Why are Convertible Bonds more appealing than Equity or Debt?

Hello finance professionals! Today let’s talk about why Convertible Bonds are once again picking up steam as a popular investing choice for institutional investors, venture capitalists and equity investors.

Amidst the volatile markets of the pandemic, a huge number of start-ups and companies with a cash-crunch found that raising money through hybrid instruments like convertible bonds was a more lucrative choice compared to traditional equity or debt. And the numbers don’t lie. In the year 2020, more than $188 billion in convertible bonds were issued worldwide.

Interestingly, the last time the world saw such a surge in popularity of convertible bonds was way back in 2008 (during another time of global uncertainty), when the amount of convertible debt issued was more than $86 billion.

To understand the business advantages of issuing convertible bonds, let’s take the example of Southwest Airlines.

Southwest Airlines offers customers the flexibility of high-speed transport with frequent and flexible departures at low-cost prices, focusing on friendly service, speed, and frequent point-to-point departures; without incurring extra costs in providing meals and lounge service.

In this way, they managed to become the country’s largest domestic air carrier, capturing more than 25% share of the domestic air travel market in the US, with this strategy that has proved effective for almost 5 decades.

When global travel was halted in April 2020, Southwest issued $2.3 billion 1.25% convertible note (due in 2025), to help the company with an influx of cash which would help it tide uncertain times. The conversion price was set at $38.48 per share.
Note: the market price of the share around that time was approximately $28. As of 16 November 2021, the share price was hovering around $48.

Why are convertible bonds so popular during volatile times?

For Companies:

–        Lower revenues due to imposed lockdowns and travel restrictions

–        Uncertain times lead to higher cash flow burn rates

–        Liquidity crunches faced in difficult times

–        Effective way of raising capital for start-ups and unproven businesses that are in capital-draining businesses

–        Ownership is not immediately diluted, unlike an issue of equity

–        The interest rate offered can be lower as compared to an out-and-out bond since investors are provided with the equity upside

For Investors:

–        Those who expect the company to do well and make a healthy turn-around, find convertible debt to be an attractive option.

–        Such a “recovery type trade” or “rescue finance” invariably offers more equity upside: the option to convert into stock once the stock prices bounce back is more valuable than redeeming the value in cash.

–        The stock option within a convertible debt is always priced at the mid-point, reflecting both: the demand for the convertible instrument, the recovery potential of the company as well as taking cognizance of the current market situation

 

Thus to put it simply, convertible Debentures offer the advantages of equity while negating the risk of uncertainty with its bond-like features.
It enables investors to be a part of the growth or turnaround story of the company without the inherent risks of traditional equity investing.

More about the Instrument: Convertible Debt

Just like any other debt or bond, convertible debentures are issued with a fixed coupon rate, a maturity date, and a redemption value. They also include a conversion option (at the option of the holder or the issuer) which allows an exchange of a certain number of shares of the issuer’s company at the time of redemption of debentures instead of cash.

When will the bonds convert (and how will an investor gain from it)?

The conversion price of the convertible bond at the time of its issue is typically more than the company’s current stock price. As we saw in Southwest’s case, the conversion price was $38.48 compared to the stock price at that time of $28). At the date of redemption, there are two possibilities:

  1. The share price rises: The fair value of the convertible bond will also increase as it has a direct relationship with the movements of the share price.
  2. The share price decreases: The investor will still get the agreed upon conversion value. This par value of the bond, which will prevent the holder from Equity-risk, is known as “Bond Floor”.

The conversion ratio of such instruments is generally set at a price which is at a premium of around 30-40% of the existing share price. Thus the option is “out of the money” (see the red area in the chart above) until the share price goes above the bond floor price (PV of coupon payments and par value of the instrument).

Now that we’ve discussed convertible bonds at length, let us find out how they’re presented and accounted for as per IFRS 9, with a simple example:

Let’s assume Sunshine Ltd. issued 1,000 nos. convertible bonds maturing in 5 years, with a face value of INR 1,000 each. They carry a coupon rate of 4% per annum, payable annually at the end of the year.

At the option of the holder, the bonds can be converted into equity shares instead of cash redemption at the end of 5 years.

The total proceeds received are thus INR 10,00,000. Market rate of interest for bonds without a conversion option is 6%.

