Published on March 14, 2014
March 2014 ACCOUNTING AND AUDITING UPDATE In this issue Airport infrastructure p1 Carving-out: the financial reporting perspective p5 The Companies Act, 2013 Emphasis on investor protection p8 Simplified hedge accounting approach - Accounting for certain ‘receive-variable, pay-fixed’ interest rate swaps p13 Year-end reminders p15 Accounting for principal only currency swaps - recent EAC guidance p23 Regulatory updates p25
There have been few sectors in India that have got as much negative press and attention as the aviation sector in the recent past. Still, the level of interest both by local and overseas investors in this sector continues to be robust. Our lead sector article for this month focusses on some of the arrangements, the business models in vogue and their implications from an accounting and reporting perspective that are unique to this sector. We also examine in this issue of the AAU, the complexity and challenges associated with carve-out financial statements. In the backdrop of an economic environment where many businesses are actively considering spin offs and value unlocking measures, carve-out financial information is increasingly used for diligence and by investors. Continuing with our ongoing series, we also highlight some of the changes in the Companies Act 2013 that focus on increased investor and stakeholder protection. This month, as we approach the March financial year end for many companies, we are including a special round up feature that attempts to summarise in one place, key developments under Indian GAAP, U.S. GAAP and IFRS in the past year that may be relevant for preparers of financial statements. Finally, in addition to our round of regulatory developments, we also cast our lens this month on recent developments in the area of hedge accounting affecting private companies under U.S. GAAP. The simplified hedge accounting proposals, on the face of it, appear to be an interesting and significant departure from the complexity that is often associated with this accounting area. 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 topics we cover, we would be delighted to hear from you. Happy reading! Editorial © 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.
1 Airport infrastructure The aviation sector is of national importance, contributing significantly to the process of economic development, enabling enhanced productivity and efficiency in the movement of goods and services. This sector usually generates employment directly and indirectly, and provides a number of feeder opportunities to an array of industries such as airports, airlines, cargo, ground handling, air navigation services, retail, real estate, tourism among others. While there have been a number of challenges faced by the sector recently, the Government’s decision to allow foreign carriers to invest in Indian airlines has given a ray of hope and could have sparked fresh interest in this sector. In this article, we have highlighted some of the key aspects of the business model and significant regulatory changes faced by this sector and, in that context, salient accounting issues and challenges. This article aims to • Highlight some of the key aspects of the business model and significant regulatory changes faced by the sector • Explain salient accounting issues and challenges. © 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. Airport Infrastructure
Airport operations and regulatory changes The revenues of an airport operator can be broadly classified into aeronautical and non-aeronautical revenues. The aeronautical revenues include ‘Passenger Service Fee’ (PSF), ‘User Development Fee’ (UDF), ‘Landing Charges’ and ‘Parking Charges’. The non-aeronautical revenues include cargo, fuel, retail, food and beverages, advertising, taxi, vehicle parking, among others. PSF and UDF are collected as part of the passenger fare by the airline operators and are remitted to concerned airport operators. These charges are regulated charges and are approved by the Ministry of Civil Aviation. a. PSF includes fees towards facilitation and security. The facilitation fee is levied to meet the expenditure on passenger facilities at the airports, and it is not utilised to fund new development/upgradation of airports whereas the security fees is towards the airport security which is collected by the airport operator on behalf of the Central Industrial Security Force (CISF). b. UDF refers to the fee collected from embarking passengers for the provision of passenger amenities, services and facilities, and is intended to be used to defray expenses for the development, management, maintenance, operation and expansion of facilities at an airport. Landing and parking charges are charged by the airport operator to various airlines who operate out of the concerned airports. a. Landing charges refer to fees collected for the use of runways, taxiways and apron areas, including associated lighting, as well as for the provision of approach and aerodrome control. The charges are levied to all airline operators who have landed at the airport during the period, at a fixed rate, depending on the weight of the aircraft (per metric tonne). b. Parking charges refer to charges collected from airline operators for the parking of aircraft and for their housing at an airport owned hangers at a fixed rate, depending on the weight of the aircraft (per metric tonne). The earning potential of non-aeronautical activities is one of the key factors that makes airports an attractive business proposition for private investors. Indeed, the performance of the retail, car parking and real estate revenue streams underscore the resilience of the airport business model and help to protect the bottom line of many airports in a difficult year. Quiet often, non-aeronautical can determine the financial viability of an airport, although what they are allowed to do with the proceeds is dictated by the ‘till system’ they operate under. The till system is used to arrive at the rates for the various regulatory charges at the airport. In order to formulate a systematic rate card for the regulatory charges for each airport operator across India and to bring about regulation, the Government of India (GOI) has set up a statutory body in December 2008 called Airports Economic Regulatory Authority (AERA or Authority). The objective of AERA is to regulate the tariff of aeronautical services at airports across India. The Authority determines tariff for the aeronautical services taking into consideration ‘the concession offered by the GOI in any agreement or memorandum of understanding or otherwise’ with the airport operators. Accordingly, the Authority undertakes an ongoing process at various airports in a phased manner to analyse and assess the implications of the principles and mechanics, relating to tariff fixation, contained in the concession agreements in consultation with the respective airport operators. The airport operators submit a multi- year tariff proposal to the Authority for determination of the tariff in advance for a period of time. The Authority analyses the proposal after which an ‘Annual Tariff Order’ is issued. The process is an ongoing process wherein these charges will be revised by the Authority from time to time. The rates for PSF, UDF, landing and parking to be charged by an airport operator would depend on the outcome of the consultations and the views of the Authority. The primary method of computing these rates would depend on the regulatory ‘till’. The principle governing the till systems is that airlines’ business is not just air-ticket and in-flight revenue, but they also should be able to participate in commercial revenues that result from such traffic; then it stands to logic that airports can also participate in the ticket and in-flight revenues of the airlines. At the outset and specifically in the Indian context, to the extent passengers are required to pay UDF (or for that matter PSF), bringing in the entire contribution of non-aeronautical charges in aeronautical tariff determination could directly reduce (perhaps proportionately) these charges that are directly borne by passengers. The three types of tills are single till, dual till or hybrid till. Under the single till principle, non- aeronautical revenues are used to subsidise aeronautical charges, and under this system, the airport operator will be allowed to earn a fixed percentage of profit on the total revenues earned by an airport operator based on which aeronautical charges to be levied are finalised. In contrast, under the dual till principle, only aeronautical revenues are considered for calculation of regulatory charges by the Authority, whereas under the hybrid till only some streams of the revenues (aeronautical and non-aeronautical) collected are considered during the calculation of the regulatory charges by the airport regulator. Hence, single till helps ensure that the burden on the passengers of such charges is reduced, as the benefit of the high profits of the airport operator from the non-aeronautical revenues helps in subsidising the regulatory charges. Single till systems can sometimes not incentivise development of non-aeronautical revenues as the airport operator does not gain. Alternatively, the single till may lead an airport to maximise non-aeronautical revenues aggressively upto a maximum extent taking non-aeronautical investment at the expense of aeronautical investment and service quality. Under a dual or hybrid till, an airport operator is incentivised to identify improvements in non-aeronautical operating and investment costs often brings down the aeronautical cost base as well as in this case, the airport operator will likely stand to gain. 2 © 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.
