THE INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIA (set up by an Act of Parliament)

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1 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIA (set up by an Act of Parliament) May 29, 2015 Mr. Hans Hoogervorst Chairman, International Accounting Standards Board IFRS Foundation 30 Cannon Street London EC4M 6XH United Kingdom Dear Hans, Sub: Comments on IASB Exposure Draft on Classification of Liabilities, proposed amendments to IAS 1 We are pleased to provide comments on the IASB Exposure Draft on Classification of Liabilities, proposed amendments to IAS 1. In this regard, we may submit that we do not agree with the proposed modifications in IAS 1 as the same do not address the Indian concerns with regard to the classification of non-current liabilities in the event of default. Accordingly, instead of providing replies to the questions raised in the Exposure Draft, we are enclosing a detailed note containing our comments on the Exposure Draft as Annexure A. With kind regards, Yours sincerely, (Sanjeev Maheshwari) Chairman, Accounting Standards Board The Institute of Chartered Accountants of India asb@icai.in

2 Annexure A Comments of the Institute of Chartered Accountants of India on Exposure Draft on Classification of Liabilities (Proposed amendments to IAS 1) Classification of non-current liabilities in the event of default 1. Paragraph 69 of IAS 1, Presentation of Financial Statements, requires that an entity usually classifies a liability as current when: (d) it does not have an unconditional right to defer settlement of the liability for at least twelve months after the reporting period (see paragraph 73). Terms of a liability that could, at the option of the counterparty, result in its settlement by the issue of equity instruments do not affect its classification. 2. Paragraph 74 of IAS 1 explains the application of the above principle in case of a breach of a provision of a long-term loan arrangement on or before the end of the reporting period as follows: When an entity breaches a provision of a long-term loan arrangement on or before the end of the reporting period with the effect that the liability becomes payable on demand, it classifies the liability as current, even if the lender agreed, after the reporting period and before the authorisation of the financial statements for issue, not to demand payment as a consequence of the breach. An entity classifies the liability as current because, at the end of the reporting period, it does not have an unconditional right to defer its settlement for at least twelve months after that date. Prevailing banking practices in India 3. In India, the prevailing banking practices are such that even though the loan covenant may provide a right to the banker to recall a loan in the event of a breach of a term or condition of a loan, it is never recalled immediately. The existing practices prevailing in India are explained by a banker as follows: While the legal position is that a loan becomes recallable on the actual Event of Default (EOD) specified, Bank typically waits for the asset to be classified as non-performing asset (NPA) as per the Reserve Bank of India (RBI) norms, even Prepared by the Accounting Standards Board of The Institute of Chartered Accountants of India 1

3 though there is no legal requirement to do so. After the asset becomes NPA, Bank again issues a letter threatening to recall the loan if the borrower does not take satisfactory steps to remedy the situation within X days. The X days specified vary considerably depending on the reasons for EOD being triggered, nature and size of facilities given, action taken by other lenders etc. However, the X days period does not exceed 30 days, as a practice. Where the EOD is not related to a financial covenant (hence the asset may not be in danger of being classified as NPA ), it is rare for the Bank to proceed to recall stage. A threat letter may be issued as a coercive measure without following-up with a recall. As mentioned above, Bank has the legal right to recall the loan upon occurrence of an EOD and expiry of the time, if any, specified in the EOD. In practice, however, lenders are required to prove before judicial authorities that every reasonable opportunity had been given to the borrower for setting right the situation. It is therefore helpful to the lender s case to allow a certain time by issue of a threat letter before actually recalling the loan and proceeding for other legal remedies. However, time and again borrowers have been able to approach lenders even after recall (or even after other legal action has been initiated) and settle their obligations through Negotiated Settlements. This is strong evidence that sufficient opportunity is available to the borrower even if the lender does not allow any grace period before recalling the loan. 4. It may thus be seen from the above that the banking practices prevailing in India are that if a breach is not substantive, e.g., breach of a financial covenant, the bank would not recall a loan. In case of a non-substantive breach, for example, the borrower has not supplied environment clearance certificate at the balance sheet date for setting up a factory, because the matter is pending before the Environment Ministry, the banker would not recall the loan. This is because the Environment Ministry usually takes a long time in clearing various proposals. In other words, the delay has nothing to do with the nature of the project affecting the quality of the loan. Even in substantive breaches, the banks wait till a loan becomes an NPA and an extension period is given within which the default is required to be made good by the borrower. Such steps are taken by the banks keeping in view the existing legal environment in the country. Further, many times, the breaches get rectified before the financial statements are authorised for issue after the balance sheet date. In view of these prevailing practices evidencing banker-customer relationship, in case the requirements of paragraph 69 (d) read with paragraph 74 of IAS 1 are to be applied strictly, it would result into large number of balance sheets of entities in the country getting adversely affected. 2

