Article. Comprehending Other Comprehensive Income (OCI) from an NBFC s Perspective: Financial Income to include items of other comprehensive income?

Transcription

1 Comprehending Other Comprehensive Income (OCI) from an NBFC s Perspective: Rahul Maharshi rahul@vinodkothari.com Financial Services Division finserv@vinodkothari.com 25 th March, 2018 Check at: Copyright: This write up is the property of Vinod Kothari Consultants P. Ltd and no part of it can be copied, reproduced or distributed in any manner. Disclaimer: This write up is intended to initiate academic debate on a pertinent question. It is not intended to be a professional advice and should not be relied upon for real life facts.

2 Introduction In January 2016, Ministry of Corporate Affairs (MCA) had announced the roadmap for implementation of Indian Accounting Standards (Ind AS) on Scheduled Commercial Banks (excluding Regional Rural Banks [RRBs]), Insurers/Insurance Companies and NBFCs. The MCA also clarified that notwithstanding the Ind AS roadmap for Companies, which were earlier laid down in the month of February, 2015, the holding, subsidiary, joint venture or associate companies of banks would also prepare Ind AS Financial Statements for accounting periods beginning 1 st April, 2018 with comparatives for the period ending 31 st March, 2018 or thereafter. Similarly, the Reserve Bank of India, the apex regulator for banks and NBFCs in the country, issued a circular in February, 2016 ingeminating the timeline for Ind AS implementation by banks issued by the MCA and pointing out certain critical issues to be considered while implementation, including a mandate on banks to submit proforma Ind AS financial statements to the RBI from the half-year ended 30th September, 2016 onwards. In the Ind AS era, the onus of presentation as well as to what should constitute Financial Statements is explained in Ind AS 1-Presentation of Financial Statements ( Ind AS 1 ) viz. defined as general purpose financial statements to include those statements intended to meet the needs of users who are not in a position to require an entity to prepare reports tailored to their particular information needs. A complete set of financial statements would comprise of: (a) a balance sheet as at the end of the period; (b) a statement of profit and loss for the period; (c) statement of changes in equity for the period; (d) a statement of cash flows for the period; (e) notes, comprising a summary of significant accounting policies and other explanatory information; A significant change introduced by Ind AS 1 is the concept of presenting the other comprehensive income ( OCI ) as a part of the statement of profit and loss for the period. OCI comprises of items of income and expense (including reclassification adjustments) that are not recognized in profit or loss as required or permitted by other Ind AS(s). An important question which needs to be addressed in relation to OCI would be whether to consider items of OCI to form part of finance income arising from financial assets as required

3 by prospective NBFCs to qualify the test? To address the same, here is a comprehensive analysis. Concept of Other Comprehensive Income In the erstwhile era of Indian Generally Accepted Accounting Principles ( Indian GAAP ), there only existed a classification of capital revenues and operational revenues, which in turn used to guide that all capital receipts were directly to be driven to the Balance Sheet and the revenue receipts were shown in Profit or Loss Account. However, there are wide range of activities which are incidental to the operations of an organization in due course of its business which lead to non-cash income or losses, for example, Fair value changes in the assets and liabilities held by an entity. Such changes are notional in nature yet certain value is created and incidentally accrued to the entity which form part of OCI. Ind AS 109, directs that an entity making equity investments to measure its investments at fair value in the financial statements, where it records the value changes through profit and loss account, except for those equity investments for which the entity has irrevocably elected to present the fair value changes through OCI. The entity which trades in equity instruments cannot take this option of initially recognizing it through OCI and has to record the fair value changes through profit and loss. The irrevocable election to present the fair value changes through OCI is only done by companies which make strategic investments and not by those who intend to gain financial endeavors from such investments. Therefore, an organization does not just create value by its cash flows and profit, but also by other value creating parameters which may include brand image resulting in changes in the value of assets & liabilities. These parameters contribute to the organization as well and to capture their impact, they are presented in OCI. It is to be noted that such items are notional in nature and are incidental to the activities of the organization, hence, are not considered as the financial endeavor of the entity. For eg. the gains and losses from investments in equity instruments for which OCI has been irrevocable elected would continue to stay in OCI even when equity instruments are sold, the cumulative gain or loss on that investment can be transferred from OCI to equity directly and the same is not routed through profit or loss account. As a consequence of above, the entity which elects OCI shall never realize the gains in the profit and loss, the same is also not required as the entity did not invest in such instruments to fulfill the primary objective of the entity. Any gain/loss on such investments are anyways not financial in nature from the perspective of financial income for NBFC test. Hence, considering OCI to form part of Finance Income of an NBFC would amount to a notionally inflated Finance Income and in turn would not picture the true Finance Income accruing from the financial assets held by the NBFC.

