CBDT issues revised and updated guidance for implementation of TP provisions

Transcription

1 Tax Insights from India Tax & Regulatory Services CBDT issues revised and updated guidance for implementation of TP provisions October 19, 2015 In brief The Central Board of Direct Taxes (CBDT) has issued Instruction No. 15 of 2015 on 16 October This instruction (new instruction) replaces Instruction No. 3 of 2003 which had been issued by CBDT on 20 May 2003 (old instruction). The old instruction had been issued to provide guidance to Transfer Pricing Officers (TPO) and Assessing Officers (AO) to operationalise the transfer pricing provisions and to ensure procedural uniformity. However, due to a number of legislative, procedural and structural changes carried out over the last few years, the old instruction is being now replaced with the new one to provide updated and adequate guidance in relation to international transactions. The new instruction mentions that similar guidance is also under consideration by CBDT for specified domestic transactions. In detail The guidelines contained in the new instruction are either: 1. similar to the ones in the old instruction; or 2. have simply been updated based on the current relevant provisions of the Income-tax Act, 1961 (the Act) and the Income-tax Rules, 1962 (the Rules); or 3. are entirely new, i.e., did not exist in the old instruction or are a modified version of the old instruction, and are also not explicitly provided either in the Act or in the Rules as they stand as of current date. In this news alert, we have focused on the third category of changes made in the new instruction [i.e., as stated in point 3. above]. These changes have been summarized below: There is now no requirement of selecting or referring a case for transfer pricing scrutiny on the basis of the value of international transaction(s), because transfer pricing cases are now being selected for scrutiny on the basis of risk parameters. The only exception to this would be in a case where the AO comes to know that the taxpayer has entered into an international transaction(s), but has either not filed an Accountant's Report (AR) under section 92E of the Act, or not declared the transaction(s) in its AR. In such a case, irrespective of the value of international transactions, the AO may refer the matter to the TPO after giving an opportunity of being heard to the taxpayer. It may be noted that the new instruction specifically mentions that this guidance would also apply in case of specified domestic transactions. Where an AR has been filed by a taxpayer, the AO can (as he could earlier), on the basis of details provided in the AR, arrive at a prima facie belief that a reference to the TPO is necessary. However, in a few situations, before making a reference to the TPO 1 or determining arm s length price (ALP) on his own 2, the AO must, as a jurisdictional requirement, 1 Under section 92CA(1) of the Act 2 Under section 92C(3) of the Act

2 Tax Insights record his satisfaction (after giving an opportunity of being heard to the taxpayer) that there is an income or a potential of an income arising and / or being affected on the determination of ALP. These situations are as follows: a) where the taxpayer has not filed an AR, or has not declared one or more international transactions in the AR, but the international transaction(s) come to the notice of the AO, or b) where the taxpayer has declared the international transaction(s) in the AR filed by it, but has made certain qualifying remarks to the effect that the said transaction(s) are not international transactions, or they do not impact the income of the taxpayer. If no objection is raised by the taxpayer to applicability of Chapter X (sections 92 to 92F) of the Act, then the AO s view would be sufficient before making a reference to the TPO. However, where any objection is raised by the taxpayer on the applicability of Chapter X of the Act, then such objections should be considered and specifically dealt with. If a TPO is the rank of an Additional / Joint Commissioner of Income-Tax (CIT), then he shall obtain approval of the jurisdictional CIT (TP) before passing the TP assessment order. On the other hand, if a TPO is the rank of a Deputy/ Assistant CIT, then he shall obtain the approval of the jurisdictional Additional/ Joint CIT before passing the TP assessment order. The jurisdictional CIT (TP) would assign a limited number of important and complex cases, not exceeding 50, to the Additional/ Joint CIT (TPOs) working in the same jurisdiction. Appropriate guidelines shall be framed for selection of such important and complex cases. The takeaways Risk based selection of cases for TP audits (from quantity to quality ) Selection of cases for transfer pricing scrutiny on the basis risk parameters is not an on-ground reality as yet. However, the fact that this has been explicitly stated in the new instruction indicates that the next round of selection of cases is likely to be risk based. So far, selection of cases based on a monetary threshold has led to a significant number of cases being selected for TP audits. As a result, the focus had shifted from a quality investigation to quantity investigations, the repercussions of which were evident in cumbersome audits, both for taxpayers and revenue authorities. Therefore, introduction of risk based scrutiny is a very rational step taken by the Indian Government which will certainly streamline the TP audit process. With such an enormous dispute resolution burden, coupled with growing pendency of cases and already strained Revenue resources, risk based selection of cases for TP audits was undoubtedly called for. Revenue authorities will now hopefully spend less time and costs on too many audits, and end up doing justice to audits which are in fact worth it. Further, valuable time of the judiciary will be effectively spent on meaningful cases, and the Government will in fact be able to collect real revenues. Taxpayers can also now focus their energies on high risk areas, and deploy their own risk assessment techniques in order to strengthen their documentation and defence files such that they are able to effectively manage compliance. However, the choice and transparency around risk parameters would determine how this policy change would be implemented on-ground. The introduction of risk based selection of cases for TP audits also indicates India s intention to adopt Action 13 of the OECD s Base Erosion and Profit Shifting project, i.e., on TP Documentation and Country-by- Country Reporting (CbCR). This is because one of the articulated purposes of CbCR has been to assist in risk assessment. Whatever be the driving factor, selection of cases based on risk assessment is a significant positive and in line with best practices followed globally. Moreover, it would surely boost investor confidence, and demonstrate India s commitment to attracting foreign investment. Situations in which AO must record his satisfaction before reference to TPO The CBDT acknowledges that there could be situations where taxpayers either do not file an AR, or do not declare a transaction(s) in their AR, or declare the transaction with qualifying statements to the effect that the transaction is itself not an international transaction, or that no income arises therefrom. To address these situations, the CBDT has put the onus on the AO to put on record why he believes that the international transaction(s) impacts, or has the potential to impact, income. This would provide the taxpayer with an additional opportunity to present its position, and may prevent occurrence of unwarranted litigation, provided PwC Page 2

