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IND-AS: Service Concession Arrangements

Published on Tue, Jun 02,2015 | 21:38, Updated at Tue, Jun 02 at 21:38Source : 

By: Santosh Maller, senior professional with member firm of EY Global

Infrastructure, including roads, ports and airports, play an important role in a country’s economic growth. To encourage private sector participation in infrastructure development, governments have formulated many public-private-partnership schemes.  A build, operate, transfer (BOT)/build, own, operate and transfer (BOOT) arrangement typically entails a private sector company (operator) constructing/upgrading infrastructure, as well as operating and maintaining it for a specific period. At the end of the arrangement, the infrastructure asset may be transferred to the government body (grantor). Under the arrangement, the operator may either get a right to charge the users of infrastructure (toll charges), or the grantor may pay specific periodic amounts (annuity payments) to the operator.

Current Practice Under Indian GAAP
No notified accounting standard deals with the subject under Indian GAAP. In 2014, the ICAI issued an exposure draft Guidance note on Accounting for Service Concession Arrangements by Concessionaires which has not yet been finalised.  In absence of authoritative guidance, differing practices seem to have emerged to account for such arrangements and many companies seem to have followed differing practices. For instance, some companies have recognized “infrastructure asset” as a fixed asset, while others have recognized it as an intangible asset. Many companies do not recognize any revenue and profits during construction period.

Typically, the grantor requires each BOT/BOOT project to be carried out by a separate legal entity. To comply with this requirement, groups engaged in infrastructure activities constitute a separate special purpose vehicle (SPV) for undertaking each project. In many cases, the SPV outsources all or a significant part of construction activity to its parent. This results in the recognition of significant construction revenue in separate financial statements (SFS) of the parent. In consolidated financial statements (CFS) all intra-group balances and intra-group transactions and resulting unrealized profits may get eliminated in full. Consequently, a group entity may have significantly lower revenue and profit in the CFS vis-à-vis the SFS of the parent.

Overview Of Ind-AS Requirements
Under Ind-AS, Appendix C Service Concession Arrangements of Ind-AS 115 Revenue from Contracts with Customers (the Appendix) applies to public-to-private SCAs if they satisfy both the following conditions:
a.    Grantor controls or regulates what services the operator must provide with the infrastructure, to whom it must provide them and at what price.
b.    Grantor controls, through ownership, beneficial entitlement or otherwise, any significant residual interest in infrastructure at the end of the arrangement period.

The Appendix states that a feature of these SCAs is the public service nature of the obligation undertaken by the operator. Public policy is for the services related to the infrastructure to be provided to the public, irrespective of the identity of the party that operates the services.

The operators do not have a right to control the use of infrastructure, due to which such assets should not be recognized as its property, plant and equipment. The operator acts as a service provider under the arrangement. It constructs/upgrades (construction service) the infrastructure used to provide public service, as well as operates and maintains (operation services) the same for a specified period. Hence, it will recognize and measure revenue arising from construction and operation services in accordance with Ind-AS 115. The operator may receive (a) intangible assets (right to collect toll charges), (b) finance asset (right to receive annuity payments, for example, from the government authority), or (c) both against the services rendered. Hence, it will recognize consideration receivable as such in the financial statements. Under the intangible asset model, toll charges collected from users are recognized as revenue. Simultaneously, the company charges the amortization of intangible asset to the statement of profit and loss. The financial asset model works similar to accounting for finance lease receivables, where amounts received are allocated between capital recovery and interest using effective interest method.

Negative Grants
Certain arrangements include the provision for negative grants, wherein the operator is required to make the payment to the grantor during the duration of the arrangement. Negative grant may be either in the form of fixed payment (upfront or annual throughout the SCA) or in the form of a percentage of revenue earned during the arrangement. A company is required to evaluate whether upfront fixed payment should be treated as an intangible asset given that it is paid towards getting the right to earn revenues by running the infrastructure during SCA and in case of annual fixed payment, whether to recognize intangible assets by crediting the liability with present value of the annual amounts payable during SCA. On the other hand, where the negative grant is in the form of share in the percentage of revenue earned during SCA, the company should assess whether the revenue is to be shown on a net or gross basis.

First-Time Adoption
First-time adoption Ind-AS standard requires the Appendix to be generally applied retrospectively. However, there is an exemption in cases where it is not practical to apply the requirements retrospectively, for example, if the determination of fair value of construction or other services is impractical. In such cases, the following treatment is applied:
-    Recognise financial and intangible assets that existed at the date of transition
-    Use Indian GAAP amounts as carrying amount at that date (no matter how previously classified)
-    Test the financial and intangible assets recognised at that date for impairment
This exemption is not a free choice and is applicable only where retrospective application is not practical.