4 As per Ind AS 1, the following items form part of OCI: (a) changes in revaluation surplus (see Ind AS 16, Property, Plant and Equipment and Ind AS 38, Intangible Assets); (b) remeasurements of defined benefit plans (see Ind AS 19, Employee Benefits); (c) gains and losses arising from translating the financial statements of a foreign operation (see Ind AS 21, The Effects of Changes in Foreign Exchange Rates); (d) gains and losses from investments in equity instruments designated at fair value through other comprehensive income in accordance with paragraph of Ind AS 109, Financial Instruments; (da) gains and losses on financial assets measured at fair value through other comprehensive income in accordance with paragraph 4.1.2A of Ind AS 109. (e) the effective portion of gains and losses on hedging instruments in a cash flow hedge and the gains and losses on hedging instruments that hedge investments in equity instruments measured at fair value through other comprehensive income in accordance with paragraph of Ind AS 109 (see Chapter 6 of Ind AS 109); (f) for particular liabilities designated as at fair value through profit or loss, the amount of the change in fair value that is attributable to changes in the liability s credit risk (see paragraph of Ind AS 109); (g) changes in the value of the time value of options when separating the intrinsic value and time value of an option contract and designating as the hedging instrument only the changes in the intrinsic value (see Chapter 6 of Ind AS 109); (h) changes in the value of the forward elements of forward contracts when separating the forward element and spot element of a forward contract and designating as the hedging instrument only the changes in the spot element, and changes in the value of the foreign currency basis spread of a financial instrument when excluding it from the designation of that financial instrument as the hedging instrument (see Chapter 6 of Ind AS 109). The test for an NBFC The RBI has prescribed a test for the companies to fall under the criteria of a Non-banking financial Company. Financial activity, as principal business is when a company s financial assets constitute more than 50 per cent of the total assets and income from financial assets

5 constitute more than 50 per cent of the gross income. A company which fulfils both these criteria will be registered as NBFC by RBI. Financial asset is a tangible liquid asset that derives value because of contractual claim of what it represents. Stocks, bonds, bank deposits, are examples of some financial assets. Composition of 50% financial income The income statement of an NBFC is generally classified into two broad categories: 1. Income from financial business 2. Income from the non-financial business The income from financial business includes the fund-based income and the fee-based income. The fund-based income for an NBFC shall comprise of net lease income, interest income (interest on inter-corporate deposits, interest on other loans, and investment income (which shall include interest, dividends, and profit on sale of investments.) nature of which are discernible and not notional. The fee-based income shall comprise of Guarantee fee, underwriting commission, other merchant banking income, income from brokering and syndication in bills/icd s/lease which are again, incomes, that cannot be comprehended as notional in nature, on the contrary, are directly associated with the course of business of an NBFC. Conclusion According to a report of the Working Group on Implementation of Ind AS by Banks in India, the working group suggested formats for the presentation of the financial statements to the RBI. The RBI vide circular (RBI/ /DBR.FID.No.1/ / ) referred to as RBI circular 1 dated August 4 th, 2016, apparently approved new formats for the financial statements. On perusal of the same, it can be seen that OCI is presented as a part of the profit and loss account, however, effect of which is not realised in the profit and loss account i.e it is only presented, but not added to the net profit/(loss) for the period. Additionally, OCI is shown as a part of statement of changes in equity under the head other equity with corresponding changes in the financial year. It is thus justifiable that OCI shall not be considered as financial income at the first instance. This is due to the fact that it is not a realized gain, rather a notional income, which is something not existing in reality. Since, OCI does not fall under the ambit of a realized income, it cannot be classified as an income from financial business nor the income from non-financial business. 1

6 Other comprehensive income is a forecast rather than a precast of the incomes of an entity as the name says, it is a caters to the need of comprehending incomes of an entity by including even those incomes which are yet to accrue to the entity and are notional in nature, yet they pose an impact on the position of an entity from a stakeholders perspective calculation of the finance income in relation to the test however is a calculation which is based on the actual financial results of an entity, not prospective results. Therefore, inclusion of items of other comprehensive income to calculate the finance income of an Entity for the test would be a mere illusionary increase in the finance income of the prospective NBFC.