Classification as per IFRS 9: It is a compound financial instrument as it contains the below 2 elements:

  • Liability component = Sunshine’s obligation to pay fixed coupon & redemption value in cash (if the holder chooses that option)
  • Equity component = Bond holder’s option to get the bonds converted into shares after 5 years (instead of a fixed cash amount)

 

Now that we have understood the concept, let us see how to account for this compound financial instrument:

Step 1 Determine fair value of the liability component. Make a simple table of Discounted Cash Flows.

Year

Coupon (4% x 10,00,000)

Principal Repayment

Total Cash Flow

Discounting Factor (at 6%)

Present Value

1

40,000

 

40,000

0.9434

37,736

2

40,000

 

40,000

0.8900

35,600

3

40,000

 

40,000

0.8396

33,585

4

40,000

 

40,000

0.7921

31,684

5

40,000

10,00,000

10,40,000

0.7473

7,77,148

 

 

 

 

Total

9,15,753

 

Thus, present value of the liability component is INR 9,15,753.

Step 2 – Assign remaining residual value to the equity component.

The residual amount of INR 84,247 (10,00,000 – 9,15,753) is thus, the equity component.

Step 3 – Accounting Entry for Initial Recognition

Particulars

Debit

Credit

Cash

10,00,000

 

     To Convertible Bond

 

9,15,753

     To Equity (Convertible Bond)

 

84,247


After initial recognition, the equity component will not be re-measured. The liability component will be accounted for at effective interest rate method as per IFRS 9.

Put on Your Thinking Cap!

  • Are you aware of any start-up that has recently raised capital through hybrid instruments? (let me know in the comments below!)
  • Did you know that until recently even Tesla Motors used to be a big issuer of convertible debt instruments?

If you have any doubts or if you’d like to discuss IFRS 9, feel free to drop me a line on my LinkedIn profile! Lastly, if you think this article would prove useful to someone, do share it with them.

Sources: The Economist, Bloomberg, Blue Ocean Strategy by Harvard Business Review Press, Investopedia.com, Calamos Investments.

How Misinterpretation & Non-Compliance of IFRS can cost you dearly!

Hello fellow-finance professional!
I wanted to share a few astonishing facts from an interesting session that I recently conducted on IFRS 9 – Financial Instruments:

  • In India, the estimated cost of financial non-compliance across financial firms was $5.5 billion in 2020
  • Businesses in the U.S. have spent $10,000 per employee on an average on regulatory costs (These include fines, penalties, litigations, arbitrations and other financial damages).
  • In the five-year period between 2013-14 and 2017-18, India Inc’s regulatory compliance costs have increased by 56.73% (from INR 14,486 crores to INR 22,705 crores). This percentage has been increasing since then. (Interestingly, this was also the time that IFRS was first implemented in India – through IndAS)
  • On a year-on-year basis, legal and professional fees went up by more than 4%.

What is the biggest reason behind such non-compliance?

The top reasons that have been identified behind non-compliance by corporates are:

  • Lack of knowledge of the regulatory laws and reporting practices.
  • Incorrect understanding of the regulatory requirements.
  • Failing to practically implement the laws and regulations accurately.

Under these circumstances, corporates place high value on employees who can help avoid or prevent companies from incurring such high regulatory costs!

Hence, it becomes imperative for finance professionals to acquire a thorough understanding of the Financial Reporting Framework, so that they can add significant value to their firm, and shine as a professional.

In a previous blog, I discussed how to determine if preference shares are debt or equity, and some real-world examples on their effect on the Debt-Equity ratio of a company. Read it here!

Today, we will find out how misinterpreting IFRS 9 led this large private-sector bank to be slammed with an INR 2 crore penalty!

As per the Reserve Bank’s licensing norms, a private bank’s promoter holding has to be brought down to 40% within 3 years of operations, 20% within 10 years and 15% within 15 years.

In line of this, RBI mandated Kotak Mahindra Bank Limited to reduce its promoter shareholding to 20% by December 31, 2018. To comply with the same, Kotak issued perpetual non-convertible preference shares which it said would reduce promoter stake from 30.3% to 19.7%.

The bank was of the opinion that this class of preference shared would be a financial liability and will not form part of equity. However, for preference shares to be considered as liability or debt, the following must also be true:

– there must be fixed percentage of dividend, and a contractual obligation to deliver cash
– the bank (issuer) must mandatorily redeem the preference shares for a fixed/determinable amount at a future date
– the holder must have the right to require the bank (issuer) to redeem the shares at a future date for a fixed/determinable amount.