4 Position in US GAAPs 5. It may be noted that Topic of US GAAP prescribes the following requirements: Callable Debt Current liabilities shall include long-term obligations that are or will be callable by the creditor either because the debtor s violation of a provision of the debt agreement at the balance sheet date makes the obligation callable or because the violation, if not cured within a specified grace period, will make the obligation callable. Accordingly, such callable obligations shall be classified as current liabilities unless either of the following conditions is met: (a) The creditor has waived or subsequently lost (for example, the debtor has cured the violation after the balance sheet date and the obligation is not callable at the time the financial statements are issued or are available to be issued [as discussed in Section ]) the right to demand repayment for more than one year (or operating cycle, if longer) from the balance sheet date. If the obligation is callable because of violations of certain provisions of the debt agreement, the creditor needs to waive its right with regard only to those violations. (b) For long-term obligations containing a grace period within which the debtor may cure the violation, it is probable that the violation will be cured within that period, thus preventing the obligation from becoming callable Drawing a distinction between significant violations of critical conditions and technical violations is not practicable. A violation that a debtor considers to be technical may be considered critical by the creditor. Furthermore, a creditor may choose to use a technical violation as a means to withdraw from its lending relationship with the debtor. If the violation is considered insignificant by the creditor, then the debtor should be able to obtain a waiver as discussed in the preceding paragraph. Carve-out made in Indian Accounting Standards (Ind AS) 6. On receipt of large number of representations from industry and after discussion with various bankers with regard to the existing prevailing practices which are reproduced in paragraph 3 above, it was decided to make changes in Ind AS 1, Presentation of Financial Statements, corresponding to IAS 1, as described below. Consideration of Materiality of a Breach 3

5 7. With a view to focus only on the substantive breaches (e.g., those that are financial covenants) the expression used in Ind AS 1 is breach of a material provision. It is felt that since materiality is all pervasive concept in the application of accounting standards, even under IAS 1, one would consider the materiality aspect of a breach of a loan covenant before deciding to classify a non-current liability into a current liability. Accordingly, adding the word material does not change the position vis-à-vis IAS 1. Further, use of the word material instead of technical or critical conveys a better understanding as the concept of materiality is used even presently to apply the requirements of various standards keeping in view the facts and circumstances of each case. Events Occurring after the Balance Sheet Date 8. Paragraph 74 of Ind AS 1, apart from making a change as indicated at (a) above, also states that the non-current liability is not classified into a current liability if the lender agreed after reporting period and before the approval of the financial statements for issue, not to demand payment as a consequence of the breach. It is felt that the modified paragraph 74 provides for a requirement which is similar to that of US GAAPs as reproduced in paragraph 5 above. Apart from making the aforesaid changes in paragraph 74, paragraph 76 of IAS 1 as reproduced below has been deleted: In respect of loans classified as current liabilities, if the following events occur between the end of the reporting period and the date the financial statements are authorised for issue, those events are disclosed as non-adjusting events in accordance with IAS 10 Events after the Reporting Period: (a) Refinancing on a long-term basis; (b) Rectification of a breach of a long-term loan arrangement; and (c) The granting by the lender of a period of grace to rectify a breach of a longterm loan arrangement ending at least twelve months after the reporting period. 9. In view of the above changes, consequential changes have also been made in Ind AS 10, Events Occurring after the Balance Sheet Date. 10. While the requirements of IAS 1 may be technically correct, they do not recognise the economic reality prevailing in the business environment in India. The requirements in accounting standards should reflect the economic reality which would help users in taking decisions keeping in view the prevailing business and economic environment in 4

6 the country; otherwise, the decisions are likely to have unintended consequences. For example, the classification of a non-current liability into current on a breach of a default which is subsequently rectified before the financial statements are authorised for issue would adversely affect the solvency ratios of the entity thereby resulting into recall of other loans which would not have otherwise occurred, and could jeopardise the existence of the entity. It appears that the US GAAPs take cognizance of the economic reality and provide for the same accordingly. The banking practices prevailing in India may be peculiar only in the emerging economies where the capital is scarce and the industry is still in the process of development. ED issued by IASB on Classification of Liabilities 11. IASB has recently issued Exposure Draft (ED/2015/1), Classification of Liabilities, (comments to be received by 10 th June, 2015), which in a way reinforces the position stated in paragraphs 69 (d), with changes as indicated below: it does not have an unconditional at the end of the reporting period a right to defer settlement of the liability for at least twelve months after the reporting period (see paragraph 73 72R). Terms of a liability that could, at the option of the counterparty, result in its settlement by the issue of equity instruments do not affect its classification. Paragraph 72R replaces the existing paragraph 74 and provides for as below: The following are examples of circumstances that create a right to defer settlement that exists at the end of the reporting period and, thus, affect the classification of the liability in accordance with paragraph 69(d). (b) However, When an entity breaches a provision of a long-term loan arrangement on or before the end of the reporting period with the effect that the liability becomes payable within twelve months after the reporting period, the entity classifies the liability as non-current if the lender agreed by the end of the reporting period to provide a period of grace ending at least twelve months after the reporting period, within which the entity can rectify the breach and during which the lender cannot demand immediate repayment. 12. It is evident that the changes being proposed in the ED do not address the concerns as expressed in the preceding paragraphs. It is, therefore, suggested that necessary changes may be made in the relevant paragraphs of IAS 1. 5