3 Tax Insights AOs are given sufficient guidance to implement this, as such issues have, in the past, been highly debated at higher judicial fora. From a reading of the instruction, it is apparent that the CBDT appreciates that applicability of Chapter X (sections 92 to 92F) of the Act would come into play only where an international transaction impacts, or has the potential to impact, income. This is undoubtedly a very rational and legally appropriate approach adopted by the CBDT, which will serve as a reminder for the tax authorities that TP is not beyond fundamentals of taxation. On an overall basis, this approach also ties in with the underlying intent of the Indian TP regulations, i.e., that of avoiding erosion of tax base in India. Notably, this is also in line with the High Court decision in the case of Vodafone (pronounced in October ), wherein the High Court had held that if an international transaction did not give rise to income under the Act, no occasion to apply Chapter X of the Act could arise in such a case. That the AO is required to record his satisfaction where a taxpayer has declared an international transaction in the AR with qualifying remarks, indicates that in scenarios where the taxpayer contends non-applicability of Chapter X, it may be advisable to provide a note in the AR stating the taxpayer s position on such transactions. However, to make this workable, the online AR format would need to be modified so as to provide for notes. The fact that the onus has been put on the AO to record why he believes that an international transaction impacts or has the potential to impact income, provides testimony to the fact that the Indian Government is putting in checks and balances to avoid arbitrary use of authority by first level assessing officers. This may also prevent taxpayers from being saddled with unnecessary adjustments and protracted litigation thereafter, at least on issues relating to applicability or otherwise of Chapter X per se. This is yet another welcome move by the Government to invigorate the investment climate in India. Limiting the number of cases per TPO Limiting the number of important and complex cases handled by each TPO is undoubtedly a laudable step taken by the Indian Government, as the large number of cases being handled by TPOs with less time on hand has probably deterred them from delving into the merits of each case. This could have led to batch processing of cases without proper application of mind, leading to unsustainable TP adjustments at higher judicial fora. However, that said, 50 cases (for senior rank TPOs) may still be a large number, particularly given the fact that these 50 cases would be important/ complex in nature. Further, even for junior rank TPOs, it would be important to prescribe a reasonable upper limit per TPO, in line with international norms (as TPO s counterparts in certain developed jurisdictions are known to handle far less cases on an annual basis). Concluding thoughts On the whole, the issuance of the new instruction reflects the Indian Government s line of thinking and philosophy on different aspects as discussed above, and clearly reflects the political will to control the volume of disputes, better utilise the Revenue s resources, and enhance international perception and investor confidence. However, having said that, onground implementation and execution remain to be seen. Let s talk For a deeper discussion of how this issue might affect your business, please contact: Tax & Regulatory Services Transfer Pricing Gautam Mehra, Mumbai gautam.mehra@in.pwc.com Indraneel R Chaudhury, Bangalore indraneel.r.chaudhury@in.pwc.com 3 Vodafone India Services Pvt Ltd v. UOI - WP No.871 of 2014, TS-308-HC- 2014(BOM)-TP, [2014] 50 taxmann.com 300 (Bombay), [2014] 368 ITR 1 (Bombay), [2014] 271 CTR 488 (Bombay), [2015] 228 Taxman 25 (Bombay), TII-19-HC-MUM-TP. PwC Page 3

4 Tax Insights Our Offices Ahmedabad Bangalore Chennai President Plaza 1st Floor Plot No 36 Opp Muktidham Derasar Thaltej Cross Road, SG Highway Ahmedabad, Gujarat th Floor Millenia Tower D 1 & 2, Murphy Road, Ulsoor, Bangalore Phone Hyderabad Kolkata Mumbai Plot no. 77/A, /A/1, 4th Floor, Road No. 10, Banjara Hills, Hyderabad , Andhra Pradesh Phone & 57, Block DN. Ground Floor, A- Wing Sector - V, Salt Lake Kolkata , West Bengal / th Floor Prestige Palladium Bayan Greams Road Chennai PwC House Plot No. 18A, Guru Nanak Road(Station Road), Bandra (West), Mumbai Gurgaon Pune For more information Building No. 10, Tower - C 17th & 18th Floor, DLF Cyber City, Gurgaon Haryana th Floor, Tower A - Wing 1, Business Bay, Airport Road, Yerwada, Pune Contact us at pwctrs.knowledgemanagement@in.pwc.com About PwC At PwC, our purpose is to build trust in society and solve important problems. We re a network of firms in 157 countries with more than 208,000 people who are committed to delivering quality in assurance, advisory and tax services. Find out more and tell us what matters to you by visiting us at In India, PwC has offices in these cities: Ahmedabad, Bangalore, Chennai, Delhi NCR, Hyderabad, Kolkata, Mumbai and Pune. For more information about PwC India's service offerings, visit PwC refers to the PwC International network and/or one or more of its member firms, each of which is a separate, independent and distinct legal entity in separate lines of service. Please see for further details PwC. All rights reserved For private circulation only This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, PwCPL, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it. Without prior permission of PwCPL, this publication may not be quoted in whole or in part or otherwise referred to in any documents PricewaterhouseCoopers Private Limited. All rights reserved. In this document, PwC refers to PricewaterhouseCoopers Private Limited (a limited liability company in India having Corporate Identity Number or CIN : U74140WB1983PTC036093), which is a member firm of PricewaterhouseCoopers International Limited (PwCIL), each member firm of which is a separate legal entity.

5 Tax Insights from India Tax & Regulatory Services CBDT prescribes final rules for use of arm s length range and multiple year data October 21, 2015 In brief The Central Board of Direct Taxes (CBDT) has now issued the final rules to give effect to the use of multiple year data and range concept which were introduced by Finance Act, These rules would be applicable to international transactions and specified domestic transactions that are entered into by taxpayers on or after 1 April In detail Use of multiple year data Would be applicable only in cases where Resale Price Method (RPM), Cost Plus Method (CPM) or Transactional Net Margin Method (TNMM) has been selected as the Most Appropriate Method (MAM). For each comparable, the data shall relate to the current year. In case such data is not available at the time of furnishing the return of income, data pertaining to up to two preceding financial years may be used. (Observation: If current year is Year zero and the financial year preceding that is Year 1 and the year prior to such year is Year 2, then it is worth noting that the rules do not envisage a situation wherein a comparable is selected only if it has data relating to Year 2.) Current year data, if available during assessment, shall be used. (Observation: This is not in line with contemporaneous documentation requirements and the requirement that documentation should exist latest by the due date of filing the return of income [Rule 10D(4)], especially if additional comparable(s) are added during assessment. This would lead to uncertainty as to the basis of arm s length price (ALP) determination, and may even result in penal consequences for taxpayers. Owing to this uncertainty over which the taxpayer has no control, penalty provisions, as they currently exist, may need modification). If a comparable is selected on the basis of preceding year data, but is not found to be comparable for the current year for qualitative or quantitative reasons, then such comparable would need to be rejected from the data set. When using multiple year data, data for each comparable shall be the weighted average of the selected years. An illustration explaining the computation is provided below: Year 0 Year 1 Year 2 Total OP/TC for the Operating profit comparable would be 900/ 5400 = 16.7% Total cost