In the absence of the above, the RBI did not agree with the classification of the instrument as a financial liability and maintained that the class of instruments continued to be “equity” instruments, with the promoters retaining their voting rights and stake.
The Reserve Bank went on to impose a penalty of INR 2 crores on Kotak Mahindra Bank Limited for non-compliance in dilution of promoter’s shareholding!

This is how the implications of IFRS 9 with regards to classification of Financial instruments, can have significant financial and legal impact on your business!

Put on Your Thinking Cap!

After understanding how misinterpreting the reporting standards can have a grave financial as well legal impact on companies, I hope you will now be able to assess:

  • Whether such class of preference shares exist in your organization?
  • Whether you have classified it accordingly?
  • Have you identified any areas which are highly vulnerable to non-compliance in your organizations?
  • What steps are you taking to ensure that you and your team comply with all regulations and Reporting Framework accurately?
  • Do you feel the need to take an experts advice while interpreting Financial Reporting Standards in your organization?

I would love to discuss these in detail with you. If you have any doubts or if you’d like to discuss IFRS 9, feel free to drop me a line on my LinkedIn profile! Lastly, if you think this article would prove useful to someone, do share it with them.

 

(^Sources: Mint, Lexisnexis, Economic Times, hyperproof, forbes, BusinessStandard, Reuters)

Can IFRS 9 – Financial Instruments impact your Company’s Existing Leverage Ratio?

While it is a general perception in the financial world that IFRS 9 – Financial Instruments could result in volatility in reported income of many companies (on account of assets being measured at fair value, and resulting change being reflected in the statement of profit and loss) – there is another significant impact of this standard on the “leverage” ratio on the financial statements of many companies.

What is leverage and leverage ratio?

In business terms, leverage means debt i.e., external fund (Borrowing) can be “leveraged” to increase the returns of a company. One of the most important leverage indicators (the Debt-to-Equity ratio) essentially shows the proportion of a company’s funds sourced from debt and how much are sourced through owners’ equity.

What is an optimal Debt-to-Equity ratio?

Exactly how much debt is ideal for a business depends on the company’s requirements from time to time and the company’s nature of operations.

For instance, capital-intensive industries such as manufacturing commonly have higher levels of debt than say, a company operating in the service industry such as Information Technology industry.

A classic example of the above: The Debt-to-Equity ratio of Tata Motors as of 31 March 2021 was 2.08 times (meaning debt is twice the amount of shareholder capital). Since the company is an automobile manufacturer requiring heavy infrastructure generally requires higher debt to fund the purpose of operating assets. As the borrowings are backed by capital assets a leverage of more than 2 times would not be so alarming.

In contrast, the Debt-to-Equity ratio of Tata Consultancy Services is 0, despite being a part of the same group of companies (Tata Sons). This proves that what is regarded as a healthy Debt-to-Equity ratio will vary from industry to industry and business to business!

An interesting point to consider here is: Do you think TCS is over-relying on equity funding? Let me know in the comments!

How one of the biggest Indian conglomerates aspires to become a debt-free company!

In a bold (and boastful?) move, Reliance Industries Ltd. chairman Mukesh Ambani declared in July 2020 that RIL had ambitions to become Net Debt-free! Which essentially meant the company had enough cash and marketable securities to pay off its existing debt.

To that end, the company repaid more than USD 21 Billion of its debt after raising over USD 44.4 billion of capital (including noteworthy investors like Facebook and Google’s acquisition of around 18% stake in Jio worth USD 10.2 billion), which was the largest ever capital raised by any company in a year globally.

This resulted in a decrease of more than 35% in the debt-to-equity ratio from 0.65 in March 2020 to 0.41 in March 2021!

A Major wave of Deleverage in the Steel Industry!

Another recent example of de-leveraging: While an increase in global steel prices might have been a cause of concern for end-consumers, it was a dream run for the major steel players in India, who went on a de-leveraging spree – managing to pay off a whopping 15% to 35% of their total debt by taking advantage of the global price rise! The below table illustrates the considerable decrease in Debt-to-Equity ratio for this capital-intensive industry:

Why is the Debt-to-Equity ratio an important financial metric?

