Several entities have been impacted by the COVID-19 pandemic. As per accounting prospective both Ind AS 36, ‘Impairment of assets’ and AS 28 ‘Impairment of Assets’, require that management consider at each report date whether there is any indication that an asset may be impaired. Ind AS 36 and AS 28 include both internal and external indicators to identify if an impairment review is required.
Revision in management business plan to incorporate the impacts of COVID-19
Under Ind AS 36 and AS 28, cash flows used for impairment testing should be based on a business plan that reflects the expected and most current impacts of COVID-19. All entities may have updated their forecasts and plans in response to current conditions. When measuring value in use, an entity should base cash flow projections on the most recent financial budgets/forecasts approved by management. Reliance on a previously approved forecast might not be appropriate in the current market conditions. There should be consistency of assumptions and forecasts applying to impairment tests of different assets required by this and other standards. For assumption refer Ind AS and AS
COVID 19 Impact on discount rate
Under Ind AS 36 as well as AS 28, the discount rate should reflect the current market assessments of time value of money for the periods until the end of the useful life of the asset/cash-generating unit (‘CGU’), market risks, geographic risks, and any other risks specific to the asset/CGU for which the future cash flow estimates have not been adjusted, as well as other factors that market participants would reflect in pricing the expected future cash flows. As a starting point in calculating such a rate, a company may use the weighted average cost of capital.
While the established methods for calculating the cost of capital should continue to be used, a re-assessment of each input into the calculation and assessment of the overall result is needed. In the current environment, certain observable inputs that go into the calculation of the cost of capital (such as risk-free rate) have declined. For many companies, the cost of debt will have increased, but this needs to be considered on a company-by-company basis. Reputed companies with good credit ratings might, by contrast, have seen a decline in their cost of debt in line with sovereign debt. At the same time, increased volatility and other indicators point to an increase in the cost of equity. Also, the heightened focus on liquidity might, for some industries, such as real estate, infrastructure and hospitality, result in an optimal capital structure that is more weighted towards equity than in the past.
All in all, this means that, for most companies and sectors, the cost of capital is presently higher than it was in 2019. Companies should consider this when completing impairment assessments in 2020.
Level of assessment of impairment
As a consequence of COVID-19, entities might have impairment indicators for assets, CGUs and groups of CGUs. The assets and CGUs will then be tested for impairment under Ind AS 36. These CGUs might include goodwill, or they might be part of a larger group of CGUs that include goodwill. A question arises as to which level an entity tests first for impairment: goodwill and then the underlying CGUs (‘top down’); or the CGUs and then related goodwill (‘bottom up’).
Ind AS 36 requires a ‘bottom up’ approach to impairment testing. The impairment test is a two-step process:
Step 1: Test the individual asset, or related CGU if the recoverable amount for the individual asset cannot be determined. Any impairment should be recognised at this step, to reduce the carrying amount to the recoverable amount. Testing performed at the CGU level would include goodwill to the extent that goodwill is monitored at this level.
Step 2: Test the CGU or group of CGUs including goodwill. This second stage is a comparison of the recoverable amount with the restated carrying amount after the step 1 impairment test.
The two-stage approach ensures that, where there are indicators of impairment, assets and CGUs within a group of CGUs are tested separately for impairment first, with any impairment recognised before the larger group including goodwill is tested.
Due to the different levels of impairment testing required, it is important, under Ind AS 36, that CGUs are correctly identified as the smallest group of assets that generate cash inflows that are largely independent of each other. Impairments should not be masked by incorporating additional assets and cash flows from the same operating segment.
AS 22: Reversal of timing difference can be construed as future taxable income to recognize deferred tax asset
Query
A Company say, B Ltd. is engaged in the business of petroleum refining and its products are sold in Oil Marketing Companies. The sale price of products depends on the prices prevailing in the international market and applicable foreign exchange rates. The company is incurring business losses from the last two financial years due to external factors like volatility in foreign exchange rates, etc.
During the current financial year 2013-14, the company has recorded certain amount of unabsorbed depreciation and unabsorbed losses in its books of accounts. Deferred Tax Liability (DTL) on timing difference on depreciation of earlier years is also recognized in the balance sheet.
Keeping in view the uncertainty of future profitability and history of recent losses, the company has not created Deferred Tax Asset (DTA) on the unabsorbed depreciation and business losses complying with the provisions contained in AS 22. Whether the company is correct in not creating DTA for above transaction? If not, what should be the correct accounting treatment?
Answer
No, the company is not correct in its accounting treatment.
As per the provisions contained in para 8, 15, 17 and 18 of AS 22 Accounting for Taxes on Income, unabsorbed depreciation and carry forward of losses which can be set off against future taxable income are considered as timing difference and to be recognized as DTA on consideration of concept of prudence. Further, DTA should be recognized in the books of accounts only where there is virtual certainty that future taxable income will be realized in future against such DTA.
However, in consideration of previous pronouncements in respect of creation of DTA/ DTL, a DTA can be created to the extent the future taxable income will be available from future reversal of any DTL recognized at the balance sheet date. In such a case, it is not necessary to consider the virtual certainty with supporting evidence and DTA should be recognized to the extent of future reversal of DTL. The reversal of timing difference can be construed as sufficient future taxable income and accordingly, the company should recognize DTA in its books of accounts to the extent of DTL which is capable of reversal in future.
Since the company has not recognized the DTA in its books of accounts, it will be treated as an error in the preparation of financial statements and should be accounted as per AS 5 Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies. Further, the company should make the required disclosures as contained in para 27 to 32 of AS 22 and para 15 of AS 5.
References :- EAC opinion Query 24, Volume 34
AS 11: Consider the substance of case to classify a foreign operation as integral or non- integral
Query
A Company say, A Ltd. is engaged in the business of exploration and production of oil and gas and other hydrocarbon related activities outside India. A Ltd. has acquired the Participating Interest (PI) in joint ventures through its wholly owned overseas subsidiary company named B Ltd. to conduct the business activities. B Ltd. operates with a substantial degree of autonomy over its operation and does not affect the day to day functioning of A Ltd. A Ltd. received its share of profit in the form of dividends and the financial statements of B Ltd. are consolidated complying with the provisions contained in AS 21 Consolidated Financial Statements.
A Ltd. treated the foreign operations conducted through overseas subsidiaries as integral foreign operations as per AS 11 and accounted accordingly. Whether the accounting treatment adopted by A Ltd. is correct?
Answer
In order to determine the accounting treatment of foreign operation, it is important to understand whether it is integral or non- integral foreign operation. The answer to above question can be determined by analyzing the provisions contained in AS 11 The Effects of Changes in Foreign Exchange Rates.
As per para 18 of AS 11, a foreign operation may be defined as integral to the operations of reporting enterprise if it carries on the business as if it is an extension of reporting enterprise’s operation. The change in exchange rate affects the individual monetary items held by foreign operation rather than the reporting entity’s net investment in that operation. While non- integral foreign operation accumulates cash and incurs expense, generates income, all in its local currency. The change in the exchange rates affects the reporting enterprise’s net investment in the non- integral foreign operation rather than individual monetary items held by foreign operation.
Further, para 20 of standard prescribes few indications for classifying a foreign operation as non- integral foreign operation. Many of times, the factual information is not sufficient for classifying each operation and hence, it is a matter of judgment to determine the appropriate classification. Thus, A ltd. should consider the facts and circumstances specific to it and should apply the criteria as specified in the standard to determine whether to classify the foreign operation as integral or non- integral.
References :- EAC opinion Query 37, Volume 34