6 Tax Insights Application of range The range concept shall be applicable when: (a) the MAM is either Comparable Uncontrolled Price (CUP) Method, RPM, CPM, or TNMM; and (b) there are at least 6 comparables. Where these conditions are not fulfilled, arithmetic mean shall continue to apply, as before, along with the tolerance range benefit. (Observation: Specifying the number of comparables may lead to a situation where the taxpayer uses range for setting a transfer price but may have to apply the arithmetic mean at the time of the assessment. Such situations could lead to a fair amount of ambiguity, uncertainty and reconciliation difficulties for taxpayers and jeopardize their TP documentation and price setting.) Once the values in a data set are arranged in ascending order, the arm s length range would be data points lying between the 35 th and 65 th percentile of the data set. If the transaction price falls within the range, then the same shall be deemed to be the ALP. If the transaction price falls outside the range, the ALP shall be taken to be the Median of the data set. The computation mechanism of range, is explained by way of illustrations below (as reproduced from the final rules): Illustration 1: Where the data set comprises 7 data points (arranged in ascending order), and the percentiles computed are not whole numbers. Percentile Formula Result Value to be selected 35 th Total no. of data points in dataset*35% = [7 * 35%] rd value* 65 th Total no. of data points in dataset*65% = [7 * 65%] th value* Median Total no. of data points in datasets*50% = [7 * 0.5] th value* * Value referred to here is the place value in the data set as arranged in ascending order. Illustration 2: Where the data set comprises 20 data points (arranged in ascending order), and the percentiles computed are whole numbers. Percentile Formula Result Value to be selected 35 th Total no. of data points in dataset * 35% = [20 * 35%] 7.00 Mean of 7 th & 8 th value 65 th Total no. of data points in dataset * 65% = [20 * 65%] Mean of 13 th & 14 th value Median Total no. of data points in dataset * 50% = [20 * 0.5] Mean of 10 th & 11 th value The takeaways Largely, the provisions seem to have given clarity in relation to use of multiple year data and application of range concept. The intent of the CBDT to reduce TP litigation is clearly visible. The reduction of minimum number of comparables required for availing the range from 9 to 6; a relative broadening/ widening of the range from 40 th - 60 th percentile to 35 th 65 th ; and allowing the use of range in case of CUP Method are undoubtedly positives emerging from the final rules. Having said that, the following aspects may need consideration by the Government, going forward: Since use of 35 th 65 th percentile is not aligned with globally followed practices, it may not find ready acceptance by Competent Authorities of other countries during a bilateral advance pricing arrangement (APA), multilateral APA or a mutual agreement procedure (MAP) negotiation. APA authorities may need to consider how a reconciliation would be done between application of range in the regular APA years vis-à-vis use of arithmetic mean in the roll back years. Let s talk For a deeper discussion of how this issue might affect your business, please contact: Tax & Regulatory Services Transfer Pricing Gautam Mehra, Mumbai gautam.mehra@in.pwc.com Indraneel R Chaudhury, Bangalore indraneel.r.chaudhury@in.pwc.com PwC Page 2

7 Tax Insights Our Offices Ahmedabad Bangalore Chennai President Plaza 1st Floor Plot No 36 Opp Muktidham Derasar Thaltej Cross Road, SG Highway Ahmedabad, Gujarat th Floor Millenia Tower D 1 & 2, Murphy Road, Ulsoor, Bangalore Phone Hyderabad Kolkata Mumbai Plot no. 77/A, /A/1, 4th Floor, Road No. 10, Banjara Hills, Hyderabad , Andhra Pradesh Phone & 57, Block DN. Ground Floor, A- Wing Sector - V, Salt Lake Kolkata , West Bengal / th Floor Prestige Palladium Bayan Greams Road Chennai PwC House Plot No. 18A, Guru Nanak Road(Station Road), Bandra (West), Mumbai Gurgaon Pune For more information Building No. 10, Tower - C 17th & 18th Floor, DLF Cyber City, Gurgaon Haryana th Floor, Tower A - Wing 1, Business Bay, Airport Road, Yerwada, Pune Contact us at pwctrs.knowledgemanagement@in.pwc.com About PwC At PwC, our purpose is to build trust in society and solve important problems. We re a network of firms in 157 countries with more than 208,000 people who are committed to delivering quality in assurance, advisory and tax services. Find out more and tell us what matters to you by visiting us at In India, PwC has offices in these cities: Ahmedabad, Bangalore, Chennai, Delhi NCR, Hyderabad, Kolkata, Mumbai and Pune. For more information about PwC India's service offerings, visit PwC refers to the PwC International network and/or one or more of its member firms, each of which is a separate, independent and distinct legal entity in separate lines of service. Please see for further details PwC. All rights reserved For private circulation only This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, PwCPL, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it. Without prior permission of PwCPL, this publication may not be quoted in whole or in part or otherwise referred to in any documents PricewaterhouseCoopers Private Limited. All rights reserved. In this document, PwC refers to PricewaterhouseCoopers Private Limited (a limited liability company in India having Corporate Identity Number or CIN : U74140WB1983PTC036093), which is a member firm of PricewaterhouseCoopers International Limited (PwCIL), each member firm of which is a separate legal entity.

8 Contents Internal financial controls: Guidance from the ICAI is here! p4 /Accounting for business combinations under Ind AS 103: Fair value all the way! p8 / Ind AS for banks and non-banking financial companies (NBFCs) p11 / Integrated reporting: A new corporate reporting model p12 / Measuring quality in audits p14 / Recent technical updates p16 PwC ReportingPerspectives October