  • The debt-to-equity ratio is often used while applying for a business loan or line of credit. Banks will take an account of the industry’s average ratio and compare the same with the company’s debt equity ratio to determine the credibility of the business.
  • For investors, the debt-to-equity ratio is used to indicate how risky it is to invest in a company.
    Generally, the higher the debt-to-equity ratio, the riskier the investment since it indicates that the company already has a significant amount of debt – however this must be assessed in conjunction with the industry standard.
  • It can help lenders to ascertain on whether to impose a debt covenant on the borrower i.e., (placing restrictions on the overall borrowing limits of the borrower while lending them money) – Often these limits are monitored by the debt-to-equity ratio.

Now that we have understood the significance of Debt-Equity ratio, let’s understand how IFRS and its principle of substance over form can impact the leverage ratio even without raising any additional capital!

How a major entertainment conglomerate’s Debt Equity ratio was adversely impacted after adopting IFRS 9?

Pre-Ind AS Scenario:

The said entertainment conglomerate had in its balance sheet “redeemable preference shares” which are preference shares issued to shareholders having a callable option implanted by default. This implies that the company can repurchase this class of shares against cash from the shareholders at the end of a fixed term.

The price at which a company can repurchase these redeemable preference shares is already decided at the time of issuing such shares.

Before the adoption of Ind AS (Converged IFRS), Redeemable preference shares were classified and accounted in the Financial Statements under “Equity”.

Impact of IFRS 9: In 2015, post the first-time implementation of Ind AS / IFRS, the media conglomerate (Zee Entertainment) had to classify their Redeemable Preference Shares as Debt which adversely impacted their Debt Equity ratio (leverage) by 0.6 times (vs. 0 times)!

This is because as per IFRS 9, Compulsorily Redeemable Preference Shares contain an “Obligation to pay” and therefore had to be classified as debt in the Financial Statements!

As a stakeholder, this would also mean that the Preference share dividend would now be recognized as an interest expense in the Statement of Profit & Loss instead of being an appropriation out of profit as was the case earlier.

What ‘Substance over Form’ principles would be taken into consideration in determining if Preference shares are Debt or Equity?

  • Are the preference shares redeemable at a fixed date?
  • Does the option to redeem held by the holder of the shares?
  • Are the payments to be made (whether as interest or dividends) mandatory for the issuer?
  • Whether a specific percentage of profit obligated to be distributed to the holders?

When the answer to the above questions is yes, the preference shares would be recognized as a Financial liability (Debt) as per IFRS 9. This is because the issuer has a definite obligation of delivering a financial asset or cash to the holders of the instrument. However, if the answers to the above questions are mixed, then the classification would vary from case to case.

Put on Your Thinking Cap!

After understanding the implications of IFRS 9 on debt-equity ratios, I hope you will now be able to assess:

  • Whether such class of Preference shares exist in your organization?
  • Whether you have classified it accordingly?
  • If classified correctly, whether you have been accounting for it appropriately?
  • Did such a reclassification impact your company’s leverage ratio?

I would love to discuss these in detail with you. If you have any doubts or if you’d like to discuss IFRS 9, feel free to drop me a line on my LinkedIn profile! Lastly, if you think this article would prove useful to someone, do share it with them.

We keep conducting 3-hour intense workshops on IFRS 9 for keen learners – keep a check on the next one HERE.

Impact of Contracts Modification on Manufacturing Companies Under IFRS 15

One of the critical IFRS standards, IFRS 15, is based on the revenue from contracts with customers. While the ultimate goal of this standard is to achieve revenue recognition, there are different criteria that need to be fulfilled for the same. For example, the important things to be in order are as described under:

  • The selling price is fixed or determinable from the company to the customer
  • A reasonable evidence of the arrangement is in place between the company and the consumer
  • Final rendering of services or delivery of products has happened

While many companies still do not realise the impact of IFRS 15, it is crucial to note that companies belonging to different sectors may have to focus on different aspects of this important IFRS standard. Say for manufacturing companies, there will be cases when they are required to deliver their total order in short bursts – i.e., delivering some quantity at regular intervals of time, especially for very large orders. Let us understand the potential impact of IFRS 15 on a manufacturing company that has a contract in place with a customer for one of its products and then the contract undergoes modification for the same product.

