Bringing Financial Reporting to Life: Practical Insights for Modern CFOs
This space is dedicated to sharing my reflections and practical learnings in the area of financial reporting.
By putting these thoughts into words, I aim to clarify and reinforce key concepts—both for myself and for professionals who seek a deeper, more applied understanding of the subject.
The intent is not to teach, but to explore and engage with the evolving nuances of financial reporting.
Understanding InVITs: Classification and Financial Reporting under AS & Ind AS
I thought the first post should be about InVITs (Infrastructure Investment Trusts). InVITs are a relatively new investment instrument in India. There are about 15 InVITs, of which only two are publicly listed.
This post is mostly about the financial reporting aspect of it, and hence, the ‘what of it’ is not explained much here.
InVITs are a new investment vehicle in India that allows investors to invest in income-generating infrastructure projects like roads, airports, and power transmission lines. Regulated by SEBI, they are designed to pool investments from multiple investors and then use those funds to invest in a portfolio of assets. InVITs distribute a major portion of their income to investors, usually in the form of dividends or capital repayments.
These are gaining traction here because they offer recurring income streams and are relatively less volatile. As explained above, these InVITs are required to distribute their collections in the form of either capital repayment or dividends. (IRB InVIT offered a pre-tax yield of 17% during FY 2022)
Given the above, let’s divide the accounting aspect into classification, recording of distribution, and measurement.
For example, let’s say Company ABC has invested in 10,000 units of an InVIT. For Q4 of FY 2023, it has declared a distribution of INR 5 (Capital repayment – INR 2, Dividend – INR 3). The cost is INR 75 per unit, and the fair value is INR 80 per unit at year-end.
How to classify InVIT units under Schedule III?
Schedule 3 (Companies Act 2013) says that investment has to be classified according to its nature, i.e., equity, preference shares, etc.
InVITs fall under the residual category of the classification, i.e,. Other investments. Here, the same can be shown as ‘Investments in units of a fund’. This holds good for both AS and Ind AS.
The treatment of capital repayment vs dividend income.
This is where it is entirely different from other instruments. Taking the quoted example above, only INR 3, i.e., dividend, should be part of the profit and loss. The other distribution of INR 2, i.e., capital repayment, should be reduced from the cost of investment, and this holds good for both AS and Ind AS.
Differences in measurement between AS 13 and Ind AS
For AS, AS 13 deals with the investments. Let us assume that this is a case of short-term. Accordingly, the measurement should be either at cost or fair value, whichever is lower. Here, the cost is now INR 73 (INR 75 less INR 2), and this cost should be compared to the fair value, i.e., INR 80.
For Ind AS, the adjustment concerning the cost is the same as explained above. However, the changes in the fair value will either flow to P&L or OCI (Other comprehensive income) depending upon the classification of the instrument.
Net Worth and Framework Arbitrage in Tenders
Have you ever wondered how the financial reporting framework could have implications in the tendering process, where the net worth of the applicant is also one of the criteria?
Let’s take an example: ABC Limited and XYZ Limited have similar net worth and are both participating in the tendering process. Assume both have issued preference shares to the tune of INR 30 crores, redeemable after 10 years, and the annual fixed dividend is 15%.
The above extant case is all fine until we find that ABC Limited applies the regular Accounting Standard and XYZ Limited, being a subsidiary of another listed entity, applies the Ind AS framework. This is where it gets differential treatment. ABC Limited, by applying the AS framework and reporting requirements of Division I Schedule III, shows it under Share Capital and Reserves.
On the other hand, XYZ Limited, by applying the Ind AS framework, classifies it as ‘financial liability’.
Now, merely due to the application of differential treatments as per the respective framework, ABC Limited has gained an edge (Net worth increases by INR 30 crores). Although the net worth is not going to be the only criterion but it has an undue advantage.
Why does ‘preference share capital’ sometimes get classified as a financial liability as per Ind AS?
Ind AS considers how the holder of the instrument is ‘behaving’. In the extant case, the holder’s behaviour is akin to that of a creditor/ lender, i.e., the risk-taking ability of the holder doesn’t take precedence.