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10 Editorial We are pleased to bring you our quarterly newsletter covering the latest developments in financial reporting as well as other regulatory updates. The Companies Act, 2013, has introduced many new reporting requirements for the statutory auditors of companies. One of these relates to section 143(3) (i) of the act, which requires the statutory auditor to additionally state in its audit report whether the company has adequate internal financial controls (IFC) system in place and the operating effectiveness of such controls. The Institute of Chartered Accountants of India (ICAI) has now reissued the longawaited Guidance Note on Audit of Internal Financial Controls over Financial Reporting (hereinafter guidance note) which provides detailed guidance on this topic. We have analysed key matters covered in the guidance note which may be of interest to the management and others. Phase 1 companies are getting ready to adopt the new Indian Accounting Standards (Ind AS) beginning 1 April As part of our continued effort to provide guidance on Ind AS, we have included an overview of certain important aspects related to accounting for business combinations under Ind AS 103. We discuss how the accounting regime for mergers and acquisitions will change for corporate India from the existing Indian generally accepted accounting principles (GAAP) and how this is expected to have a significant impact, especially for companies planning major restructuring of operations, reorganisations or acquisitions. The Reserve Bank of India (RBI) has recently recommended to the Ministry of Corporate Affairs (MCA) a roadmap for the implementation of Ind AS for banks and non-banking financial companies (NBFCs) from onwards. Our comments and next steps are included in this edition. We also discuss integrated reporting, which is another important development in a stream of proposed reporting innovations aimed at improving the usefulness of corporate reporting. This edition includes the salient features of the concept release on potential audit quality indicators (AQI) issued by the Public Company Accounting Oversight Board (PCAOB), which seeks public comment on potential AQIs and may provide new insights on how to evaluate the quality of audits, including how high quality audits may be achieved. Finally, we have summarised other Indian as well as global regulatory updates. We hope you find this newsletter informative and of continued interest. We welcome your feedback at pwc.update@in.pwc.com.

11 Internal financial controls: Guidance from the ICAI is here! The new Companies Act, 2013, now requires auditors to also opine on whether a company has an adequate internal financial controls (IFC) system in place and the operating effectiveness of such controls. This is in addition to the existing audit opinion on financial statements. While this requirement was originally applicable to financial statements ending 31 March 2015, considering the lack of guidance, this applicability was deferred and is now effective for the year ending 31 March Due to the deferral of this reporting requirement, the Ministry of Corporate Affairs (MCA) retained the reporting requirement relating to internal controls in certain specific areas under the Companies (Auditor s Report) Order, 2013 (CARO). Reporting on IFC is undoubtedly a paradigm shift from the reporting required under CARO. The ICAI has now reissued the longawaited Guidance Note on Audit of Internal Financial Controls over Financial Reporting (guidance note), which provides detailed guidance on this topic. IFC: Regulatory mandate under Companies Act, 2013 Relevant clauses Requirement Applicability Directors Responsibility Statement: Sec. 134(5)(e) Board report: Rule 8(5) of Companies (Accounts) Rules Code for IDs: Sec. 149(8) and Schedule IV AC terms of reference: Sec. 177 Auditor s report: Sec. 143(3)(i) Board to confirm that IFCs are adequate and operating effectively Board report to state the details in respect of the adequacy of IFC with reference to the financial statements IDs to satisfy themselves on the integrity of financial information and that financial controls are robust and defensible Evaluation of IFC Auditors to report if the company has adequate IFC systems and that they are operating effectively (from ) Listed companies All companies All companies having IDs All companies having an AC All companies AC Audit committee ; ID Independent directors ; CFS Consolidated financial statements What do IFC encompass? The guidance note provides the necessary criteria for maintaining effective IFC for companies. It draws upon the Internal Control Components of Standard on Auditing (SA) 315, Identifying and Assessing the Risks of Material Misstatement Through Understanding the Entity and its Environment, which includes the following five required components: Control environment Entity s risk assessment process Control activities Information system and communication Monitoring of controls The guidance note explains that for auditor reporting, the term IFC is restricted within the context of the audit of financial statements and relates to internal control over financial reporting only (ICFR). This is also consistent with the practice adopted internationally, e.g. Sarbanes-Oxley (SOX) reporting in the US. This is a relief as it removes unnecessary ambiguity by excluding from the scope operational controls, i.e. those facilitating the effectiveness and efficiency of company s operations, and also differentiates ICFR from enterprise risk management and risk management policies which boards of companies have to maintain. The guidance note reproduces the definition of the term ICFR from the US Auditing Standard (AS) 5: An Audit of Internal Control Over Financial Reporting that is Integrated with An Audit of Financial Statements issued by the PCAOB: A process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company s internal financial control over financial reporting includes those policies and procedures that: pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; 4 PwC

12 provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorisations of management and directors of the company; and provide reasonable assurance regarding prevention or timely detection of unauthorised acquisition, use, or disposition of the company s assets that could have a material effect on the financial statements. Building blocks of an ICFR audit P L A NNIN G D E S IG N & I M P L E M E N T A T IO N Start Identify significant account balances/ disclosure Items Assess the design of controls 6 1 Assess and Manage Risk Manage Audit Engagement Identify & understand significant flows of transactions 2 Assess the Implementation of controls 7 Identify risk of material misstatements 3 Appropriate design & Implementation ` of controls? Identify controls which address risk of material misstatements 4 Identify applications, associated IT environment, ITGC 5 Assess audit impact and plan other suitable procedures 8 Plan operative effectiveness testing 9 R E P O R T IN G O P E R A T IN G E FFE C T IV E N E S S Plan nature, timing and extent of testing operative 10 effectiveness Assess impact on audit opinion 14 Perform operative effectiveness testing 11 Form audit opinion on financial statements 15 Assess findings and conclude on operative effectiveness 12 End Form opinion on IFC 13 Prepare and Control Audit Documentation Continuous Focus on Audit Quality Source: Guidance Note on Audit of Internal Financial Controls over Financial Reporting PwC ReportingPerspectives 5