Accounting issues and challenges in the airport sector Service concession arrangements The arrangement between the Government and the private sector that formalises the private sector participation in this sector, is referred to as ‘service concession arrangement’ (SCA). SCAs are common in the Indian infrastructure scenario, and especially in the ‘greenfield’ airport sector. The private operators enter into a SCA whereby the Government grants the company exclusive right and privilege to carry out the development, design, financing, construction, commissioning, maintenance, operation and management of an airport. Indian GAAP does not provide any guidance on the accounting for SCA by the operator or grantor; thus, varying accounting policies have been adopted by different operators. The Institute of Chartered Accountants of India (ICAI) proposed an Exposure Draft (ED) on Guidance on Accounting for Service Concession Arrangements in 2008. The ED replicates the principles which are set out in IFRIC 12, Service Concession Arrangements under IFRS. The current accounting practices under Indian GAAP which are followed by various Indian companies are as below: • The cost incurred on the infrastructure, which is the subject matter of the SCA, is normally capitalised as fixed assets by various Indian airports. The useful lives for the purpose of depreciating the asset does not exceed the concession term. • The revenue from airport operations are recognised on an accrual basis, net of service tax, applicable discounts and collection charges, when services are rendered and it is probable that an economic benefit will be received, which can be quantified reliably. • Concession fee payable to the GOI is usually a percentage of the total revenue earned by an airport operator and is accounted for as an expense in the case of airports. The accounting for service concession arrangements as per IFRIC 12 depends on whether the airport operator is exposed to demand risk which leads towards following an intangible asset model as against a financial asset model. The key highlights of both the models are as below: Airport charges derived using the single till approach are, therefore, likely to be lower than charges derived under a dual till because of the sharing of profits generated by non-aeronautical activities. Airports and their investors, particularly with privatisations, are increasingly becoming aware that their commercial revenue profits could be significantly enhanced through application of the dual till system. Financial asset model • Recognises the concession activity as a financial asset as the grantor bears the demand risk and the operator has an unconditional right to receive cash irrespective of the use of the infrastructure • No fixed asset/property plant and equipment is recognised in the books • Initial phase will involve construction contract like accounting (recognition of revenue and expense) • A financial asset (receivable) is recognised as proceeds from the construction activity • Interest income is recognised on an effective interest rate basis. Intangible asset model • Recognises the concession activity as an intangible asset to the extent that it has a right to charge for use of the infrastructure • No fixed asset/property plant and equipment is recognised in the books • Initial phase will involve construction contract like accounting (recognition of revenue and expense) • An intangible asset is recognised as proceeds from the construction activity • Collections in relation to the concession are treated as revenue and intangible asset will be amortised. 3 © 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.
