The Companies (Indian Accounting Standards) Rules, 2015 (Ind-AS), converging substantially with the International Financial Reporting Standards (IFRS), will impact banks in the country in a two-fold manner. First, it can impact their businesses, given the corporates to which they have lent have already started to report under the Ind-AS from the current year, thereby impacting financial ratios and covenants. This is likely to impact the banks’ processes of credit appraisal, covenant setting and credit rating, as the financial position of these corporates may look very different under Ind-AS.
Second, it will impact banks’ own financial statements, where the new principle-based standards may largely override RBI’s rule-based accounting. Banks currently prepare their financial statements as per the Accounting Standards as notified under the Companies Act and the statutory requirements under the banking regulations, circulars and guidelines issued by RBI from time to time. RBI prescribes rules around income recognition, asset classification, impairment provision, and de-recognition. The move to Ind-AS is a paradigm shift that introduces several complex concepts. With newer concepts, such as expected credit loss recognition for loan and investments, interest recognition on effective interest rate basis, emphasis on fair valuation measurement, evaluation of risk and reward criteria for transactions related to priority sector lending (PSL) and asset reconstruction companies (ARCs), this transition is bound to have an organisation-wide impact.
Banks will have to determine the impact on product design, lending policies, credit assessments, covenant monitoring, tax planning, and regulatory capital. This would also require changes to policies, processes, governance structures, business planning processes, risk management strategies, IT systems, etc.
Some of the key accounting changes and their resultant impacts are summarised here.
Expected credit loss (ECL) : Expected credit loss recognition under Ind-AS is significantly different from the current rule-based provisions, and will replace the existing IFRS requirement where impairment is recognised on an ‘incurred loss’ basis. ECL must be recognised for all financial assets that are not measured at fair-value through a profit-and-loss account. Unlike the current RBI IRAC norms, where the provision is based on days past due (DPD) and has a trickle effect, it will accelerate the loss recognition early on. In case a bank has underwritten bad quality assets or has assets where credit has deteriorated since origination, there would be a higher amount of impairment charge that would now be recognised. Further, the scope for ECL is fairly wide and includes not only for the drawn-down value of loans and investments but also off balance-sheet items such as undrawn commitments and financial guarantee contracts. Robust methodology, assumptions and techniques are required for determining ECL as it will have lot of subjectivity involved. Banks undertaking capital computation based on the internal rating-based approach would therefore be better placed to do it while differences between Basel and Ind-AS still exist.
Financial instruments (classification and measurement) : Under Ind-AS, classification of financial assets is based on cash-flow characteristics and business models (i.e., intention to collect contractual cash-flows or sell). Hence, the identification of the core held-to-maturity (HTM) book would be required, which can now only be carried out at a cost. Also, based on the Ind-AS rules, investments in equity shares, security receipts and units of venture capital funds will now be required to be measured at fair values at each reporting date. Where the bank has an intention to syndicate or sell down a loan or a portion thereof, these may now be required to be measured at fair value as against cost.
Similarly, the substance of the contractual arrangements (discretionary coupon distribution, loss absorption features) will help determine the equity/liability classification. For example, perpetual/tier I bonds with loss-absorption features may be classified as equity whereas mandatory redeemable preference shares may be classified as financial liability. Acceptances and endorsements will get recognised in the financial statements and will no longer be off balance sheets.
Interest recognition: Under existing norms, loan-processing fees and costs relating to origination of loans are recognised upfront in the profit-and-loss account. Under Ind-AS, these fees will be amortized over the estimated life of the loan using the Effective Interest Rate (EIR) method. Similarly, investments purchased at a discount or premium will also be amortised using EIR (yield) basis. Banks would therefore need to ascertain the type of fees that would be part of YTM and that can be taken upfront, which would require a close assessment of various fees such as agency fees, lending fees, arrangement fees, structuring fees, mandate fees, commitment fees, etc.
De-recognition: De-recognition criteria are stringent under Ind-AS. Securitisation transactions which meet the true sale criteria as per RBI norms may not meet the de-recognition requirements under Ind-AS. Accordingly, such transactions may lead to the grossing up of the balance-sheet. Banks which structure the securitisation transactions through trusts may have to consolidate such trusts under the new control model of Ind-AS. Banks investing in pass-through certificates issued by such structured vehicles have to carefully evaluate the cash flow characteristics of the instrument as well as the extent of risk participation in such instruments to assess if these can be carried at amortised costs.
Consolidation: Assessment of clauses in the contract with respect to participative rights, potential voting rights, power to govern relevant activities, right to variable return, temporary control exemptions need to be studied in greater details for assessment of consolidation. A closer look is required for strategic debt restructuring (SDR) cases as well.
Fair valuations: All derivatives will have to be fair-valued unless they are designated in a hedge relationship. Entities will also have to consider the impact of their own credit risks, such as CVA/DVA, while determining fair valuation.
LeasesSecurity deposits paid on lease-hold premises are to be measured at fair value on initial recognition. Also, evaluation of escalation clauses and lease incentives for recognition of lease expenses would be required to be amortised.
Other areas: Other areas of impact would include share-based payments and employee benefits that would impact the financial statements. Needless to mention, there would be extensive disclosure requirements for financial instruments and segment reporting.
As the adoption of Ind-AS will be one of the most fundamental changes to affect the banking industry in India. The transition needs to be planned, managed, tested, monitored and executed in a phased manner and banks need to gear up for the same. Banks would also need to track the regulators position on all these issues, and would need to recalibrate outcomes based on any guidance issued related to Ind-AS transition.
The author is partner
(risk consulting), KPMG in India.
Views are personal