13 To whom does this apply? The guidance note clarifies that reporting on ICFR by auditors will be applicable to both listed and unlisted companies, including small and oneperson companies. This is in line with the requirements of section 143(3)(i) of the Companies Act, Furthermore, it states that auditors will have to report on ICFR in respect of both stand alone and consolidated financial statements. In respect of consolidated financial statements, it will cover subsidiaries, joint ventures (JVs) and associates of the group, which are companies incorporated in India, since the Companies Act applies to such entities. It is relevant to note that the ICAI has adopted a similar approach with respect to reporting on various clauses in CARO on the consolidated financial statements. Accordingly, auditors of foreign components of an Indian parent are not required to report on ICFR. When does this apply and for financial statements of which period? Another aspect which required clarification was whether the comments in the auditor s report should describe the existence and effective operation of ICFR during the period under reporting of the financial statements or as at the balance sheet date. The guidance note clarifies that auditors will have to report whether a company has an adequate ICFR system in place and whether the same was operating effectively as at the balance sheet date of 31 March In practice, this will mean that when forming its audit opinion on ICFR, the auditor will surely test transactions during the financial year ending 31 March 2016 and not just as at the balance sheet date, though the extent of testing at or near the balance sheet date may be higher. If control issues or deficiencies are identified during the interim period and are remediated before the balance sheet date, then the auditor may still be able to express an unqualified opinion on the ICFR. For example, if deficiencies are discovered, the management may have the opportunity to correct and address these deficiencies by implementing new controls before the reporting date. However, sufficient time will need to be allowed to evaluate and test controls, which will again depend on the nature of the control and how frequently it operates. This will be a matter of professional judgement. This is particularly important for companies for the current year ending 31 March 2016, as it will be the first year when auditor validation of ICFR will be required. In addition, reporting on ICFR will not apply to interim financial statements, such as quarterly or half-yearly, unless such reporting is required under any other law or regulation. Integrated audit Both corporates and auditors in India will need to come to terms with the concept of a combined or an integrated audit, which includes an audit of ICFR over financial reporting and financial statements. The guidance note acknowledges that while the objectives of the audit of ICFR and audit of financial statements are not identical, the auditor now needs to plan and perform work in such a way that it achieves the objectives of both the audits in an integrated manner. In such an audit, the auditor is required to plan and conduct the audit to fulfil the following: Obtain sufficient evidence to support the auditor s opinion on the ICFR as of the year end Obtain sufficient evidence to support the auditor s control risk assessments for the purposes of the audit of the financial statements It is relevant to note that any system of internal controls provides only a reasonable assurance on the achievement of the objectives for which it has been established. The guidance note also permits auditors to use the concept of materiality in determining the extent of testing such controls. Standards on Auditing issued by the ICAI, which now also need to be complied with under the Companies Act, 2013, do not fully address the auditing requirements for reporting on the system of ICFR. The guidance note suggests that the relevant portions of the Standards on Auditing will need to be considered by the auditor when performing an audit of ICFR (e.g. the requirements of SA 230, Audit Documentation, when documenting the work performed on ICFR; of SA 315, when understating internal controls). The guidance note essentially provides supplementary procedures that will need to be considered by the auditor for planning, performing and reporting an audit of ICFR. Reporting As per the guidance note, auditors will have to issue a qualified or an adverse opinion on ICFR if material weaknesses in the company s ICFR are identified as part of their audit. Material weakness is a deficiency, or a combination of deficiencies, in ICFR over financial reporting, such that there is a reasonable possibility that a material misstatement of the company s annual or interim financial statements will not be prevented or detected on a timely basis. A material weakness in ICFR may exist even when the financial statements are not materially misstated. The guidance note also specifies indicators of material weaknesses, such as the following: Identification of fraud, whether or not material, on the part of senior management 6 PwC

14 Errors observed in previously issued financial statements in the current financial year Identification by the auditor of a material misstatement of financial statements that would not have been detected by the company s IFC over financial reporting Ineffective oversight of the company s external financial reporting and internal financial controls over financial reporting by the company s audit committee An adverse opinion will be issued if such matters are pervasive to the financial statements i.e. they impact various elements, accounts, or items of the financial statements, or a substantial portion of the financial statements. Additionally, significant control deficiencies will have to be reported to the audit committee. Comparison with international practices It is interesting to note that the guidance note has similarities with PCAOB Auditing Standard No. 5, which is applied by auditors in the context of SOX reporting in the US. For example, various paragraphs from the US auditing standard have been inserted within the guidance note, including definitions such as significant deficiency and material weakness related to internal controls. Also, in India, auditors are not required to report on the management s assertion of effectiveness on IFC. Reporting under the act will be an independent assessment and assertion by the auditor on the adequacy and effectiveness of the entity s ICFR. What next? The guidance note is a fairly comprehensive document covering over 200 pages, with detailed guidance in several areas related to ICFR, such as the internal control components, entity-level controls, information technology controls, understanding and documentation of process flows, including flow charts, use of service organisations and sampling. Both the management and auditors will have to quickly familiarise themselves with and decipher the details of this guidance note in order to gear up for the year-end reporting on IFC! PwC ReportingPerspectives 7

15 Accounting for business combinations under Ind AS 103: Fair value all the way! Background Mergers and acquisitions have become increasingly large and complex in today s business environment. Under the current Indian GAAP, such transactions are accounted for under three different accounting standards (AS): Accounting for mergers and amalgamations under AS 14, accounting for acquisition of a group of assets being a business under AS 10, or by preparing consolidated financial statements which include subsidiaries under AS 21. The current Indian GAAP are mainly driven by form and may not truly reflect the underlying substance of such mergers/acquisitions. Furthermore, because of the application of different standards, the accounting consequences for economically similar transactions can significantly vary, thereby lacking consistency and comparability. Ind AS 103 will fundamentally change the way business combinations, mergers and acquisitions will be accounted for going forward. It is a single comprehensive standard that provides detailed guidance on accounting for business combinations irrespective of the nature, structure or legal form of the transaction. This will clearly bring in uniformity and comparability in accounting for all types of business combinations. In this article, we analyse certain important aspects related to accounting for business combinations under Ind AS 103 wherein companies, especially those planning major restructuring of operations, reorganisations or acquisitions, should be aware of. Which transactions are covered within the scope of Ind AS 103? the relevant activities of the investee, i.e. those activities that significantly affect the investee s returns. Under Ind AS, it is only one parent that can control another subsidiary, unlike the case of Indian GAAP, where the same subsidiary could have been potentially consolidated by two parent holding companies. Accounting for formation of a joint arrangement and acquisition of subsidiaries by an investment entity that are carried at fair value are specifically scoped out of the standard. Similarly, purchase of assets or a group of assets (those sets of assets and activities that do not constitute a business ) are also scoped out of the standard. What is a business? Ind AS 103 defines a business as An integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs or other economic benefits directly to investors or other owners, members or participants. The acquirer will first have to evaluate whether the activities of the acquiree meet the above definition of business. In order to meet this definition, it needs to have inputs (assets and other resources controlled by the acquiree) and processes (i.e. strategic management processes, resource management processes, etc.) which, when applied to the inputs, are capable of producing outputs. In simple terms, the acquiree should have assets and processes which are capable of generating outputs. Outputs can be in various forms, such as cost synergies, profits and dividends. Let s explore this with an example: This distinction is important because it significantly changes the accounting of the transaction. Acquisition of businesses is accounted for under the acquisition method of accounting prescribed by the requirements of Ind AS 103. On the other hand, accounting for acquisition of assets or a group of assets is less cumbersome and covered by other Ind AS, such as Ind AS 16 on property, plant and equipment or Ind AS 38 on intangible assets, as applicable. This is quite fundamental because acquisition of businesses results in goodwill or negative goodwill, which is absent in the case of acquisition of assets or a group of assets. How will assets and liabilities be recorded by the acquirer under the acquisition method of accounting for business combinations? Ind AS 103 requires the mandatory use of the acquisition method of accounting for business combination. The pooling of interest method of accounting for mergers and acquisitions under the current Indian GAAP will no longer be permitted under Ind AS other than in the case of transactions between entities under common control. Essentially, under the acquisition method of accounting, all assets acquired (subject to certain exceptions) and liabilities assumed on the date of acquisition of control of the acquired business will be recorded at their fair values. Entities will also need to identify any previously unrecognised intangible assets of the acquiree. This will result in recognition of not only higher amounts, but also of additional items of intangible All transactions or events in which an entity obtains control over one or more businesses are covered under the scope of this standard. Therefore, understanding what constitutes a business is the starting point before any business combination accounting can be done. The next step is to determine whether the investor has obtained control over the business control is the unilateral power to direct Entity A acquires 100% interest in another entity B. Entity B has only a piece of land and a building but no other activities, employees, etc. Effectively, in this situation, Entity A has only acquired land and a building by acquiring Entity B. Accordingly, in the absence of any processes, the purchase of Entity B will not meet the definition of a business and so this transaction will be scoped out of Ind AS 103. On the other hand, say, Entity B, which owns the land and building, is also operating a hotel in the building comprising inputs (employees and other assets), processes (reservation systems, billing systems, etc.) and regular customers visiting the hotel. In this case, Entity A has effectively acquired an operating business. Such a transaction will be within the scope of Ind AS PwC