Taxation Airport operators may be eligible for deduction under section 80-IA of the Income-tax Act, 1961 (IT Act), subject to the conditions specified therein. The benefit under section 80-IA is available to the operator developing/developing and maintaining/developing, operating and maintaining an infrastructure facility. The term ‘infrastructure facility’ for this purpose includes airport. Section 80- IA specifies the period for which the deduction is available. For the purpose of claiming the benefit, the company should, inter alia, be in a position to demonstrate that the relevant income in respect of which the benefit is claimed is ‘derived’ from the specified business. This can lead to a lot of accounting challenges in relation to the adequacy of tax provisions. Even though an airport operator may be eligible to claim benefit under section 80-IA of the IT Act, the provisions of Minimum Alternate Tax (MAT) would apply. The IT Act allows for a carry forward of the MAT credit (representing the difference between the MAT paid and the tax liability under the normal provision of the IT Act) for a ten year period. Such credit can be set-off in the manner as prescribed under the IT Act. The above could have an impact on the accounting for taxes in relation to creation and carry forward of the MAT credit asset in the books. Basically, MAT credit will need to be tested for recoverability and utilisation since 10 years may not be sufficient for an airport operator to break even or earn taxable income. Conclusion The world seems to be focussed on Indian aviation – from manufacturers, tourism boards, airlines, global businesses to individual travellers, shippers and businessmen. The airport operators operate in a potentially lucrative industry but are exposed to a number of variations in terms of demand and significant investment outlays, but also quite significantly, the impact of changing regulation that can fundamentally affect their enterprise values. 4 © 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 Carving-out the financial reporting perspective In the current business environment, a number of companies are either divesting or acquiring businesses that are part of existing companies/businesses. These acquisitions/disposals of parts of existing enterprises are referred to as carve-outs. A carve-out is often a strategic option for companies to not only survive but also create wealth for the investors. Carve-outs may consist of disposal of subsidiaries, segments, components, or any product line (carved-out entity/business) as a part of the overall strategic plan. This article discusses some of the key challenges from the financial reporting perspective in relation to sale/purchase of business undertakings on a going concern basis. Carve-out financial information Carve-out financial information refers to financial statements prepared by aggregating historical financial information relating to business activities (components) that had previously been reported as part of a larger reporting entity. The carve-out financial statements includes all relevant activities that have been a part of the history of the business and which can be expected to be repeated as the business continues in future. The carve-out financial information should, also, ideally reflect the relevant activities/ operations of the carve-out entity on a stand-alone basis. These activities/ operations may have never been reported in the general purpose financial statements separately. Carve-out financial information is key for valuation of businesses carved-out. Such information provides a basis for assessing the business model and understanding the nature of the business by the investors. The endeavor is to have the business running on a standalone basis and separated operationally, for smooth transition to a new entity created in the transaction. It is worthwhile to note that no specific technical guidance, including definition of a carve-out, exists currently under the Indian GAAP (IGAAP). The periods for which the comparatives are provided in the carve-out financial statements will depend on the sale arrangement and the buyer’s/investor’s requirements. Special considerations need to be given for transactions between the carved-out business and other businesses in the entity. Such transactions may not have been captured separately as they are not inter-segment transactions if the carve out business is a part of a single segment. This situation can be further complicated if the carved out business is represented in more than one segment in general purpose financial reporting. An entity should assess whether it would be practicable to prepare the carve- out financial statements using a set of criteria determined to be appropriate. It is important to assess the extent to which the entity is able to separate each component’s financial performance and assets/liabilities from the rest of the entity without making significant assumptions related to amounts/items shared with the rest of the entity. This article aims to • Highlight the practical issues faced while preparing carve out financial statements. © 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.
Financial reporting challenges Carving out of business has several financial reporting challenges. Since most of the business transfers are designed as ‘slump sales’ for tax benefits, this article discusses the accounting issues for such transactions from an acquirer and acquiree’s perspective. While a dedicated standard is not available under the IGAAP, references are made to existing standards, the most relevant being AS 10, Accounting for Fixed Assets from which analogies can be drawn. In the absence of more specific accounting guidance under IGAAP, it is not uncommon for companies to draw an analogy from other bodies of accounting literature such as U.S. GAAP. Further, at transaction level, compilation of the financial data for the carved out entity can prove to be practically onerous due to the widespread use of integrated accounting and ERP packages. The major challenges on compiling financial data for the carve- out entity is broadly segregated into three major aspects that are discussed in this article. 6 Acquirer’s challenges ‘Slump sale’ as a concept has been discussed under the Income Tax Act, 1961 (the IT Act) along with detailed provisions on the tax implications. It describes a slump sale as a transaction that involves transfer of one or more ‘undertakings’ as a going concern in return for a lump sum consideration without values being assigned to the individual assets and liabilities. An undertaking could be a division, business unit, product line or a business activity taken as a whole. However, it does not include individual assets or liabilities or a combination there of, not constituting a business activity. Under AS 10, where several assets are purchased for a consolidated price, the consideration is apportioned to the various assets on a fair basis as determined by competent valuers. Hence, the acquirer will account for all the assets and liabilities at values determined post a valuation process. This may require recognition of assets not recognised by the seller, on account of these not meeting the separate recognition criteria for the seller. Common examples of the same are brands, patents, technical know-how. However, the recognition of such assets is subject to the definition of assets as enunciated under the relevant standards under IGAAP. For instance, under AS 26, Intangible assets, an intangible asset e.g., portfolio of customers is not recognised in absence of legal rights to protect or control the economic benefits expected to accrue from the underlying asset. In such instances, the amount attributable to these assets is accounted as goodwill. Further, under AS 10, goodwill is generally accounted in the books only when some consideration in money or money’s worth is paid for it. Whenever the consideration paid for the acquisition exceeds the net assets of the seller, the excess is termed as ‘goodwill’. Goodwill arises from business connections, trade name or reputation of an enterprise or from other intangible benefits enjoyed by an enterprise. As a matter of financial prudence, certain entities write off goodwill acquired over a period of three to five years. However, AS 10 does not require the goodwill, accounted on a slump sale, to be amortised mandatorily. AS 26 requires goodwill to be amortised systematically over the best estimate of the useful life (subject to the rebuttable presumption of the useful life of an intangible asset not exceeding 10 years). On account of lack of clarity in the accounting literature, there are mixed industry practices. Some companies amortise based on the AS 26 guidance, while the others opt for impairment testing rather than amortisation. Further, a deferred tax asset (DTA) may be recognised by the carved out entity/ acquirer on the carried forward losses and/or unabsorbed depreciation if virtual certainty (of the existence of future taxable income to absorb those losses) can be demonstrated. The acquired company may not have recognised the DTA due to