In the recent case, the High Court of Delhi has ruled that preference share capital should be classified under ‘share capital’ for the simple reason that “where redeemable preference shares are issued but not honoured when they are ripe for redemption, the holder of those shares does not automatically assume the status of a ‘creditor'”.
Now, considering the above, don’t you think the Standard Operating Procedure meant for vendor selection should incorporate & uniformity has to be ensure it from a reporting framework perspective?
PMS Investments and Disclosure Ambiguity
Let’s talk about the disclosures from the Schedule III perspective today pertaining to the investments.
Without digressing, let’s focus on what the guidance note has to say. The guidance note specifies that the investments made by the Company shall be classified on the basis of the nature, i.e., investment property, equity, preference shares, debentures, mutual funds, etc.
Explaning With Example
Company ABC, as part of its treasury management, decides to invest INR 1 Cr. Accordingly, they decide to invest through PMS (Portfolio Management Services). Let’s say that this PMS rebalances the investments every month (i.e., they decide what to sell/ buy every month). As of March 31, 2023, let’s say the investment of 1 Cr looks: 50% equity, 35% in bonds, and the balance 15% is held in cash.
What is PMS?
PMS is a service provided by financial professionals to help you invest your money. They create a customized investment plan based on your goals and risk tolerance, and then manage your portfolio by buying and selling investments on your behalf. Minimum investment size is INR 50 lakhs in India at present as per SEBI Regulations
Now, while preparing the financial statements, how will you disclose this investment? Do you take this 1 Cr and break it down and classify it under respective heads i.e., equity, bonds, etc.?
Should companies disclose based on end-use (equity, bonds) or treat PMS as one unit?
My opinion is that we should disclose it under ‘Other non-current investments’ without breaking into components for the following reasons.
- The decision to sell/ hold/ buy rests with the fund managers’ discretion.
- The Company can’t withdraw the funds partially if the capital invested falls below INR 50 lakhs (As per SEBI regulations), and hence the whole investment acts as a single bucket.
- If we were to break it and classify, where should we show ‘Cash’? Remember that calls pertaining to cash, i.e., quantum, timing, etc, are taken by the fund manager, and the Company has no say.
- This is very much akin to the mutual funds, i.e., the amount invested in mutual funds is also invested in various instruments, and part of it is also held in cash, but we don’t break it and classify.
The above holds good both in the case of AS and Ind AS.
Government Incentives: Are They Financial Assets under Ind AS?
As it is known that to classify an asset as a financial asset under Ind AS, one of the key elements is that there has to be a contractual right to receive the cash or other financial asset.
Now, this is the reason why statutorily bound assets/ liabilities do not get classified as financial assets/liabilities. Such as income tax payable, tax refunds, etc. These are shown under other current/ non-current assets (liabilities) in the financial assets.
Keeping the above in mind, how do you classify the incentives receivable from the Govt?
This could be either the state government or the Central government. Examples could be MEIS, SEIS, etc. There are differing views on this, and I have come across both cases of financial statements.
I was recently reading an article where I stumbled upon an interesting case law. Below is the gist in the least possible number of words.
The Hon’ble Supreme Court in the case of ‘State of Haryana v. M/s. Somaiya Organics (India) Ltd‘ ruled that government incentives are enforceable contracts, and the failure of the government to pay such incentives would amount to a breach of contract. The Court also held that the government’s liability to pay incentives cannot be denied on the ground of financial difficulties faced by the government.
Keeping this caselaw, how do you think the classification should be?
Impairment Testing in a High-Interest Economy: Key Audit Considerations for CGUs
The Pandemic threw a wrench into the economic climate of the world and thereby bringing it to come to a grinding halt.
As we all waited with gritted teeth to watch out for the appropriate measures to be taken by the respective governments., There came a series of announcements by and large increasing the money supply. The vicious cycle of economics is such that increasing the money supply will result in inflationary trends, and to combat this, we saw a series of rate hikes everywhere.
Without going into technicalities, an increase in inflation and interest rates will impact the way a company/country works since we are in a globalization era and not a solitary confinement. Higher interest rates will bring a lot of assets within the ambit of impairment testing.
So I thought I would list down the following important factors which have to be considered from the audit angle while testing CGU (Cash Generating Units).
