By Manish Sheth
The adoption of Indian Accounting Standard – (IndAS) has catapulted India to the centre stage of high quality and transparent financial reporting. It will also ensure comparability between the financial statements in accordance with the global accounting standards and more importantly, it will synchronize the financial statements to economic reality.
While the IndAS implementation has been deferred for banks by a year, the journey of convergence initiated by NBFCs has already begun.
Some of the key accounting implications to NBFCs are as under:
Expected Credit Loss (ECL)
As against existing methodology of rule-based provisions for credit losses, IndAS expects NBFCs to follow an expected credit loss model (ECL model), wherein the loan loss provision is calculated on the basis of the loan books historical loss experience and future expected credit loss depending on the credit quality assessment. The introduction of IndAS may lead to a significant increase in the charge to Profit and Loss account for the NBFCs having higher track record of past NPAs. Newly-formed companies will find the process of adoption of IndAS quite challenging as they dont possess historical credit risk data and may have to rely on the industry data.
The model should not only build the historical data but should also consider the forward-looking information based on the customers expected recovery patterns, time of recovery, probability of default (PD) and recovery expected from collaterals (LGD). Variety of ingredient used by NBFCs while following ECL model poses a challenge to the users in terms of its analysis and benchmarking performance amongst the peers.
Amortization of fee income under effective interest rate (EIR)
Commercial understanding at the time of any lending is always based on the concept of XIRR, which gets split between upfront fees and the yield. Under Indian GAAP, fees were getting accrued to P&L upfront whereas yield was accruing over the tenure of the loan. Under IndAS, accounts will now start reflecting the commercial understanding and hence fees generated on loans will have to be amortized over the life of the loan. This will result in a temporary deferral of revenue recognition. For the NBFCs, it means a negative impact on its profits and hence, in its net worth. Profit and Loss account will get normalize over the period.
Fair value implications on financial assets
On the date of transition, all financial assets have to be recorded in the balance sheet at fair value. The impact of fair valuation of financial assets, post initial recording in the balance sheet may have to be accounted through the statement of profit and loss (FVTPL). FVTPL could have a positive or a negative impact on the profitability of a company. More importantly, the mark to market gain or losses as on every reporting period will result in a volatility in the Profit and Loss account.
Consolidation of Subsidiaries
Some of the NBFCs have formed joint ventures (JVs) with partners. Most of them are having a shareholders agreement covering a variety of rights including veto over certain matters. These may be in the nature of protective rights. Under IndAS, one will have to evaluate the definition of “Control” based on the agreement between the partners. These may lead to some extreme situations – either consolidation of the entire balance sheet and P&L of a JV or de-consolidation of the same, as the case may be. These, in fact, will change the entire top line or the balance sheet size of an entity on a consolidated basis. In some of the extreme situations, even some of the SPVs will have to be treated as subsidiaries and need to be consolidated for e.g. securitizations trusts floated by Asset Reconstruction Companies (ARCs), over which it has “control”.
As opposed to the existing requirement of segmenting the operations of the group based on similarities of “risks and rewards”, IndAS expects financials to disclose the segments based on the managements evaluation of financial information for allocating resources and assessing performance. This is a welcome change, as it ensures that user of financial information views the exact information, which chief operating decision maker (CODM or management) uses for the purpose of strategy formulation and resource allocation.
Overall, its a welcome change but it comes with lots of challenges to the NBFCs as they will have to muddle with certain non-rule based management estimates. It also poses challenges to the entire community of the users of financial information like regulators, investors, analysts, credit rating agencies and lenders as they will have to analyse information, recreate models and take decisions based on the non-conventional reporting.
(Manish Sheth is Group CFO at JM Financial)