the virtual certainty test not being met. The value of such DTA can impact the value of goodwill recognised. This could be subject to a consideration of whether the tax losses and unabsorbed depreciation will be allowed to be carried forward for the carved out entity which may or may not have been a separate entity for the purposes of tax assessments previously. © 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 Seller’s challenges The announcement of the seller’s decision to carve out an entity calls for various disclosures from the accounting view point. AS 24, Discontinuing Operations (AS 24) provides detailed guidance for ‘discontinuing operation’. AS 24 defines a discontinuing operation as a component of an enterprise that is being disposed off pursuant to a single plan substantially, in its entirety or in a piecemeal way, by selling off the assets and settling liabilities individually or terminating through an abandonment. A discontinuing operation represents a separate major line of business or geographical area of operations, that can be distinguished operationally and for financial reporting purposes. The accounting treatment for the respective assets and/or liabilities should ideally be in line with the respective accounting standards as prescribed under IGAAP The disclosures required by AS 24 include description of the operation, date of the initial disclosure event, date of expected completion of the transaction, amount of revenue and expenses attributable to the operation, carrying amounts of assets and liabilities of the operation, pre-tax profit or loss from ordinary activities attributable to the operation and net cash flows attributable to the operation in the current reporting period. These are required till the plan is substantially completed or abandoned, though full payments may not have been received. A discontinuing operation may not be a segment as defined under AS 17, Segment Reporting. A part of a segment may also qualify as a discontinuing operation. However, this determination would likely require judgement since AS 24 does not prescribe a specific threshold for this assessment. Disposal of a business unit, division, segment or line of business does not call into question the ability of the seller to continue as a going concern. However, if the discontinuing operation forms a substantial part of its operations and if the carve-out or sale could result in no other operations for the seller, then the going concern assumption would need to be assessed appropriately and this is in an area that would require significant judgement. For a sale of fixed assets that do not meet the definition of a discontinuing operation under AS 24, the disclosures would be governed by AS 10 that requires the assets retired from active use and held for disposal to be stated at lower of the net book value and net realisable value (NRV), separately in the financial statements. Expected losses are recognised in the income statement immediately. Other key considerations for carve–out financial information Allocation of expenses, to reflect the history of the relevant activities of the carved out entity, too deserves a mention. Absence of a systematic basis for internal allocations of the common costs, add to complexity. On account of absence of guidance under IGAAP, it is important to determine that allocations should be verifiable and can be measured reliably. For example, a carve-out of a division in which common assets and common personnel are used for other components that will not be included in the carve-out financial statements will require more complex allocations versus a component that is a separate legal entity and maintains separate accounting records. As the complexity in the computation of allocations increases, so does the level of judgement required to assess whether the resulting financial statements are consistent with their intended use. Allocations should not be arbitrary, and should be based on expenses/income actually incurred and that are clearly identifiable. Allocations should be based on a systematic and rational basis appropriate for each item being allocated. Allocations by size (e.g., total revenue or total assets) are likely to be inappropriate unless a direct correlation can be drawn between size and the expense incurred. Examples of reasonable bases for determining allocations include specific identification, headcount, usage/ utilisation, payroll, time, square footage, and/or time spent. In case the carved out entity is a segment, division or a product line, the inter segment, division or product line, transactions eliminated for the purposes of compilation of the consolidated financial information, would need to be identified. It would further need to be evaluated if these were transacted at an arm’s length price. Identification of assets and/or liabilities out of the pool of the common assets and/or liabilities, for example corporate office space, loans borrowed/advanced, derivatives and employee benefits can also pose to be difficult. Further, identification of open and on-going commitments like purchase orders and sales orders would also need to be considered. Conclusion To summarise, the preparation of carve- out financial statements is far from straightforward and encompasses a number of special considerations need to be taken into account. Companies preparing carve-out financial statements may find that a significant investment in time and resources are necessary to meet these challenges. Also, guidance in GAAP is currently limited in this area and most stakeholders would welcome any future measures to standardise the carve- out procedures to ensure consistency in reporting of such information. © 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 Emphasis on Investor Protection The Companies Act, 2013 While institutional investors, corporates and promoters are often able to safeguard their interests through the knowledge and resources that they possess; it is the individual and minority investors whose interests sometimes remain vulnerable to decisions and actions taken by the companies and those charged with governance. The Report of the Expert Committee on Company Law (the Report) constituted by the Ministry of Company Affairs vide Order dated 2 December, 2004 under the Chairmanship of Dr. Jamshed J. Irani examined the question as to whether a separate Act is required for investor protection. The Committee noted that a framework exists in India to deal with criminal offences; the requirement is to provide a suitable orientation to corporate law so that the investor, irrespective of size, is recognised as a stakeholder in the corporate processes, as a separate Act would require special enforcement mechanism with attendant coordination issues. It was identified that in order to have clearly laid down rules leading to corporate governance, transparency, accountability and a mechanism to enforce non-compliance should be built in the Company Law itself. Therefore, the Companies Act, 2013 (2013 Act) incorporates a number of provisions that are directed towards investor protection. This article provides an overview of the investor protection measures included in the Act. This article aims to • Highlight the requirements of the 2013 Act regarding investor protection • Explain our observations regarding these changes. © 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 Oppression and mismanagement and classification suits As per section 399 of the Companies Act, 1956: • in case of a company having share capital, not less than 100 members of the company or not less than one-tenth of the total number of its members, whichever is less, or any member or members holding not less than one-tenth of the issued share capital of the company, provided that the applicant or applicants have paid all calls and other sums due on their shares • in the case of a company not having a share capital, not less than one-fifth of the total number of its members have a right to apply to the Company Law Board for considering the case and pass an appropriate order so as to address the concern of oppression or mismanagement. While similar provisions also exist in the 2013 Act, it also introduces the concept of class action suits. As per section 245 of the 2013 Act, if any class of investors are of the opinion that the management or conduct of the affairs of the company are being conducted in a manner prejudicial to the interests of the company or its members or depositors, then these investors or a class of them can, as a class, file an application before the Tribunal on behalf of the members or depositors, seeking passage of appropriate orders. The following are the classes of investors who can apply to the Tribunal: i. in the case of a company having a share capital, not less than 100 members of the company or not less than 10 per cent of the total number of its members, whichever is less, or any member or members singly or jointly holding not less 10 per cent of the issued share capital of the company, subject to the condition that the applicant or applicants have paid all calls and other sums due on his or their