16 assets, which, under the Indian GAAP, generally get subsumed within goodwill. Examples of intangibles include customer relationships, patents, brands and inprocess research. Recognition of such intangibles will consequently also increase the reported amortisation expense in the acquirer s consolidated financial statements. It is also important to note that purchase price allocations can become a complex and time-consuming exercise, requiring the timely involvement of experts. How is goodwill or bargain purchase (negative goodwill) determined in a business combination and what is its accounting treatment? Goodwill is determined as the excess of (a) over (b) below: The aggregate of the following: Consideration transferred by the acquirer Amount of any non-controlling interest (NCI) Acquisition date fair value of the previously held interest in the acquiree in the case of a business combination achieved in stages The fair value of the acquisition date net assets acquired Under the current Indian GAAP, there is diversity in practice with respect to goodwill accounting. Goodwill arising on amalgamation is amortised, whereas goodwill on the acquisition of subsidiaries in the consolidated financial statements is not amortised. Under Ind AS, goodwill will not be amortised but, at a minimum, tested for impairment annually, irrespective of whether there are any indicators of impairment. This is another significant change compared to the current Indian GAAP, where impairment testing is performed when indicators exist. Besides accounting implications, from a tax perspective, non-amortisation of goodwill can potentially increase the amounts of minimum alternate tax (MAT) profits and, consequently, MAT liabilities under the Ind AS regime. Bargain purchase gain (negative goodwill) refers to a situation where the consideration transferred by the acquirer is less than its share of fair value of net assets acquired. This is expected to be an unusual situation and to occur rarely in circumstances such as a distress or forced sale. Companies will need to exercise caution when faced with such a situation and reassess whether they have properly recognised all the assets and liabilities, including their amounts. Only when there is clear evidence that the business combination is a bargain purchase, the acquirer recognises the resulting gain in other comprehensive income on the acquisition date and accumulates the same in equity as a capital reserve. In the absence of clear evidence, the difference is directly recognised in equity as part of the capital reserve. This is also a specific deviation from the International Financial Reporting Standards (IFRS), which requires the bargain purchase gain to be recorded in the statement of profit and loss. Principles of Ind AS 103: double column approach Consideration Previous interest Non-controlling interest What happens when control is acquired in stages, i.e. step acquisitions? Often it is noted that control over subsidiaries is acquired in stages, for example, where an entity initially acquires, say, 40% equity interest in an entity, making it an associate and thereafter acquires additional, say, 50% interest, thereby gaining control. Under Ind AS 103, the interest held in a subsidiary before control is acquired (in this example the previous 40% interest) is fair valued on the date when control is acquired. The difference between the carrying value of such previously held interest in the acquiree and its fair value on the date when control is obtained is recognised in the profit and loss account. In the above example, the acquirer will have to fair value its previously held interest of 40% in the acquiree on the date it acquires the additional 50% interest, = Goodwill/bargain purchase Assets, liabilities and contingent liabilities and the difference between such fair value and the carrying value of the 40% interest will be recorded in the statement of profit and loss as unrealised gain/loss. Again, this is a big shift from what we do today under Indian GAAP, which is essentially based on a cost accumulation method for control achieved in stages. Where an additional interest is acquired in an entity which is already controlled (in the above example, say, if the investor acquires the balance 10% stake at a later date), the transactions is accounted as an equity transaction. In such cases, the difference between the consideration paid and the reduction in the noncontrolling interest (NCI) is charged directly against the parent s equity. How is consideration measured in a business combination? Consideration transferred in a business PwC ReportingPerspectives 9