Audit Considerations for Cash Generating Units (CGUs)
Price maker
The most important factor is whether the Company is a price maker. Higher interest rates will eventually result in higher input costs eating into the margins of the Company. The cash flows here depend on the ability of the Company to transfer this burden onto the customers.
This phase is an interplay between retaining the market share versus retaining the margins, the clear winner will be the one who is a price maker, i.e., who can retain the market share without impacting the margins. Read the extract below from one of the reports.
“Most companies have continued to safeguard their profit margins, demonstrating pricing power and perhaps the reason inflation is easing slower. As we wrote on Wednesday, the profits of NSE200 stocks have grown by around 9 percent (+21 percent ex commodities) according to an ICICI Securities report. “
Product mix
During the hard times, if the Company channels the resources to those products where the profitability is high, the Company will be able to pool the cash flows.
A classic example here could be that of McDonald’s, where they undertake something called ‘menu engineering’. Here, they collect data about consumer preferences and focus on high-margin products while keeping costs in check.
Default probability
The discount rate used in the calculation of DCF is a function of the risk-free rate. It is the interest rate on the long-term Govt bonds. It is important to note that one has to consider the risk-free rate of the Company where the Company is operating.
The term ‘risk-free’ implies that there would be no risk of default. However, anything can happen (Sri Lanka). One of the indicators that implies there is a risk is the CDS spread. This is the insurance on the bonds.
Cashflows
The higher interest rates should not just be reflected in the discount rates, but it has to be seen if the cash flows are going to be impacted. It is important to understand the space where the business is operating.
For example, if there is an inelastic demand for the product, as in the case of tobacco products, the demand is not affected in spite of the price increases.
I would like to end this by making some references to the book ‘Narratives and Numbers’ by Ashwath Damodaran. DCF calculations involve a lot of assumptions in the form of narratives and highly complex numbers, in which we can get lost in the way.
Hence, there has to be a balance between the narratives and numbers. Without a story, you cannot understand the numbers. However, stories create connections and get remembered, but numbers convince people.
Lease Classification: Ind AS 116 and Sub-letting Rights
Recently, while reviewing the lease agreement of the premises situated outside India, there was a clause restricting the subletting of the premises.
Now, keeping this restriction, should we not classify this as ‘leases’ under Ind AS 116? i.e. Will this hinder the lessee’s right to direct the usage of the asset?
From the point of this clause, we should consider the following:
- Does the lessee have control of the asset?
- Is this clause a protective right?
We have to look at para B24 of the standard to answer this. If the scope, such as how and for what purpose, is predetermined in the contract, an entity has the right to direct the usage of the asset throughout the period only if it has the right to operate in such a way that falls within that predetermination of ‘how’ and ‘what’. Therefore, the Company can direct the usage/ make its whimsical decisions, but within the predetermined scope.
Hence, assessing under the presumption that an asset can have innumerable uses will make it look restrictive. To put it in a better way, the scope of the contract, i.e., usage, cannot be construed as ‘restriction’.
Furthermore, the scope acts as a protective right to the lessor. This can stem from various factors such as statutory limitations. For example, in Dubai, subletting is allowed only if there is express consent from the lessee.
Why Bringing Leases on the Balance Sheet Matters
It is worthy of our appreciation to acknowledge the dynamic nature of the accounting framework.
Among the various factors that have previously kept investors and stakeholders in the dark, the deliberate exclusion of certain liabilities from balance sheets, particularly lease obligations, stands out. These liabilities are a critical aspect to consider when assessing a company’s financial health.
A significant number of investors and analysts have historically overlooked the impact of leases when evaluating leverage ratios due to their absence on the face of financial statements. Consequently, the leverage position of a company often appeared distorted. This holds particular significance for capital-intensive industries, such as the airline sector.
To address this issue and achieve the commendable objective of financial transparency, the introduction of IFRS 16/ Ind AS 116 brought about changes in the recognition of operating leases.
To illustrate the significance of these changes, let’s examine the financials of an airline company, such as Indigo.
In the case of Indigo, approximately INR 14,600 crores of liabilities were acknowledged, which were previously excluded from the balance sheet entirely.
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