shares ii. in the case of a company not having a share capital, not less than one-fifth of the total number of its members or iii. not be less than one hundred depositors or not less than 10 per cent of the total number of depositors , whichever is less, or any depositor or depositors singly or jointly holding not less than 10 per cent of total deposits of the company. The Tribunal, under section 245, has the powers to pass one or more of the following orders: i. restraining the company from committing an act which is ultra vires the articles or memorandum of the company or leads to breach of any provision of the company’s memorandum or articles ii. declaring a resolution altering the memorandum or articles of the company as void if the resolution was passed by suppression of material facts or obtained by mis-statement to the members or depositors iii. restraining the company and its directors from acting on such resolution iv. restraining the company from doing an act which is contrary to the provisions of this 2013 Act or any other law for the time being in force v. restraining the company from taking action contrary to any resolution passed by the members. Apart from the above, the Tribunal can also pass order to claim damages, compensation or demand any other suitable action from or against: i. the company or its directors for any fraudulent, unlawful or wrongful act or omission or conduct or any likely act or omission or conduct on its or their part ii. the auditor, including the audit firm of the company for any improper or misleading statement of particulars made in his audit report or for any fraudulent, unlawful or wrongful act or conduct, or iii. any expert, advisor, consultant or any other person for any incorrect or misleading statement made to the company or for any fraudulent, unlawful, wrongful act or conduct or any likely act or conduct on his part. The provisions of the 2013 Act are different from those in the Companies Act, 1956 in two aspects. Firstly, unlike the Companies Act, 1956, not only the equity shareholders or members, but also depositors can apply to Tribunal. Secondly, the right to seek compensation from the company, its directors, auditors, any expert or advisor has also been added. The section provides protection to the investors from those in control of the company. It is clear that the intent of the legislation is that apart from the company and its directors, the auditor, an expert, an advisor or consultant can also be asked to pay for damages/compensation if it is found that these parties acted in a fraudulent, unlawful or wrongful manner. Class action suits can have their own advantages. The first advantage is reduction in cost of litigation which an investor has to bear. While the companies can withstand long-legal battles, it is often commented that, individual depositors and shareholders are not able to bear the legal costs over a long-term. A class of investors coming together and applying for the same cause could reduce the cost of litigation for the investors. The second advantage is a potential change in behaviour. The new law applies significant pressure on the directors, auditors, advisors and/or consultants to act professionally, with due care and without any bias. It is also expected that as the law would get settled and as the cases would get decided, what is acceptable and what is not would get clearly defined. While the advantages of a class action suit would likely benefit the investors; the companies, directors, auditors, advisors and consultants would potentially have to deal with increased litigation and associated costs including dealing with frivolous or illegitimate claims by unscrupulous stakeholders. © 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 Addressing grievances of investors Companies having more than 1,000 shareholders, debenture holders, deposit- holders or other security holders at any time, during the financial year are required to constitute a ‘Stakeholders Relationship Committee’ to resolve the grievances of security holders. It is envisaged that an investor grievance redressal mechanism with a non-executive chairman would help ensure protection of the interest of investors through timely intervention. Related party transactions1 Related party transactions has been an area of focus for auditors, regulators and the shareholders. There have been concern that related party transactions could be used for siphoning of funds and defrauding investors. Due to this reason, the Companies Act, 1956 contained provisions like section 297 and section 299. Perhaps, it was felt that the extant sections 297 and 299 of the Companies Act, 1956 do not comprehensively cover the relationships where a director or the Board could be seen to have compromised in their fiduciary duties towards the company and its investors. Therefore, the term ‘related parties’ has been defined in the 2013 Act (the Companies Act, 1956 did not define related party). The definition of ‘related party’ with respect to a company is a wider definition and includes holding company, subsidiary company, sister subsidiary, associate company, directors, key management personnel (including relatives), firms/ companies where directors/relatives are interested and senior management i.e., members of core management team one level below executive directors including functional heads. Senior management/ functional heads have been included in the draft rules even though they may not be in a position to control or take key decisions of the company. Further, ‘relatives’ in relation to an individual covers specified elder and younger generations without distinguishing between financially dependent and independent relatives. Nature ofTransaction Limits Specified • Sale/purchase or supply of any goods or materials • Availing or rendering of any services • Buying/selling/leasing of property • Appointment of agent for purchase or sale of goods, materials, services or property Aggregate with previous transactions during a financial year/individual transactions > five per cent of annual turnover or 20 per cent net worth, per last audited accounts (whichever is higher) • Appointment to any office or place of profit in company, subsidiary or associate Monthly remuneration exceeding INR 0.1 million • Remuneration for underwriting subscription of any securities or derivatives Remuneration exceeding INR 1 million It may also be noted that the director’s report under section 134 of the 2013 Act is also required to include the details of related party transactions requiring consent of the Board/special resolution of members along with the justification for entering into them. In January 2013, the Securities and Exchange Board of India (SEBI) had released its ‘Consultative Paper on Review of Corporate Governance Norms in India’ to align the existing corporate governance norms in India with the then existing Companies Bill, 2012 and other international practices. Consequent to the enactment of the 2013 Act, the SEBI Board has on 13 February 2014, approved the proposals to amend the corporate governance norms for listed companies in India. The amendments shall be applicable to all listed companies with effect from 1 October 2014. The SEBI norms require approval of all material related party transactions by shareholders through special resolution and seem to be more onerous than the related section under the 2013 Act. The related party transactions are defined to include the following transactions: i. Sale, purchase or supply of any goods or materials ii. Selling or otherwise disposing of, or buying, property of any kind iii. Leasing of property of any kind iv. Availing or rendering of any services v. Appointment of any agents for purchase or sale of goods, materials, services or property vi. Related party’s appointment to any office or place of profit in the company, its subsidiary company or associate company vii. Underwriting the subscription of any securities or derivatives of the company. The 2013 Act has made significant amendments vis-à-vis related party transactions regarding the approval process of related party transactions. The transactions of the above mentioned nature of a company with its related parties, which are not in the ordinary course of business and which are not arm’s length would require the consent of the Board of Directors of the Company. It is expected that the Board of Directors, while approving such transactions, would keep the investors’ interest above their personal interest and discharge their fiduciary duties effectively. In case it is proved otherwise, the Act provides for serious consequences like fine and imprisonment, including class actions suit against the directors. Under the 2013 Act, prior shareholders approval by special resolution would be required in respect of related party transactions exceeding the following prescribed limits: i. Paid up share capital of the Company equals or exceeds INR 10 million; or ii. Related party transactions exceeding following threshold limits: 1 KPMG publication: Companies Act 213 – New Rules of the Game October 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.
