Chairman of National Advisory Committee on Accounting Standards Y H Malegam, one of India’s most reputed auditors talks about four key carve-outs that India has made place for as it converges to IFRS.
Below is a verbatim transcript of the interview. Also watch the video.
Q: Can you just list for me what are the three-four key carve-outs that you have allowed for?
A: There are not too many. I would say the major carve-outs are about 4 in number and again I must explain why those carve-outs are there. There are certain standards which to us do not make sense in the Indian context and we have brought this to the attention of the International Accounting Standards Board (IASB). Other countries also have similar problems; they have also brought it to the attention of the International Accounting Standards Board. We have been personally assured by the chairman of the IASB, David Tweedie - who is a friend of mine for the last thirty years and also the Indian member on the IASB - that they are conscious of these problems but they have a very busy agenda. It is not possible for them therefore to give an immediate response to our concerns and therefore it may take some time before they address those issues. Therefore in the interim we have the option that either we adopt the standard or we have a carve-out and we thought we should have a carve-out.
Let me explain to you what these carve-outs are:
The first carve-out is on the standards on business combination. Now where this applies mainly is when you acquire another company whether it is through a merger or through an acquisition, what the standard says is that when you acquire a business, you value all those assets which you acquire at their fair value and you arrive at the aggregate of the net assets which you have acquired and then you compare that with the consideration which you are giving. If the consideration, which you are giving, is more than the value of the assets which you have acquired, you treat the difference as a good will. But if the consideration you are giving is less than the value of the assets, you assume that you made a bargain purchase and take the difference to the profit and loss account as if you made a profit. We said that is totally illogical.
So what we have carved out is we have said you first establish that there was a bargain purchase that means are there any circumstances which indicate that you made a bargain purchase. For example, was there a distressed sell, did you acquire a BIFR company. If you are satisfied that there is a bargain purchase then if you have this difference and you say you have made a gain, you recognize that gain but not to your profit and loss account because it has nothing to do with the operations of the year, you take it to other comprehensive income. However, if you are not able to establish that there are any circumstances which suggest that there is a bargain purchase then you cannot recognize this gain and take it to your profit and loss account or to other comprehensive income. That is the first one.
The second issue, which has arisen, is regarding the gain or loss on the translation of a borrowing in foreign currency. As you know, we are going to have a lot of expenditure on infrastructure development. Much of that expenditure will be financed out of external borrowings and in India if you have an external borrowing, you necessarily have to denominate in a foreign currency. This is not the position for those who have drafted the standard. If someone in the US wants to borrow abroad, he doesn’t have to issue a bond in another currency. He issues a US bond. In the UK, they issue a UK bond and in Europe, they issue a Euro bond. So they don’t have a problem of translation. Now let us assume that you have borrowed something and that money is repayable at the end of ten years. What the standard says is that each year, you translate that outstanding balance at the spot rate of exchange even though you are going to make a payment in the end of ten years. And if there is a difference, you treat that as a gain or a loss and take it to your profit and loss.
That creates a huge volatility in our profit and loss account. What we have suggested is that this assumption that at the end of ten years, you will pay at the same rate as the spot rate today is an illogical assumption. We don’t know how the rates will change. Therefore secondly the exchange gain or loss is nothing else but an additional cost of borrowing and therefore it makes more sense that if you on translation have a gain or loss, you spread this over the balance period of the loan so that is the second carve-out, which we have had.
There is a third carve-out, which has been worked out; this is on the question of fair value of liabilities. Now what the standard says is that if you borrow money and you use that money to acquire an asset or in the sense that you borrow money and say you loan that to someone else. Now if you are carrying that loan at its fair value then you are entitled to opt to carry the liability also at fair value otherwise there would be a mismatch.
Now where will a fair value of your loan change – it will change if you have given a loan, the fair value of that loan will change if interest rates change. If you have given a loan at 10% and the market rate of interest goes to 12%, value of your loan will drop and you have made a loss. But at the same time if you have borrowed money at 8% and the interest rate goes to 10% then to that extent you have made a gain, so the two would cancel out.
What they are saying is that all changes in fair value of the liability should be booked to the profit and loss account whereas we have said that a fair value for liability can change not because of a change in interest rates but it can change because of deterioration in your own performance. So suppose for example, you start making losses then your rating goes down. If your rating goes down, your cost of borrowing will move up since you borrowed at a lower rate.
You have not made any gain whereas this way you will make a gain and you take the credit to the profit and loss account. Now this is exactly what happened in Lehman Brothers. When Lehman Brothers rating changed, they made a notional gain and they distributed dividends out of that. So we said we are not prepared to accept that position and our carve-out is that we will make the adjustment to fair value for changes in interest rates but we will not make the adjustment for changes in rating. So that is the third carve-out.
The final large carve-out is – I must tell you and incidentally what we discussed about foreign currency borrowing being a problem, it is very actively agitated by South Korea also. So we are coordinating with South Korea to make a common representation to IASB.
Q: It could be a common issue with emerging markets where several companies tend to raise money?
A: Mainly South Korea has taken the lead, Japan also has mentioned about it to some extent but mainly we are coordinating with South Korea. Now the fourth issue where this problem of carve-out has come in is there is a standard on the determination of the recognition of gain or loss or the fair value of property or on construction contracts. The standard on the construction contract says that if you are doing a construction which takes you five years then you don’t wait till the end of the fifth year to book the profit; you do it on a percentage of completion basis.
Now they have given an interpretation to say that when you construct a building for one individual, in that case you can book it on a percentage of construction basis but if you construct a building and you are selling an ownership flat, they say the sale of the flat is not a construction contract, it is a sale of a goods or product.
Therefore, you can book the profit only when you handover possession of the flat. This would create a lot of problems for industry. First is, conceptually we think it is wrong because when you are selling a flat, you cannot sell a flat except by also having an access to a lot of common facilities- the lifts, the sewage system, the water supply, the electricity- all of that is part of that building. So to say that when I am selling a flat, it is like selling a motorcar or selling an air-conditioner is not correct and if you adopt this practice, what would happen is that the construction companies would have to defer the booking of the profit only till the flat is sold or possession is handed over which would create a lot of volatility.
So all countries, where there is large construction going on, are facing these problems. So Malaysia also has the same problem and they have also said we will not adopt this standard or this interpretation and we have said we will not adopt it.
Q: So these are the four main carve-outs and I think it will be fair to expect that if you have approved them and NACAS has approved them, this is what the ultimate situation is likely to be when the standards get notified?
A: Yes, exactly.