Context
Convergence of the Indian Accounting Standards (“Ind AS”) with the International Financial Reporting Standards (“IFRS”) can be regarded as the most significant milestone in the Indian accounting paradigm, which has fundamentally altered the rules for the preparation and interpretation of financial statements (“FS”) as also the ground rules for structuring M&A deals.
The process to transition to Ind AS was initiated way back in 2006, with a view to enhance acceptability and transparency of the financial information communicated by Indian corporates, through their FS[1]. While formulating the IFRS-converged Ind AS, efforts have been made to keep each Ind AS aligned with the corresponding IFRS standards, and departures have been made where it was absolutely essential to tweak the standard in line with India’s economic and legal landscape.
In his Budget Speech in July 2014, the then Hon’ble Union Finance Minister, Late Shri Arun Jaitley, outlined his vision for adoption of Ind AS, stating that:
“There is an urgent need to converge the current Indian accounting standards with the International Financial Reporting Standards (IFRS). I propose for adoption of the new Indian Accounting Standards (Ind AS) by the Indian companies from the financial year 2015-16 voluntarily and from the financial year 2016-17 on a mandatory basis. Based on the international consensus, the regulators will separately notify the date of implementation of Ind AS for the Banks, Insurance companies etc. Standards for the computation of tax would be notified separately.”
Ind AS has been made applicable to companies in a phased manner from April 1, 2015 onwards, and has now become mandatory for all listed companies and unlisted companies having net worth in excess of INR 250 Crore, along with their holding, subsidiary, associate and JV companies[2]. As of date, 39 different Ind AS have been notified by the MCA, pursuant to Section 133 of the Companies Act, 2013 (“Act”)[3].
It would be fair to say that implementation of Ind AS can be considered as a monumental step in the history of accounting in India. Ind AS is a consequence of growing internationalisation of shareholdings of Indian companies, their increasing presence in international capital markets for fund raising and global M&A transactions.
Migration to Ind AS has resulted in preparation of high-quality, principles-based, globally comparable FS, making it easier for Indian companies to raise funds from international equity and debt markets without the necessity of recasting their accounts as was required under the I-GAAP accounting standards in the past. Ind AS has also resulted in significantly higher level of disclosures in the FS, resulting in greater transparency.
However, it needs to be noted that the transition from I-GAAP to Ind AS has not been smooth for various stakeholders like the CFOs, Audit Committee members, M&A lawyers and even auditors, as Ind AS provides for a fundamentally different accounting treatment for various corporate transactions, with its focus on ‘fair value accounting’ and ‘substance over form’.
The Ind AS have also introduced several new concepts like discounting, provisioning based on expected credit loss method and purchase price allocation, which has significantly improved the quality of disclosures in the FS. However, unlike the relatively straightforward I-GAAP standards, Ind AS is primarily founded on ‘judgments’ and ‘reasonable estimates’, bringing in a higher degree of subjectivity.
The new standards are undoubtedly far more complex than its predecessor, and requires significant amount of time commitment and training for familiarity and comprehension of its implications. Even seasoned accounting practitioners have found it extremely challenging to master the complexities of key provisions of various Ind AS. Particularly, various Ind AS that deal with ‘financial instruments’ are extremely complex, but very important for M&A and capital market lawyers.
From an M&A standpoint, the lack of adequate domain knowledge of Ind AS results in a situation where ‘commercial calls’ are made during proposed M&A deals, without evaluating the specific implications from an Ind AS accounting perspective. This can lead to potential oversights in decision making, adversely impacting the outcome of a transaction.
While a detailed commercial, legal and tax analysis is undertaken at the outset, before finalising structuring of the transaction and other deal specifics, an evaluation of the Ind AS accounting implications is often deferred until the very end. On many occasions, the deal structure undergoes a major change at the last minute, once red flags from an Ind AS accounting standpoint are pointed out by the auditors.
Application of Ind AS – Some Key Issues faced from an M&A Standpoint
Whilst the relevance of Ind AS is often underestimated in India’s M&A circles, various Ind AS have acted as a thorn in the flesh while structuring M&A deals. Some of the key issues that have arisen are briefly discussed below.
- Put Options: Under Ind AS 32, a puttable financial instrument can be classified as an ‘equity instrument’ only if certain specified criteria are met. The manner in which the put option clause is drafted will directly impact the treatment of the puttable financial instrument – whether it is to be treated as ‘equity’ or as a ‘financial liability’ under Ind AS 32. Another issue that arises is the accounting policy that should be adopted for recognising the change in the carrying amount of such put liability on each reporting date, and whether such changes should be presented in the P&L Account or in the ‘Other Equity’ section of the balance sheet.
- Buyback clause in the SHA: If the SHA provides an exit option to the investors in the form of a buyback of their securities, the wordings in the ‘buyback clause’ can determine if such securities will be classified as an ‘equity instrument’ or ‘debt instrument’ under Ind AS 32. The investee entity would have to ensure that the buyback clause clearly provides that the buyback will be undertaken solely based on the discretion of the Board, after the commercial and legal feasibility of the buyback is evaluated, in line with the pre-conditions for buyback of securities, as prescribed under Section 68 of the Act.
- CCPS providing for a fixed coupon: Another issue that may arise is whether providing for a fixed coupon on CCPS would result in a scenario where the CCPS is not treated in the books as an ‘equity instrument’, but as a ‘debt instrument’ under Ind AS 32.This issue has arisen despite the fact that dividend is payable in case of CCPS only if there are sufficient distributable profits/free reserves, and such dividend declaration is approved by the Board of Directors (“Board”). Hence, the articles of the company and the dividend distribution policy (if any) would have to be carefully worded to ensure that recommendation of dividend is based on the discretion of the Board, after taking into account the extent of distributable profits/ free reserves, and other agreed financial parameters.
