS-9) criteria of transfer of risk and reward.

Financial Assets

Unlike Indian GAAP, where treatment of certain financial instruments like preference shares as either liability or equity was left to the business, Ind AS prescribes that a financial instrument – that has a contractual obligation of the issuer to deliver cash (or other financial asset) to the holder or even the right vested with the issuer to exchange financial assets and liabilities in a potential unfavorable condition – needs to be treated as a liability and not equity.

Hence, this standard will make companies to treat certain instruments that are in the form of equity (so far) need to be converted into a liability, viz., redeemable or convertible preference shares. It must be noted here that such treatment of preference shares as liability will lead to treatment of payments (preference dividends) as a charge to profit and loss account and thus reducing the net income reported.

Ind AS also prescribes to separately show the equity and liability component of financial instruments that is compounded in nature, like, convertible debentures. Financial instruments like derivatives need to be measured at their fair value and any gains/losses need to be accounted for profit or loss. What it means is that any mark-to-market gain/loss that has so far been an out-of-balance-sheet adjustment (as per Indian GAAP) will find their way into the balance sheet as per the Ind AS (IndAS-30).

These differing treatments of financial assets and liabilities are expected to impact key financial performance indicators like debt-equity ratio, interest coverage ratio and EPS, in addition to the net income reported. The impact also goes upto influencing non-compliance with debt covenants (of existing debt arrangements) and managerial remuneration and ESOP distribution.

Business Combinations

Strangely enough, there weren’t any accounting standards under Indian GAAP that comprehensively dealt with business combinations. (AS-14 was applicable only for amalgamations/purchases). Indian GAAP in contrast to Ind AS, was based more on the legal form than substance. For example, the process of recognizing the net assets taken over at their fair value (IndAS-103) vis-à-vis at book value under Indian GAAP is about to change the way purchase consideration is treated in accounting books.

Another requirement to not amortize the goodwill acquired in a business combination, instead to test for impairment annually is expected to be a blow on the income statement. The post-acquisition financial statements of the acquirer are expected to look different and at the same time more informative due to the fair valuation of assets and liabilities, various other new disclosures regarding the cost of acquisition (as per Ind AS) and a higher/lower charge on profit and loss account for the depreciation/amortization of assets and adjustments for contingent liabilities.

Above are selected few areas, changes in which are expected make life difficult for the accountants, auditors and all other stakeholders and in-depth analysis will open-up even more critical areas. Companies like HUL and Marico have already published their impact reports and as could be observed in the case of HUL the topline (sales) numbers are higher (due to changed revenue recognition norms) as per Ind AS, in the said quarter, performance indicator like the PBIT margin and NP margin have decreased giving a paradoxical anomaly to the analyst community.

Various other such requirements make the financial statements to look different. The convergence process is expected to significantly affect companies’ day-to-day operations and reported profits may differ significantly. In summary, we can say that below might be the impacts investors and investment analysts might have to be cautious of:

• Performance measures used by companies might change, including those used for managerial compensation
• Covenants of financial liabilities might get affected, including key ratios relating to solvency, liquidity and valuation
• Dividend payout policies may also change in the future
• Especially in the case of banking and financial companies, changes in capital structure to meet capital adequacy norms of regulators can be expected
• NPAs, the most debated issue in the recent quarters are another area that will make balance sheets of banking companies look even more bleak due to the Ind AS norms to recognize NPA like a reserve for bad debt than as a total of defaulters’ borrowing

The QIFY17, being the first reporting quarter with the new Indian Accounting Standards – Ind AS compliant results can expect to bring few surprises to the investors and considering the inefficient market structure that India has, with the lack of investment analysis literacy, is sure to make it a chaotic season of earnings.