Getting the complete picture

The use of judgment in the preparation of financial statements is pervasive

The Indian economic environment has seen some rapid changes in the past half decade. A new corporate law (Companies Act, 2013) which places prime focus on corporate governance, a national indirect tax (GST) regime that has the potential to converge the whole of India into one market, a series of steps to curb black money (demonetisation, benami law, et al) and a crusade against bad loans — these are only a few of the several reforms ushered in to create a “new India”.

In this whirlwind of changes, India Inc has also taken the first giant leap towards a progressive financial reporting regime — adoption of  Ind-AS or Indian Accounting Standards, the accounting standards converged with International Financial Reporting Standards (IFRS).In the past few weeks, a set of large listed companies have successfully reported their first annual financial results as per Ind-AS. Now it is for the analysts to pull out every weapon in their armoury and penetrate into this high quality, yet complex financial reporting environment.

Mark Twain, the great author said, “Facts are stubborn things, but statistics are pliable.” That is somewhat the story of an overall analysis of the impact Ind-AS has had on the corporates. To be more specific, think about these statistics derived from a study conducted by Grant Thornton India of 522 listed companies who declared their annual financial results for financial year 2016-17: on a like-to-like basis with the old accounting standards applied for the comparative period (FY 2015-16), profitability dwindled by a whopping Rs 13,680 crore or an average 6.2 per cent. On the other hand, net worth of these companies increased by 1.8 per cent as a result of the transition.

These statistics don't tell the true story in isolation. One needs to go deeper into constituents of our very complex economy to understand what is the message underlying the fine print. To illustrate, while certain sectors like Telecom, Infrastructure, Logistics, Real Estate and Services have witnessed 5-10% decline in their net worth, Manufacturing, Media, Automotive and Retail have reported a 5-10% increase. What led to these varying degrees of changes across the spectrum of corporate India applying the same set of accounting standards (Ind-AS)?

A general answer to this question lies in the way management of these companies have exercised the accounting policy choices available to them upon transition to Ind-AS. One of the buzz words in these new accounting standards is determination of “fair value” and that is where lies the crux of the matter.

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Firstly, there are few areas where use of fair values is optional. For instance, upon transition to Ind-AS, companies have a choice to either measure their property, plant and equipment at fair value or carry them “as-it-is” from the old accounting standards. This single reason contributed Rs 92,420 crore to the increase in net worth of listed companies reporting under Ind-AS. Of this, manufacturing sector alone has reported an increase of Rs 65,614 crore on this account. Companies see this as an opportune time to get their fixed assets at values representative of their market worth in comparison to the historical costs, which,especially for immovable assets, lose relevance and reliability with time.

Secondly, and more importantly, the determination of fair value itself is judgmental. However, analysts and investors should stay assured that these humongous changes are made by companies with mandatory disclosures. Flip through the heaps of “notes to accounts” and you will find good amount of qualitative data to facilitate your decision making. A word of caution here — analysing Ind-AS financial statements is by no means an easy task and hence expert advice must be sought before drawing conclusions.

Another dimension to the use of fair values lies in the way those fair values are accounted for, which in turn depends on how the management evaluates the features of an underlying asset or liability. As an example, certain financial assets are required or permitted to be carried at their fair values. The business model of the entity determines the geography within the financial statements where those fair values are recorded — in statement of profit and loss or in other comprehensive income (OCI). The veracity of this can be understood from the fact that entities within the infrastructure sector reported decrease in their net worth by Rs 13,196 crore on account of fair value changes in financial assets recorded in P&L whereas the oil and gas sector parked gains of Rs 26,135 crore due to fair value changes in financial instruments in OCI (i.e. reserves).Across all sectors, over 50 per cent of the companies have elected to carry some or all investments at fair value through OCI, with both positive and negative impacts on net worth. There are various decision making points before management concludes the best accounting policy choice for its business. It is important that directors, particularly the independent directors of companies review those decisions and test them against highest standards of corporate governance.

The use of judgment in preparation of financial statements is pervasive and there are innumerable circumstances where management is faced with multiple scenarios to choose from. Ind-AS forces preparers to be foresighted in their conclusions and use the financial statements to tell their story as it unfolds or rather before it does. A good example of this new requirement is the way companies will account for credit losses or bad debts. While much of the financial services sector will adopt Ind-AS from financial year 2018-19, the non-financial sector has given a flavour of this already. Indian corporates have reported a decline in their net worth by a staggering Rs 10,032 crore on account of expected credit losses. Does it mean the old accounting standards permitted books of account to lag behind business realities? It's a difficult question to respond.

Winston Churchill once said, “Men occasionally stumble over the truth, but most of them pick themselves up and hurry off as if nothing ever happened.” As one reads Ind-AS financial statements, it is important that one doesn't overlook scattered pieces of information which need to be joined together to see the complete picture.

The writer is a partner at Grant Thornton India LLP