11 Investments/loans Section 372A of the Companies Act, 1956, inter alia, contains provisions relating to (i) giving of loans by a company to any other body corporate and (ii) giving of guarantee/security, in connection with a loan made by any other person to, or to any other person by, any other body corporate. It provides a limit beyond which the aforesaid loan/guarantee/security requires previous approval of shareholders by a special resolution passed at a general meeting and approval of public financial institutions in relevant cases. The section also lays down other conditions for aforesaid loan/guarantee/security, including a stipulation of rate of interest on loan being not lower than prevailing bank rate. On the other hand, section 185 of the 2013 Act provides that no company shall, directly or indirectly, advance any loan, including any loan represented by a book debt, to any of its directors or to any other person in whom the director is interested or give any guarantee or provide any security in connection with any loan taken by him or such other person. The major change is that section 185 applies to private companies also (unlike section 295 of the Companies Act, 1956 which applies only to those private companies which were subsidiaries of public companies). Further, the explicit exemption to giving of loans by a holding company to its subsidiary and to provision of security/guarantee by a holding company for loans taken by its subsidiary has also not been retained. While this is going to cause a significant difficulty to wholly owned subsidiaries who work on the finances provided by the holding companies, it would provide alienation to the investors’ money from being exposed to risk other than those risks which were perceived by the investors while making the investment. Recently, the MCA has clarified that till the time section 372A of the Companies Act, 1956 is repealed and section 186 of the 2013 Act is notified, a holding company is allowed to give guarantee or provide security in respect of loans made by banks or financial institutions, to its wholly owned subsidiary company provided such loans are exclusively used by the subsidiary for its principal business activities. The scope of the exemption is limited as it covers only guarantees and security provided and does not extend to loans given by a holding company to its wholly owned subsidiary company. Whistle blowing mechanism Apart from the corporate governance and transparency, the 2013 Act also requires all listed companies, companies which accept deposits from the public and companies which have borrowed money from banks and public financial institutions in excess of INR 500 million, to establish a vigil mechanism for directors and employees to report genuine concerns in such manner as may be prescribed. The 2013 Act also requires that the vigil mechanism, to be put in place should provide for adequate safeguards against victimisation of persons who use such mechanism and make provision for direct access to the chairperson of the Audit Committee in appropriate or exceptional cases. This provision in the 2013 Act could help ensure that the Audit Committee gets the information of cases/situations which could jeopardise the interest of the investors and others interested in the working and operation of the company. © 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 Serious Fraud Investigation Office The entire gamut of corporate governance and transparency oriented measures in the 2013 Act would work only if there is a mechanism to monitor compliance. An investigation into the affairs of a company can be initiated by the Central Government in the following circumstances: i. on receipt of report from the Registrar of Companies or inspector ii. on intimation of a special resolution passed by the company that its affairs are required to be investigated iii. in public interest iv. on request of any department of central government or state government. The investigation into the affairs of the company can be in the hands of inspectors as appointed by the Central Government or by assignment of the case to Serious Fraud Investigation Office (SFIO). The 2013 Act gives statutory status to the SFIO. SFIO will comprise experts from various relevant disciplines including law, banking, corporate affairs, taxation, capital market, information technology and forensic audit. Investigation report of SFIO filed with the Court for framing of charges shall be treated as a report filed by a Police Officer. SFIO shall have power to arrest in respect of certain offences which attract the punishment for fraud. Recognition of SFIO would strengthen and expedite the investigation process. The legal and statutory powers vested with the SFIO and its broad-based composition with experts drawn from various relevant disciplines would help make the process more effective. Conclusion The 2013 Act contains many of the necessary ingredients to boost and safeguard the interest of a wider range of stakeholders. It will be interesting to see if 2013 Act will achieve the objectives with which these provisions were inserted into the law. © 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 Simplified hedge accounting approach Accounting for certain ‘receive-variable, pay-fixed’ interest rate swaps Companies often find it difficult to borrow fixed rate debt and rely on variable-rate debt and then enter into a receive-variable, pay-fixed interest rate swap to economically convert their variable-rate borrowing into a fixed-rate borrowing. Under U.S. Generally Accepted Accounting Principles (U.S. GAAP), a swap is a derivative instrument. Topic 815, Derivatives and Hedging, requires that an entity recognise all interest rate swaps on its balance sheet as either assets or liabilities and measure them at fair value. Topic 815 permits an entity to elect accounting method known as ‘cash flow hedge accounting’ to mitigate the income statement volatility of recording a swap’s changes in fair value, if certain requirements under that Topic are met. This hedge accounting results in presenting interest expense in the income statement as if the entity had fixed rate debt. But, many private companies contend that, due to lack of resources and difficult to understand and apply complex hedge accounting, they lack the expertise to comply with the requirements to qualify for hedge accounting. This requirement includes contemporaneous documentation at the inception of the hedge and the hedging effectiveness testing, both at the inception of the hedge and on an ongoing basis. In addition, some stakeholders also questioned the relevance and cost associated with determining and presenting the fair value of a swap that is entered into for the purpose of economically converting a variable rate borrowing to a fixed-rate borrowing. Because of the practical difficulties, many private companies do not elect to apply hedge accounting, which results in income statement volatility. The FASB1 has recently issued guidance that provides