Scenario

Take for example, a manufacturing company ABC that produces office chairs. It has an order of 900 chairs for total cost of INR 9,00,000 (INR 1000 per chair) from two different IT companies XYZ and DEF. For these orders, there is one contract each in place between ABC and the respective companies XYZ and DEF. Considering the magnitude of the order, the manufacturer (ABC) agrees to deliver equal number of chairs in 3 separate phases (over next three months) – making it 300 chairs per delivery for both the customers.

Now, after the first delivery of 300 chairs, XYZ demands for an additional 300 chairs over and above the earlier order of 900 chairs. For this additional order, ABC offers a volume discount to XYZ (a discount it normally offers to most of its clients ordering similar quantity of chairs), making it INR 900 per chair (total INR 2,70,000 for 300 chairs). So, they modify the contract for a total order of 1200 office chairs.

At the same time, after first delivery of 300 chairs, DEF demands for the same number of additional chairs (300) over and above the initial order of 900 chairs. Now, ABC decides to give a better volume discount to DEF as it expects more bulk orders from this particular client. So, it decides to offer the additional 300 chairs at just INR 800 per chair (total INR 2,40,000 for 300 chairs).

In such a scenario, how will the revenue be accounted for from the contract between ABC and XYZ, as well as from the contract between ABC and DEF, considering the entire order gets delivered that year?

Under Earlier Guidelines of IAS 18

In case of IAS 18, the revenue for the order delivery is taken into account at the time of delivery, and there is no requirement to consider stand-alone selling price of the products for the add-on order.

Revenue for that year (under IAS 18) from contract between ABC and XYZ =

INR 9,00,000 for the initial order of 900 chairs + INR 2,70,000 for the additional order of 300 chairs = INR 11,70,000 (for all the 1200 office chairs delivered)

Revenue for that year (under IAS 18) from contract between ABC and DEF =

INR 9,00,000 for the initial order of 900 chairs + INR 2,40,000 for the additional order of 300 chairs = INR 11,40,000 (for all the 1200 office chairs delivered)

Under New Rules of IFRS 15

In case of IFRS 15, this typical contract modification can be classified into two types:

1.Separate Contract

2.Not a Separate Contract

The contract modification is considered as a separate contract (original contract is considered as it is) when the following is fulfilled:

  • The add-on products / services in the contract modification should be distinct from the products / services in the original contract.
  • Amount considered for the products / services in the additional order should reflect the stand-alone selling price of those products / services.

If any or both of the above two criteria for a separate contract are not fulfilled, then, the contract modification is not a separate contract.

For the above scenario, the first criteria is met since the office chairs in the additional order are distinct from the ones in the initial order. So, the revenue recognition for the order from companies XYZ and DEF depends wholly on the second criteria about the amount of products (chairs) reflecting their stand-alone selling price.

For XYZ, the discount offered is a standard one which the manufacturer generally offers to every customer ordering this number of office chairs. Here, the price quoted in the add-on order reflects the stand-alone selling price of these office chairs. Thus, the subsequent contract modification is considered as a separate contract (resulting in the price change being considered only for the additional chairs ordered) and we have the calculation as under:

Revenue for that year (under IFRS 15) from contract between ABC and XYZ =

INR 9,00,000 for the initial order of 900 chairs + INR 2,70,000 for the additional order of 300 chairs = INR 11,70,000 (for all the 1200 office chairs delivered)

However, for DEF, the discount offered is much higher than the normal discount that the manufacturer offers generally to its customers, because it expects a long- term association with DEF. So, in this case, the price quoted for the chairs in the add-on order does not reflect their stand-alone selling price. Thus, the subsequent contract modification is considered as not a separate contract, but a part of the original contract itself. In simple words, the price change becomes applicable not only for the additional chairs ordered, but also for the chairs ordered as part of the original contract that were not delivered at the time of contract modification. So, we practically have to consider the revenue recognition before contract modification and after contract modification as under (for contract of ABC with DEF):

  1. Before contract modification

Transaction price = INR 3,00,000 for the 300 chairs delivered from the initial order (before contract modification; at INR 1000 per chair)

      2.  After contract modification

Overall Transaction price = INR 6,00,000 for the 600 chairs that were undelivered from the initial order (at the time of contract modification; at original price of INR 1000 per chair) + INR 2,40,000 (for the additional 300 chairs at discounted price of INR 800 per chair) = INR 8,40,000 for 900 chairs delivered after the contract modification