17 combination is measured at fair value. It is calculated as the sum of the acquisition date fair values of the assets transferred by the acquirer; the liabilities assumed by the acquirer and the equity interests issued by the acquirer. Examples of consideration are cash, other assets, a business or a subsidiary of the acquirer, contingent consideration, ordinary or preference equity instruments, options, warrants, etc. The overriding principle is that all forms of consideration are measured at fair value on the date when control is obtained over the acquiree. How are transaction costs related to a business combination accounted for? Acquisition related costs are not part of the consideration paid by the buyer to the seller for the acquired business. Instead, these are costs incurred for separate services received by the company. Accordingly, they are not accounted for as a part of the business combination, but treated as separate transactions and expensed in the period in which the costs were incurred. Examples of such costs are consultancy and legal charges, costs related to investment bankers, valuation experts and other third parties. This is a significant difference from the current Indian GAAP where transaction costs are included as part of the cost of acquisition/ consideration paid and therefore included in the determination of goodwill. What is contingent consideration and how is it accounted for in a business combination? Many business combinations contain provisions which require the buyer to make additional payments to the seller in the future based on the occurrence of specific events such as the acquired business reaching a particular threshold of revenues, earnings before interest, taxes, depreciation and amortisation (EBIDTA) or other milestones. This is commonly referred to as contingent consideration. Ind AS 103 requires the contingent consideration to be measured at fair value on the date of acquisition and is recognised as a part of the consideration. Accordingly, it affects the goodwill recognised at the date of the business combination. Contingent consideration is treated as a liability or equity depending on the manner in which it is settled. Liability classified contingent consideration is subsequently fair valued at each reporting date, and the difference is recorded in the income statement. On the other hand, equity classified contingent consideration is not subsequently remeasured. The 10 PwC difference between the settlement value and the initial fair value is recorded in the equity in such cases. Under the current Indian GAAP, there is no specific guidance to account for contingent consideration. There is diversity in the practice whereby some may have estimated and recorded the amount of such a contingent consideration at the date of acquisition, while others may have accounted for it based on the actual settlement. Additionally, under the current Indian GAAP, some companies may have accounted for the change in the estimate of the contingent consideration as an adjustment to the cost of acquisition, while others may have charged it to the profit and loss account. Now Ind AS 103 makes this accounting consistent as discussed above. In practice, we have observed that the payment of contingent consideration also gets linked to the continued employment of the selling shareholders of the acquired entity in the combined entity for a specific period of time. Termination of employment services of the selling shareholders result in forfeiture of such contingent consideration payments. Under Ind AS, in such circumstances, the contingent consideration is recorded as compensation expense in the profit and loss and not capitalised as part of cost of acquisition. Companies entering into such types of earn-out arrangements should carefully evaluate the terms of such contracts as this can have a significant impact on its financial statements going forward. Mergers approved under high court schemes Presently, under Indian GAAP, accounting for mergers occurs from an appointed date even though the scheme becomes effective upon approval of the high court and submission of the court order with the Registrar of Companies (RoC). This effective date is generally much later than the appointed date. In such a scenario, the assets and liabilities are recorded from the appointed date, including the calculation of the resultant goodwill/ capital reserve. Going forward, under Ind AS, this may need to change. Ind AS 103 requires business combination accounting to be done on the date when the entity obtains control over the acquiree. In a court scheme, it is likely that the date, when the control passes to the acquirer, will be the date when the high court approves the scheme, resulting in acquisition accounting from this date and not the appointed date. As more guidance evolves in this area, companies planning such mergers and reorganisations should carefully evaluate their court schemes keeping in mind the requirements of Ind AS 103. What are the common control business combinations and how are they accounted for? Common control transactions are business combinations between entities that are ultimately controlled by the same parent, both before and after the combination, e.g. fellow subsidiaries. Under IFRS, there exists an accounting policy choice where such transactions are recorded either at the predecessor s carrying values (historical basis) or at fair values of the acquired assets and liabilities. However, under Ind AS 103, specific guidance has been included in the standard (Appendix C of Ind AS 103) requiring such common control business combinations to be recorded using the pooling of interest method. This means that all the assets and liabilities will be recorded at their pre-combination carrying values, and there will be no goodwill arising on such transactions. This will be a significant change from the current practice and can also have consequential tax implications. Summary As summarised in this article, Ind AS 103 introduces several new concepts and will significantly impact the way business combinations, mergers and reorganisations are accounted for going forward. Finance, legal, tax, business and commercial teams will have to closely interact and evaluate the implications of this new standard while planning such transactions. Currently, all listed companies desirous of undertaking a scheme of arrangement are required to obtain a no-objection letter from the stock exchange(s) before filing such schemes with any court or tribunal. The Companies Act, 2013, has introduced a requirement that no compromise or arrangement should be sanctioned by the tribunal unless a certificate by the company s auditor is filed with the tribunal to the effect that the accounting treatment, if any, proposed in the scheme of compromise or arrangement is in conformity with the prescribed accounting standards. However, the above requirement has not been made effective yet. Once it becomes effective, it will bring in the same level of compliance by unlisted companies as previously introduced by the Securities and Exchange Board of India (SEBI) for listed entities.

18 Ind AS for banks and non-banking financial companies (NBFCs) MCA s notification dated 16 February 2015 made Ind AS applicable for certain categories of companies. However, it specifically excluded NBFCs, banking companies and insurance companies. Furthermore, these entities are not permitted to apply Ind AS voluntarily. The good news is that RBI recently issued its Fourth Bi-monthly Monetary Policy statement on 29 September 2015 recommending to the MCA a roadmap for the implementation of IND AS for banks and NBFCs from As per the statement, RBI has constituted a Working Group (Chairman: Sudarshan Sen) for the implementation of Ind AS. The report of the Working Group will be available on the RBI website by end of October 2015 to seek public comments. This surely is a positive and welcome development demonstrating India s commitment towards the adoption of Ind AS. One of the most significant Ind AS that will impact banks and NBFCs is the new IFRS 9 on financial instruments. Though this standard applies to all entities; financial institutions in particular are expected to be affected the most from the new requirements of the expected credit loss (ECL) impairment model. This new impairment model for financial assets seeks to address the criticisms of the incurred loss model and will result in recognition of impairment losses earlier. Assessing the impact of IFRS 9 will take a significant amount of time and resources, especially to implement the changes in a systematic manner, taking into consideration the impact on data, systems and financial models. India has decided to early adopt the new IFRS 9 on financial instruments by notifying Ind AS 109: Financial Instruments, though IFRS 9 is globally mandatory for financial periods beginning 1 January Accordingly, the roadmap recommended by RBI is well timed with the effective date of IFRS 9 globally. This will help the Indian financial sector to learn from global experience and align its financial reporting with rest of the world. It is now for the insurance regulator Insurance Regulatory and Development Authority to come up with an Ind AS roadmap for companies in this sector. PwC ReportingPerspectives 11