hedge accounting alternatives (i.e., the simplified hedge accounting approach) with a practical expedient to apply cash flow hedge accounting for ‘receive-variable, pay-fixed’ interest rate swaps, that are entered into for the purpose of economically converting a variable-rate borrowing into a fixed-rate borrowing to reduce income statement volatility, and address the concerns about the difficulty in understanding and applying the hedge accounting model. Scope The simplified hedge accounting apply to all entities, except for public business entities, not-for-profit entities as defined in the Master Glossary of the FASB Accounting Standards Codification, financial institutions as described in paragraph 942-320-50-1 (e.g., banks, savings and loan associations, savings banks, credit unions, finance companies, and insurance entities) and employee benefit plans within the scope of Topics 960 through 965. Requirement of simplified hedge accounting approach Under this approach, an entity may assume no ineffectiveness for ‘receive- variable, pay-fixed’ interest rate swap designated in a hedging relationship under Topic 815. This article aims to • Summarise the recently issued FASB guidance that provides hedge accounting alternatives • Explain the transition requirements. 1 Financial Accounting Standards Board © 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 This approach can be applied provided all of the following criteria are met:3 a. Both the variable rate on the swap and the borrowing are based on the same index and reset period (for example, both the swap and borrowing are based on one-month London Interbank Offered Rate [LIBOR] or both the swap and borrowing are based on three- month LIBOR). In complying with this condition, an entity is not limited to benchmark interest rates described in paragraph 815-20-25-6A. b. The terms of the swap are typical (in other words, the swap is what is generally considered to be a ‘plain- vanilla’ swap), and there is no floor or cap on the variable interest rate of the swap unless the borrowing has a comparable floor or cap. c. The repricing and settlement dates for the swap and the borrowing match or differ by no more than a few days. d. The swap’s fair value at inception (that is, at the time the derivative was executed to hedge the interest rate risk of the borrowing) is at or near zero. e. The notional amount of the swap matches the principal amount of the borrowing being hedged. In complying with this condition, the amount of the borrowing being hedged may be less than the total principal amount of the borrowing. f. All interest payments occurring on the borrowing during the term of the swap (or the effective term of the swap underlying the forward starting swap) are designated as hedged whether in total or in proportion to the principal amount of the borrowing being hedged. Application of simplified hedge accounting approach Under the simplified hedge accounting approach, a private company has the option to measure the designated swap at settlement value instead of fair value. The primary difference between settlement value and fair value is that counter-party non-performance risk is not considered in determining settlement value. One method of estimating settlement value is to perform a present value calculation of the swap’s remaining estimated cash flows using a valuation technique that is not adjusted for nonperformance risk. Companies may apply simplified hedge accounting on a swap-by-swap basis. If any of the conditions, for applying the simplified hedge accounting approach subsequently cease to be met or the relationship otherwise ceases to qualify for hedge accounting, the gain or loss on the swap in accumulated other comprehensive income will be reclassified to earnings in accordance with paragraphs 815-30-40-1 through 40-6, with the swap measured at fair value on the date of change, and subsequent changes in fair value reported in earnings in accordance with paragraph 815-10-35-2. For example, if the related variable-rate borrowing is prepaid without terminating the ‘receive- variable, pay-fixed’ interest rate swap, the gain or loss on the swap in accumulated other comprehensive income shall be reclassified to earnings. Similarly, if the ‘receive-variable, pay-fixed’ interest rate swap is terminated early without the related variable-rate borrowing being prepaid, the gain or loss on the swap in accumulated other comprehensive income shall be reclassified to earnings. Under the simplified hedge accounting approach, documentation required to qualify for hedge accounting must be completed by the date on which the first annual financial statements are available to be issued after hedge inception rather than concurrently at hedge inception. Disclosure The current disclosure requirements in Topic 815 and Topic 820 on fair value measurement continue to apply for a swap accounted for under the simplified hedge accounting approach. In order to comply with those disclosures, amounts recorded at settlement value should be used in place of fair value wherever applicable with amounts disclosed at settlement value subject to all of the same disclosure requirements as amounts disclosed at fair value. As per guidance in ASU 2014-03, a swap which has been covered under this simplified hedge accounting approach is not considered a derivative instrument under Topic 815, for the purpose of applying disclosure requirement in Topic 825, about the fair value of financial instruments. Transition The simplified hedge accounting approach is effective for annual periods beginning after 15 December 2014, and interim periods within annual periods beginning after 15 December 2015. Early adoption is permitted to existing swaps, that meet the qualifying criteria on a swap-by-swap basis, during the year the new guidance is initially applied. In determining whether an existing swap meets all of the criteria in paragraph 815-20-25-131D to qualify for applying the simplified hedge accounting approach, the criteria that the swap’s fair value at the time of application of this approach is at or near zero does not need be considered. Instead, the swap’s fair value at the time the swap was entered into (or acquired) by the company should have been at or near zero. A private company can apply either a modified retrospective approach or full retrospective approach for adopting the simplified hedge accounting approach. Under modified retrospective approach, adjustments should be made to the assets, liabilities, and opening balance of accumulated other comprehensive income and retained earnings (or other appropriate components of equity) of the current period presented to reflect application of hedge accounting from the date the ‘receive-variable pay-fixed’ interest rate swap was entered into (or acquired) by the entity. Under full retrospective approach, financial statements should be adjusted to reflect the period-specific effects of applying hedge accounting from the date the receive-variable, pay-fixed interest rate swap was entered into (or acquired) by the entity and corresponding adjustments should be made to the assets, liabilities, and opening balance of accumulated other comprehensive income and retained earnings (or other appropriate components of equity) of the earliest period presented to reflect application of hedge accounting from the date the ‘receive-variable, pay-fixed’ interest rate swap was entered into (or acquired) by the entity. Companies need to provide the disclosures in paragraphs 250-10-50-1 through 50-3, Accounting Changes and Error Corrections, in the period that the entity adopts guidance in ASU 2014-03. 