Thus, the price per chair post contract modification comes out to be INR 933. 33 ( 8,40,000 / 900). Thus, final revenue recognition for contract modification between ABC and DEF is done as under:

Revenue for that year (under IFRS 15) from contract between ABC and DEF =

INR 3,00,000 for the 300 chairs delivered from the initial order (before contract modification; at INR 1000 per chair) + INR 8,39,997 for the 900 chairs delivered after contract modification (at INR 933.33 per chair)

= INR 11,39,997 (for the total 1200 chairs)

 

Final Takeaway

Upon above comparison, the total revenue for contract between ABC and XYZ is the same under IAS 18 and under IFRS 15. And it is the same case for contract between ABC and DEF. So, what has been the impact of IFRS 15? Well, the timing of revenue is quite different. And this can have a significant impact on the taxes, financial ratios, dividends, etc. And as a manufacturing company, you need to be cautious about several things such as:

-Whether to recognize revenue over a period of time or at that point of time?

-How to take into account the contract modifications?

-How do you offer volume discounts to your customers?

 

To learn IFRS 15 and other IFRS standards from the industry subject matter experts, do check out our IFRS Acumen and Diploma in IFRS courses.

Cheers!

Ramanujam Narayan

Business Head – Finance First | CFO – ConTeTra Universal LLP

Lease Accounting – Aspects No One is Talking About

Ind AS 116 – Leases, has already become effective for Companies from April 1, 2019. For listed Companies, this means that the results they declare for Q1 2019 must factor the effect of the new lease standards. Whereas the unlisted Companies have time till the declaration of their annual results for the adoption of the Standard.

Ever since the new Standard is released, there have been many articles which highlight what are the effects of the Standard on a company’s financial statement. So, unless you live under a rock, you would have already heard about it. To bring you up to speed, some significant implications of the new Standard are:

1.      No operating lease – all leases will be accounted as a finance lease.

2.      EBITDA Enlightenment – With rent expense converted to interest expense and depreciation, the EBITDA will show an improvement. (Well, a point to note is, EBITDA is a non-GAAP measure, i.e. not shown on the face of Statement of profit and loss. So, it’s a measure used by analysts and investors, don’t know why as interest and depreciation are recurring charge of running a business)

3.      Changing the ratios – the lease standard brings in newer assets (Right-of-use) and liability (lease liability) leading to change in important ratios such as Return on Assets and Debt-Equity ratio. This has called for corporates having loan covenants to immediately reach out to their lenders and re-discuss these relevant matrices unless they want to end up breaching the covenant and face hassles that go with it. (Well, some people do like excitement.)

Now let us take a more in-depth look at some finer points in this new lease standard which we do not hear so much about. These are the bitter nuances not discussed in boardroom (because they are boring – I meant the details, not the board members), and expected to the handled by the finance team, who were not nominated for any Ind AS / IFRS training as they are busy working on these new Standard (Huh, the irony!).

So, here are 4 such critical aspects that should help you get a better grip on the Standard (there are many more pointers, but I think these 4 can help you get started). All these points are from the lessee perspective (come on, who talks about lessors anyway!)

 

1.     Short term leases or Underlying asset value is low (optional) –

a.      Short term lease is a lease, at the commencement date, has a lease term of 12 months or less and does not contain a purchase option. Not the remaining lease term on the date of transition or period end but the total lease term estimated on inception is considered.

b.     Assets are be considered as low value in absolute term. Some examples of low value assets as given by the Standard are – tablet, personal computer, small items of office furniture and telephones.

In case of short term lease or leases with underlying asset value is low, the Standard provides an option to either account it as operating lease or account it is Right-of-use.

What many have assumed is that if the lease fits into either of this category then it must be accounted as operating lease. Unless one realizes that this is an option they are likely to make incorrect decision.

This is a good option to not let your loan-covenants get affected and avoid lender discussion by opting the operating lease accounting. Like-wise it may be more prudent for companies to account for all lease (even if they belong to this category) as Right-of-use, if there are volumes of such leases and if EBITDA is an important parameter.

 

Choices can be made only when one is aware of the options.

