Priyanshu Gundana, Partner, Price Waterhouse & Co.
The power sector in India is highly regulated, with continuing regulator's involvement in pricing, security of supply and extensively capital intensive. Till 1991, the whole infrastructure sector (of which power is a part) was primarily under government ownership, but due to severe foreign exchange crisis and a lack of capital for expanding infrastructure capacity, the Indian government allowed private foreign and Indian investments in the sector. As a part of privatisation of Public Sector Units (PSUs) a Disinvestment Commission was set up during 1991 -92 for identifying PSUs for equity disinvestment.
The main goal of public sectors is to serve public needs without regard to profit or loss (P&L), while the private sectors' goal is profit maximisation. Hence in order to attract private investors government started various model of public private partnership (PPP), including giving guaranteed return on investment.
The Indian Accounting Standards (Ind AS), is based on the International Financial Reporting Standards (IFRS), with some departures (carve outs). This will change the way revenues, assets and liabilities are calculated, and require extensive disclosures by the company in the financial statements.
The aim is to make financial statements more transparent. At a very fundamental level, Ind AS focusses on substance rather than legal form, and the risks and rewards of the underlying transactions. In this article we have tried to examine the significant accounting gap between old Indian GAAP and Ind AS that are relevant for the infrastructure sector companies.
Classification in Equity and Liability
In the power sector it is very common to fund the company through complex instruments like preference shares and subordinate debts. Under Indian GAAP, there is no clear guidance which prescribes distinction between equity and liabilities. Essentially, classification and accounting for liability and equity is dictated by the legal form of the instrument.
Under Ind AS, an entity will have to determine the appropriate classification of an instrument as a liability or equity based on the substance of the contractual arrangement, rather than its legal form. As an overriding principle, Ind AS requires a financial instrument to be classified as a financial liability if the issuer is required to settle the obligation in cash or another financial asset. Further, Ind AS requires certain compound financial instruments to be separated into a liability and equity component. For example, mandatory redeemable preference shares which until now were shown as part of equity under Indian GAAP will get classified as liability going forward under Ind AS. Also the dividend and dividend distribution tax on such capital will get recorded through the income statement as a borrowing expense instead of equity. This will result in higher interest expense and lower net equity going forward.
On the other hand, compound instruments such as convertible debentures and preference shares will be split into liability and equity components by applying fair valuation techniques at inception. Foreign Currency Convertible Bonds (FCCBs) will be treated as compound financial instruments, requiring split accounting. The interest on liability component is recognised using the effective interest rate (EIR). Since determination of EIR also considers premium on redemption, the said premium is also charged to P&L and cannot be adjusted against the securities premium.
This change in classification is likely to significantly affect the balance sheet structure of an entity, reported net worth and results of entities, especially those having complex capital structures. Companies may also need to take a closer look at their debt covenants requiring a proactive dialogue with their lenders.
In the infrastructure and power sector, there are lot of joint venture arrangements which under current accounting standards are consolidated based on the equity and the board structure, resulting in majority being consolidated as a subsidiary. Under current accounting standards, joint control entities are consolidated on a line by line basis on a proportionate basis.
However, under Ind AS due to significant control being exercised by the minority shareholder based on the shareholders agreement terms, the entities earlier consolidated as subsidiaries end up consolidated as joint control entity under Ind AS; and joint control entities are consolidated as equity pick up. This change will impact the total revenue, total borrowings, and total assets of the company.
Accounting for differences arising on foreign exchange borrowings
Power companies are capital intensive companies and have exposure to long-term foreign currency monetary items. In the current Indian GAAP as per under para 46A of AS 11, companies are allowed to capitalise foreign exchange differences on long term foreign currency borrowings on depreciable assets or amortise it over the period of the loan if obtained for other purposes.
Whereas Ind AS requires the exchange fluctuation on translation or settlement of the foreign currency monetary items to be recognised in the income statement. There is an optional exemption in Ind AS 101 for continuing the existing policy of long term monetary assets and liabilities, but exemption is not applicable on exchange differences arising on any funds received from the bank subsequent to April 1, 2016, for companies under phase 1. Due to huge fluctuations in rupee value this change will lead to increase in volatility in income statement and will have a long term impact.
Minimum Alternate Tax (MAT)
The Central Board of Direct Tax (CBDT) had constituted a Committee to suggest a framework for computation of MAT for Ind AS compliant companies. Based on their report, the Finance Bill, 2017 proposes to amend section 115JB of the Income tax Act 1961 (Act). These amendments were long awaited by the companies as there is a consequential impact of the Ind AS adjustments on the P&L statements. Given below is the brief overview of the proposed framework.
The profit shall be adjusted as follows:
1. For those items that are already specified under section 115JB of the Act,
2. Items in OCI that would be reclassified to P&L statement, will be included in the book profit of financial year in which these items are reclassified to P&L.
3. Items in OCI that will not be reclassified to P&L statement shall be included in book profit equally over a period of five years from the year of adoption except for adjustments in relation to revaluation of property, plant and equipment (PP&E) and intangible assets and gain and losses from investments designated at fair value through OCI, which will be included in the year of disposal/retirement/realisation.
4. Other adjustments recorded in other equity shall be included in book profit equally over a period of five years from the year of adoption, except for adjustments in relation to PP&E and intangible assets recorded at fair value as deemed cost, investments in subsidiaries, joint ventures and associate at fair value as deemed cost and cumulative translation differences of a foreign operations which will be included in the year of disposal/retirement/realisation.
The profit before OCI shall be adjusted as follows:
1. For those items that are already specified under section 115JB of the Act, 2. Items in OCI that will not be reclassified to P&L shall be included in book profit except for adjustments in relation to revaluation of property, plant and equipment (PP&E) and intangible assets and gain and losses from investments designated at fair value through OCI, which will be included in the year of disposal/retirement/realisation.
Crux of the Matter
Entities in the power sector should gain an understanding of Ind-AS and evaluate how it will affect their specific accounting policies and practices. All entities will need to evaluate the requirements of Ind-AS and make sure they have processes and systems in place to collect the necessary information to implement the standards and make the required disclosures.
The impact of Ind AS adoption is also beyond accounting, cutting across organisation and various functions/areas such as direct and indirect taxes, contractual arrangements with customers, suppliers, lenders, IT systems and controls, including requiring timely communication with various stakeholders. Therefore, it is imperative that the companies in the power sector get it right.