2 FASB Accounting Standards Update No. 2014-03 January 2014 © 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 Year-end review The year- end review highlights major developments in accounting, disclosure and regulatory matters in India along with the new accounting and disclosure matters in International Financial Reporting Standards and United States Generally Accepted Accounting Principles. The year-end review is intended to be a reminder to our readers of developments that may affect financial statements for companies during the year ending 31 March 2014 or in future periods. We would recommend the readers refer to the official standards or other information for complete descriptions of the new requirements and their respective provisions. This article aims to • Provides a reminder of the recently issued financial reporting and regulatory developments that may affect financial statements as at 31 March 2014. © 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 Indian Generally Accepted Accounting Principles Revised Guidance Note on accounting for oil and gas producing activities Revision to the Guidance Note deals with areas where there are developments in recent times including in the nature of operations like sidetracking, farm-in farm-out, accounting matter related to impairment, greater refinement in definitions of terms specific to the industry particularly, reserves, and presentation and disclosure requirements. This revised Guidance Note comes into effect in respect of accounting periods commencing on or after 1 April 2013. Restatement of accounts due to audit qualifications Securities Exchange Board of India (SEBI) vide its circular dated 13 August 2012 mandated listed companies to submit either Form A (unqualified/matter of emphasis report) or Form B (qualified/ subject to/except for audit report) along with the Annual Report to the stock exchanges. It is also envisaged that the qualified audit reports will be scrutinised by Qualified Audit Review Committee (QARC) and if necessary, the company will be required to restate its books of accounts to provide true and fair view of its financial position. SEBI vide its circular dated 5 June 2013 has clarified that the restatement of books of accounts shall mean that the company is required to disclose the effect of revised financial accounts by way of revised pro- forma financial results immediately to the shareholders through Stock Exchange(s). The financial effects of the revision may be carried out in the annual accounts of the subsequent financial year as a prior period item so that the tax impacts, if any, can be taken care of. Revised requirements for the stock exchanges and listed companies in a scheme of arrangement under the Companies Act, 1956 Vide circular dated 21 May 2013, SEBI has provided clarification/modifications to its circular dated 4 February 2013 on revision to clause 24(f) of the equity listing agreement. As per the revised clause of the listing agreement, listed companies are required to file draft scheme of amalgamation/merger/reconstruction/ reduction of capital with the stock exchanges before submitting to High Court for approval. SEBI has now provided for clarification/ modifications which are related to requirement of valuation report, time limit available with SEBI to submit its comments to stock exchange on the draft scheme, applicability and matters related to voting by public shareholders through postal ballot and e-voting in specified cases. SEBI notifies SEBI (Issue and Listing of Non-Convertible Redeemable Preference Shares) Regulations, 2013 SEBI notifies regulations for issue and listing of redeemable preference shares vide notification dated 12 June 2013. The regulations provide for comprehensive regulatory framework for public issue and listing of non-convertible redeemable preference shares and issue and listing of perpetual non-cumulative preference shares and perpetual debt instrument, issued by banks on private placement basis in compliance with Guidelines issued by RBI. Amendments to SEBI (Buy Back of Securities) Regulations, 1998 Vide press release dated 25 June 2013, SEBI brought significant amendments to buyback of shares or other specified securities from the open market through stock exchange mechanism. Amendments relate to matters such as minimum buy-back limit, maximum buy-back period, creation of escrow limit, restriction on further raising of capital, time period for another buy-back offer, etc. Commencement of 98 Sections of Companies Act, 2013 and commencement of Section 135, Corporate Social responsibility along with Schedule VII of the Act Ministry of Corporate Affairs (MCA) issued a notification dated 12 September 2013 for commencement of 98 sections of the Companies Act, 2013. MCA also issued a notification dated 18 September 2013 which clarifies that the relevant provisions of the Companies Act, 1956 which correspond to the provisions of 98 sections of the Companies Act, 2013 cease to have effect from 12 September 2013. On 27 February 2014, MCA has notified commencement of section 135, Corporate Social responsibility along with Schedule VII of the Act, Companies (Corporate Social Responsibility Policy) Rules, 2014 and amendment to Schedule VII (Activities which may be included by companies in their Corporate Social Responsibility Policies) of the Act. As per the notifications, the aforesaid provisions will come into force with effect from 1 April 2014. Clarification on applicability of provision of Section 372A of the Companies Act, 1956 MCA vide circular dated 19 November 2013 has clarified that Section 372A of the Companies Act, 1956 dealing with inter-corporate loans continues to remain in force till Section 186 of the Companies Act, 2013 is notified. Clarification on applicability of Section 182(3) of the Companies Act, 2013 MCA vide circular dated 10 December 2013 has issued clarifications on disclosures to be made under Section 182 of the Companies Act, 2013 pursuant to the scheme relating to ‘Electoral Trust Companies’ in terms of Section (24AA) of the Income-tax Act, 1961 coming into force. MCA issues clarification on Section 185 of the Companies Act, 2013 MCA vide general circular no. 03/2014 dated 14 February 2014 has clarified that till the time section 372A of the Companies Act, 1956 is repealed and section 186 of the Companies Act, 2013 is notified, a
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