2.     Impact on transition –

Lessee can opt for either of the following transition approaches:

a.      Retrospectively to each reporting period – Under this approach the new lease standard is applied to all the reporting period as if the lease standard was always applied. All earlier period rental expenses are written back and the effect of interest expenses and depreciation is accounted. This results in the impact accounted in retained earnings at the beginning of the earliest reporting period i.e. while preparing the financials for Mar 2020, the comparative year end will be Mar 2019 and the effect of transition will be accounted on the retained earning as of 1 April 2018.

b.      Retrospectively with the cumulative effect of initially applying the Standard recognized at the date of initial application – This is same as point (a) with the only difference being that the effect of transition will be accounted on the retained earning as of 1 April 2019 (the date of transition)

Certain pointers which doing the transition working are:

·      Operating lease having a remaining life of less than 12 months as on the transition date can be kept out of the working i.e. they can be continued to be accounted on straight-line basis. This is an option.

·      Lease liability will be equal to the discounted value of the remaining future lease payments

·      Right-of-use assets can be accounted at a) Lease liability on commencement of the lease term which is depreciated for the lease term lapsed. or b) lease liability on the date of transition adjusted for any prepaid or accrued lease payments (i.e. rent straight lining). Option (b) is will result in no effect on retained earnings.

·      Leases accounted as finance leases under IGAAP, the value of the carrying amount of the right-of-use asset and the lease liability at the date of initial application shall be the carrying amount of the lease asset and lease liability immediately before that date measured applying Ind AS 17.

3.     Treatment on cash flows –

While determining the cash flow from operations we adjust the following 2 items (something we learned in our college days):

a)     Non-operating items

b) Non-cash items

Under IGAAP rental expenses was never adjusted as it is considered as an operating item, as these leased assets were used in the operating of the business. However, the new Standard replaces rental expense with interest expenses and depreciation, and it does have a impact on the cash flows as well.

The depreciation being non-cash expenses will be added back to the cash from operating activities, the payment of installment (Principal component) will be reflected under investing activity and the interest component will get classified as financing activity.

This surely put cash from operations in a positive light. This new Standard increases cash from operating activity even without a new penny of cash added to the business, beautiful isn’t it.

While all components of a financial statement are prepared on accrual basis only cash flow statement is prepared on cash basis. The entire idea of a business is to run an operating cycle and generate cash out of it and cash from operating activity is the prime indicator of how well the company can do this. This new Standard defiantly dilutes this perspective.

4.     Discount rate –

In determining the Lease liability i.e., the present value of all the future minimum lease payments a discount rate is required. This rate should be the interest rate implicit in the lease, this can be determined only if the cost of the asset is available so that the difference between the total lease value and the cost is considered as the interest component. However, it is likely that this is not available in most of the case (except for intercompany transactions).

In such a case, the discount rate can be considered as the incremental borrowing rate. The rate of interest that a lessee would have to pay to borrow over a similar term, and with a similar security, the funds necessary to obtain an asset of a similar value to the right-of-use asset in a similar economic environment.

So every time a new lease it taken or there is any modification the discount rate should be worked out as per the specifics of the lease. There is no single rate that will fit all the leases and all the companies.

However, for the limited purpose of transition, if option (b) “Retrospectively with the cumulative effect of initially applying the Standard recognized at the date of initial application“ is chosen then the lessee’s incremental borrowing rate at the date of initial application can be applied.

This seems to be a nicely crafted standard (by IASB who prepared IFRS – 16, India just “converged” it) and the working and implementation can be easy if you have 10 odd leases. I did say you will be facing challenges if you have more lease and haven’t began implementation till now.

Hoping that this article will help in bringing more clarity on the Standard. Watch out this space for more insights on IFRS. Do share with your friends who might find it helpful.

Cheers!

Ramanujam Narayan

Business Head – Finance First | CFO – ConTeTra Universal LLP

 

Challenges faced by NBFCs in the Adoption of Ind AS

Having assisted many companies in transition from IGAAP to Ind AS we have come across aspects that many companies ignore as part of their transition process. Everyone has been underestimating the time and efforts involved in the transition process and ends up resorting to some quick fixes to meet timelines.

These quick fixes do work for the purpose of a one-time transition, but management often misses out on planning on how the adjustments/working can become part of their periodic reporting, as all reporting going forward has to be under Ind AS only.

Phase 2 of the roadmap of adoption of Ind AS for NBFC has been made effective 1 April 2019. By virtue of this, all NBFCs meeting the phase 2 criteria are required to report all interim and annual period financial as per Ind AS.