Impact On Balance Sheet Ratios And Profit Forecasts
Since the accounting model required by the Appendix is significantly different from the traditional “fixed asset” model, it is critical to determine whether an arrangement falls within its scope. This is not always straightforward due to the complexity of the contracts setting out key terms of the SCA. One challenge that may arise is in determining whether the government body controls any significant residual interest in the infrastructure asset at the end of the concession arrangement. Firstly, it may not be clear whether there is any significant residual interest in the asset at the end of the arrangement, particularly if the assets are subject to wear and tear (example, toll roads) and the arrangement is for a long period of time. Secondly, control could be represented by an option with the grantor to purchase the asset back at fair value from the operator at the end of the concession. The Appendix acknowledges that the grantor's control over any significant residual interest should both restrict the operator's practical ability to sell or pledge the infrastructure and give the grantor a continuing right of use throughout the period of the arrangement.

Companies that enter into SCAs may wish to consider at the tendering and planning stage whether the structure of the contract will require accounting as per the Appendix or not, to enable them to forecast the impact on balance sheet ratios and profit forecasts.

Impact On Revenue
Classification of the arrangement into intangible or financial asset will have a significant impact on the contract revenues recognized. For example, accounting under the intangible model would give rise to double the revenues compared to a contract with nearly identical cash flows that is accounted for using the financial asset model. Selection of the model to be applied is not an option. Rather, the model flows from whether the operator has the right to charge for services (intangible model) or the right to receive cash flows from the grantor (financial asset). This may require careful analysis, since a contract that initially appears to fall within the intangible model may have an element of guaranteed cash flows. For example, if during early years of the contract, the government body guarantees a minimum level of revenues from the operation of a new expressway to encourage private investment, there may be both a financial asset and an intangible asset. Accounting for these “combined model” concessions may involve dividing costs and revenues into the two components of the contract which may involve use of significant management judgment and estimations.

Estimates And Fair Values
Accounting for concession arrangements typically involves an extensive use of estimates and valuations, which are expected to have a significant impact on the company’s financial statements. For example, construction revenues and costs need to be recognized for construction of the infrastructure. Since the contract is unlikely to specify separately the revenue from construction, it is necessary to allocate the contract revenues into various distinct individual performance obligations, i.e., construction, operations, maintenance, etc. based on their relative stand-alone selling prices. Companies may need to use either internal or external benchmarking for similar contracts, since an assessment of profitability on a SCA is normally made on an overall IRR basis and not separately for the construction and operation phases of the project.

Further, under intangible asset model may involve obtaining a fair valuation of any assets contributed/ services rendered by the operator as well as estimates of future cash flows arising from the right to use the asset. Resulting intangible asset will be subject to future impairment tests.

Possible Implications On Taxes And Revenue-Sharing Levies
Under the Appendix, the operator initially accounts for the arrangement as a rendering of construction service in exchange of the intangible asset or financial asset. The recognition of construction revenue before the project is operational may have significant tax consequence.

It would have an impact on companies covered under minimum alternative tax (MAT) under the Income Tax Act, since there will be construction revenue and profit in books during pre-operational phase of the project. In non-MAT scenarios, treatment under Income Computation and Disclosure Standards (ICDS), is not adequately clear at the moment, since there is no specific ICDS standard dealing with SCAs. Operators would have to closely monitor the developments under ICDS.

Under indirect tax laws, there have been recent judicial pronouncements on whether the operator in a BOT contract can be construed as a ‘dealer’ for the purpose of assessment of VAT/works contract tax. Upon application of the Appendix, operators would have to examine whether and the extent to which their indirect tax positions are likely to be affected, for example, the value on which and at what point VAT would be potentially levied.

Many SCAs require operators to pay levies on revenue-sharing basis i.e. operator pays a percentage of revenues to the government. Upon application of the Appendix, under the intangible asset, as discussed above, there is “double accounting” for revenues – initially as construction services and later as operations revenue. Operators will have to examine whether this gives rise to additional revenue-sharing obligations.

Implications &  Communication With Investors And Other Stakeholders
Contracts accounted for under the Appendix may impact availability of project finance. The property, plant and equipment will be de-recognized from its balance sheet and replaced with a financial or an intangible asset or a combination of both. Also, accounting for SCAs will result in a mismatch between book profits and actual cash flows, particularly in case of an intangible asset model where profits on construction may be recognized in advance of the actual operating cash inflows. Operators would initially have construction revenues and profits, without necessarily having cash resources to pay dividends. Therefore, institutions and shareholders may need to be educated to focus attention on cash flows instead of fixed assets and profits. Companies will need to also review loan covenants to assess whether the terms need to be adjusted in light of the Appendix.

Impact On IT Systems
Application of the Appendix may require significant changes to accounting process and controls. For example, for large-scale projects, it may be necessary to implement a separate IT module to deal with the estimation processes for construction revenues and the matching of future revenues against related assets. Management needs to decide whether internal management reporting is required to be aligned with Ind-AS requirements.


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