- Affirmative Voting Rights (AVMs): If the AVMs are all pervasive and also extend to operational matters, the auditors may take a view that such rights amount to exercise of ‘significant influence’ and/ or ‘control’ over the investee, and would result in consolidation of financials in accordance with Ind AS 28 and Ind AS 110. Application of Ind AS has resulted in divergent views on drawing a distinction between two finely classified AVMs – one that are purely ‘protective rights’ and the others that extend to operational/ day-to-day business and management aspects.
- Identification and classification of entities: The Ind AS provides for a much wider and a more subjective definition of key terms like ‘subsidiaries, ‘associates’, ‘related parties’, ‘significant influence’, ‘control’ etc., when compared to the definition provided under the Act and the SEBI Listing Regulations. To illustrate, unlike the Act, Ind AS 28 provides that an entity can be classified as an ‘associate’ even if the shareholding is below 20%. Given the expansive definitions, implications from an entity-classification and consolidation standpoint would have to be carefully evaluated, while structuring deals.
- Ind AS 103 (Business Combinations): Accounting Standard Ind AS 103 provides guidance on the accounting for business combinations under the acquisition method. The implications under Ind AS 103, especially with regard to restatement of FS, determination of ‘acquisition date’, tests for identification of ‘business’, differences in accounting for an asset acquisition and a business combination, contingent consideration, measurement of non-controlling interests, etc., should be closely evaluated while finalising any deal structure.
How would Ind AS familiarity benefit an M&A practitioner?
The issues discussed above highlight the significance of undertaking an Ind AS analysis before any transaction structure or deal specifics are finalised. While structuring a potential M&A deal, an Ind AS analysis should be placed at the same pedestal as the standard commercial, legal, risk and tax analysis that is undertaken.
For M&A practitioners, a basic familiarity with the relevant Ind AS will also facilitate the process of negotiation of transaction documents, where parties can be sure that what they are agreeing to commercially does not affect them from an accounting standpoint, post the closing of the transaction.
Moreover, as discussed above, an Ind AS analysis assumes utmost relevance while drafting key aspects like put/ call option clauses, terms of issuance of CCPS, AVMs, exit rights, etc. To illustrate, keeping the Ind AS at the back burner could potentially result in a situation where a put option clause would have to be re-engineered at the very last minute, after the auditor expresses his view regarding whether the puttable instrument will be classified as ‘equity’ or as a ‘financial liability’.
A knowledge of Ind AS will also facilitate an effective review of the FS of the target, evaluate the veracity of the disclosures made, and understand key risks and potential red flags.
Approval of FS by the Audit Committee/ Board – Is there really an objective evaluation of Ind AS Compliance?
Another issue relates to the extent to which Ind AS compliance is scrutinised, before the FS are approved by the Audit Committee/Board. Section 129(1) of the Act inter alia provides that the FS should present a true and fair view of the state of the company’s affairs, and comply with the applicable accounting standards. Further, Section 134(5) inter alia provides that the Directors’ Responsibility Statement should state that in preparation of the FS, applicable accounting standards have been followed, along with proper explanation relating to material departures.
Given the technicalities involved, before approving the draft FS, can any director confidently affirm, beyond doubt, that the FS prepared by the management conform to all applicable Ind AS? Many Ind AS require the management to make ‘judgments’ and ‘estimates’ on various aspects, making their application very subjective and context specific. Most Board members are unfamiliar with the intricacies of such Ind AS, thereby hampering their ability to exercise ‘independent judgment’ and make informed decisions.
Concluding Thoughts
Due to its complexity and subjectivity, key stakeholders are finding it challenging to apply various Ind AS provisions in practice. Given the extent of subjectivity involved, two auditors can have polar opposite views on interpretation and application of a particular provision in an Ind AS. Unfortunately, Ind AS has become like a gigantic ‘jigsaw puzzle’ that nobody wants to solve.
Whilst it has now become essential for M&A lawyers to familiarise themselves with potential Ind AS implications for effectively negotiating the transaction documents, greater regulatory clarity is also required to effectively apply Ind AS to key transactional aspects. This will act as a starting point in ensuring that auditors adopt a consistent view on material accounting issues impacting M&A deals.
It needs to be acknowledged that the Ind AS Implementation Committee of the ICAI has done a stellar job in promoting familiarity with Ind AS, by publishing high quality literature (in the form of educational material and guidance notes) and conducting various training programs/ seminars on the intricacies of Ind AS. Despite ICAI’s commendable efforts, key stakeholders are still not adequately familiar with the nuances of Ind AS – even though it has almost been a decade since Ind AS was notified.
To ensure that Ind AS is effectively applied in practice, and to familiarize the stakeholders with all its vital aspects, it is essential to conduct more training programs/workshops/skill enhancement sessions on a war footing. Until there is a significant change in the approach, ‘Ind AS illiteracy’ among key stakeholders is perhaps the worst kept secret of India Inc.
[1] Indian Accounting Standards (Ind AS): An Overview, published by ICAI (Revised Edition, 2021), at Pg. 7.
[2] For certain regulated sectors like banking and insurance, the Ind AS Accounting Standards have still not come into force.
[3] The list of notified Ind AS Accounting Standards are available at – (i) ICAI – The Institute of Chartered Accountants of India; and (ii) Accounting Standards (mca.gov.in).
Tags: Accounting Standard, Audit Committee, Companies Act 2013, Financial Statements, Indian Accounting Standards, Insurance Companies, International Financial Reporting Standards (IFRS), Legal Analysis, M & A Transactions, Mergers & Acquisitions, SEBI Listing Regulations, Tax Analysis