Unlike other sectors, for an NBFC the areas affected are multifold with wide implications due to the Financial Instruments accounting standard. Listed NBFCs (Debt as well as equity) have already reported and are in process of reporting their Sept ended financials as per Ind AS. However, for unlisted NBFCs 31 March 2020 will be their first Ind AS reporting to be published latest by 30 Sept 2020.

Management of these NBFCs would consider Sep 2020 to be ample of time to make all the necessary adjustments and would not have even begun the transition process. However, this may not be true given the wide range of Ind AS implications for NBFCs.

In our interactions with CFO’s and financial controllers, below are 5 key challenges that Finance function of NBFCs have encountered which others who are in process of implementation can learn from:

1.     Late starters:

Many CFOs admit that they started the process of Ind AS adoption very late as they underestimated the time, skill, efforts and resources involved in the process. Starting late had many disadvantages for the company such as:

  • Diverting significant resources and time towards the transition process thereby effecting the regular Finance operations.
  • Missing out on some of the areas which have Ind AS implications
  • Taking quick fixes that are difficult to untangle for accounting in subsequent periods

2.     System Upgradation:

Some key areas that have implication for an NBFCs are:

  • Accounting for all income and expenses related loan asset using effective interest rate method
  • Cost incurred for issues of debt to be amortized using the effective interest rate method
  • Accounting of 100s of leases as per Ind AS 116, requiring creation of Right of Use assets and lease liability
  • Fair valuation of security deposits

These are some of the areas which due to their complexity or volume are best automated. Without evaluating the need for system changes for such areas, it can lead to cumbersome excel workings period-on-period which can be prone to errors.

3.     Upskilling the team:

This is one of the most ignored activities on the mind of many CFOs. Ind AS adoption can be a one-time activity that can be accomplished by the involvement of professional consultants however what about all future reporting periods?

There is an acute need to upgrade the skills of the finance team so that they are well versed with Ind AS and its implication on companies’ financials and reporting. A skilled finance team can be a great asset to the management as they will be able to handle aspects such as:

  • Ongoing financial statement preparation
  • Anticipate the income statement and tax implication of any financial instruments
  • Identify System and process changes needed to ensure relevant data is made available and much more.

4.     Ratio changes:

This is what analysts, investors, regulators, and other stakeholders look out for. Not paying attention to the change in the ratio can be a costly mistake. Adoption of Ind AS is likely to change many of the ratios that an NBFC’s is required to report and this may require management to take some action such as aligning stakeholders, evaluating any carve-outs available under Ind AS, etc.

Companies who are not planning Ind AS transition well in advance are likely to face time constraints to be able to take any decision once the ratio is affected due to Ind AS adoption.

5.     Data issues:

This has been one of the biggest challenges faced by many Ind AS adopters. For Phase 2 NBFCs the date of adoption of Ind AS is 1 April 2019. However, the date of transition for Ind AS will be 1 April 2018 hence Ind AS will be adopted for comparative period as well.

For adoption of Ind AS in the comparative period the company is required to make available all the necessary data existing as of each period end as well as for during those periods.

Further for the purpose of building the Expected Credit Loss (ECL) model companies will be required to make available the data of the past 1-2 years prior to the date of transition.

Extracting all the past data has been a challenge for many companies and it can easily take weeks to just get the right set of data and build models around it. Without proper data, nothing can be possible.

These are just some of the challenges that are faced by CFOs and the finance team in the adoption of Ind AS. It is advisable for those who are yet to adopt Ind AS to learn from what others have encountered and plan well for a smooth transition to Ind AS.

Hope this article helps you in planning your transition to Ind AS and adopting Ind AS holistically rather than considering it as a one-time affair. If you or any of your colleagues are looking for IFRS / Ind AS implementation for any NBFC, do get in touch with us at ConTeTra Universal, where we have implemented Ind AS successfully for a few NBFCs and listed companies. Do share with your friends who might find it helpful.

For more information on Ind AS transition, you can download our free ebook – IFRS Changing the Financial Landscape. This ebook highlights, how India’s financial reporting perspectives are undergoing a significant change and aspects that Ind AS adopters need to look out for.

Ramanujam Narayan

Business Head – Finance First | CFO – ConTeTra Universal LLP