19 Integrated reporting: A new corporate reporting model Background We are quite familiar with the term financial reporting, and used to reading board and management reports which form a part of the annual report. However, the latest buzzword in the area of reporting is integrated reporting. There is active discussion on this topic and it is also on the radar of various regulators and stakeholders. Here is how an integrated report is defined: An integrated report is a concise communication about how an organisation s strategy, governance, performance and prospects, in the context of its external environment, lead to the creation of value over the short, medium and long term. Corporate reporting norms have been evolving with increasing expectations from various stakeholders, including investors, government and regulators. Stakeholders intending to assess the appropriateness of corporate behaviour find it increasingly difficult to navigate through lengthy annual reports. Moreover, key messages can get lost in these reports due to immaterial or repetitive disclosures. Corporate reports are already more complex and heavily regulated than earlier. Over the last decade, corporate reporting has received a lot of attention and there have been considerable changes in the extent of reporting sought with the objective of ensuring transparency. Recent changes will ensure transparency in reports: Convergence with IFRS, i.e. notification of Ind-AS and its application in a phased manner Focus on reporting of non-financial components, for example, disclosure for not incurring expenditure on corporate social responsibility (CSR) initiatives Increasing momentum for sustainability reporting Corporates have also started realising the need to have a fundamental change in reporting wherein the focus is not just on the financial capital but also on demonstrating the value created by the entity while operating within its economic, social and environmental system. The intended change requires a deeper understanding of all the building blocks of the business value creation process. This will enable corporates to develop a reporting model that will give an insightful picture of its performance, and sufficient information to assess the quality and sustainability of that performance. With this objective, companies are increasingly revisiting their annual reports to see how they can make improvements in their reporting structure within the existing legal and regulatory requirements. Some of the questions they can consider asking themselves include the following: Current model How does the outcome of the stakeholder dialogue link up with the company s strategy and risk? How does it connect to the key value drivers and performance, and how will these factors ultimately impact the company? How is integrated reporting different? Integrated reporting is achieved when it shows how governance connects with remuneration and risk, when strategy is designed to exploit a changing market environment, and when strategic priorities align with key resources, relationships and key performance indicators. So, what else is different about integrated reporting? Certain key differences with regard to the current model are given in the following table: Integrated reporting/future model Focus Past, financial Future, connected and strategic Timeframe Short term Short, medium and long term Detail Long and complex Concise and material Compliance Rule bound Responsive to circumstances Presentation Paper based Technology based Thinking Silos Integrated Stewardship Financial capital All capital (human, intellectual, social, natural, etc.) Source: International Integrated Reporting Council (IIRC) Types of capital Finance capital, intellectual capital, human capital, natural capital, manufactured capital, social and relationship capital The capitals are stocks of value that are increased, decreased or transformed through the activities and outputs of the organisation. 12 PwC

20 What needs to be done? Corporates need to embed the approach of integrated thinking throughout their decision-making process to identify how the organisation uses and affects its important capitals, as well as the tradeoffs between the capitals and in its value creation process. Boards should always meet with an agenda item on the capitals used and affected, as well as the ongoing relationships with stakeholders. In order to plan and prepare for a quality integrated report, organisations should strive at ensuring participation and consensus at leadership and governance levels. Accountability for the preparation of the report should be fixed with clarity around the processes which in turn will be dependent on the organisational size and structure. Efforts should be made to ensure that the report provides insight into the nature and quality of the organisation s relationships with its key stakeholders. Determining materiality is one of the cornerstones of an effective integrated report and immaterial information should be avoided. Accordingly, only matters that substantively affect the organisation s ability to create value should be reported on. In determining whether matters are material, consideration should be given to all aspects of the organisation strategy, governance, performance, prospects, and the important capitals. The primary purpose of an integrated report is to explain to providers of financial capital how an organisation creates value over time. An integrated report benefits all stakeholders interested in an organisation s ability to create value over time, including employees, customers, suppliers, business partners, local communities, legislators, regulators and policymakers. The ability of an organisation to create value for itself enables financial returns to the providers of financial capital. This is interrelated with the value the organisation creates for stakeholders and society at large through a wide range of activities, interactions and relationships. When these are material to the organisation s ability to create value for itself, they are included in the integrated report. Source: IIRC Recent initiatives The work of the International Integrated Reporting Committee (IIRC) and corporate chambers has resulted in rising awareness around the need for change and providing mechanisms to achieve this by experimenting with the structure and content of reporting. Some of the recent initiatives are: The CII-ITC Reporting Lab which brings management and investors together to innovate and shape reporting to better meet their needs. Market leaders are taking voluntary initiatives and have started structuring their reports around the new reporting model. They plan to innovate across all corporate reporting and take stock of its environmental, social and economic impact. In one of the recent speeches of the President of the Institute of Chartered Accountants of India (ICAI), the importance of an integrated report was acknowledged. It was also mentioned that the ICAI has taken up a project to study the framework of integrated reporting and explore the possibility of making it applicable to Indian companies. PwC ReportingPerspectives 13

21 Measuring quality in audits On 1 July 2015, PCAOB issued a concept release to seek the public s viewpoints on potential AQIs that may provide new insights on how to evaluate the quality of audits and how high quality audits are achieved. Why was the concept release issued? The PCAOB commented that audit quality should be the most significant driver in the public company audit market. Currently, there is minimal publicly available information regarding indicators of audit quality at individual auditing firms. Consequently, it is difficult to determine whether audit committees, who ultimately select the auditor and management, are focussed and have the tools that are useful in assessing audit quality that will contribute to making the initial auditor selection and subsequent auditor retention evaluation processes more informed and meaningful. The PCAOB, as part of its responsibility to improve audit quality, issued a concept release seeking the public s comments on 28 possible AQIs and whether this information will be useful for audit committees, audit firms, investors and regulators. How does it matter? As per section 177 of the Companies Act, 2013, audit committees in India are required to recommend the auditor s appointment/reappointment to the board of directors and also review and monitor the auditor s performance. The PCAOB concept release, although intended for public companies in the US, can provide useful information to audit committees in India in discharging its functions. What are the AQIs? The concept release recommends a framework of 28 possible AQIs for evaluating audit quality. These 28 AQIs are based on an audit firm s audit professionals, audit process and audit results. These are discussed below: The goal of the AQI project is to improve the ability of persons to evaluate the quality of audits in which they are involved or the ones they rely on and to enhance discussions among interested parties. Audit quality should be the most significant driver in the public company audit market influencing auditor selection and retention. Audit professionals: Measures relating to (i) availability of resources, (ii) competence, and (iii) focus. Availability Competence Focus Tone at the top 1. Staffing leverage 2. Partner workload 3. Manager and staff workload 4. Technical accounting and auditing resources 5. Persons with specialised skill and knowledge 6. Experience of audit personnel 7. Industry expertise of audit personnel 8. Turnover of audit personnel 9. Amount of audit work centralised at service centres 10. Training hours per audit professional 11. Audit hours and risk areas 12. Allocation of audit hours to phases of the audit Audit process: Measures relating to an audit firm s (i) tone at the top and leadership, (ii) incentives, (iii) independence, (iv) attention to infrastructure, and (v) record of monitoring and remediation of identified matters impacting audit quality. Incentives Independence Infrastructure Monitoring and remediation Financial statements Internal control 13. Results of independent survey of firm personnel 14. Quality ratings and compensation 15. Audit fees, effort and client risk 16. Compliance with independence requirements 17. Investment in infrastructure supporting quality auditing 18. Audit firms internal quality review results 19. PCAOB inspection results 20. Technical competency testing Audit results: Measures relating to (i) financial statements, (ii) ICFR, (iii) going concern reporting, (iv) communications between auditors and audit committees, and (v) enforcement and litigation. Going concern Communications between auditor and audit committee Enforcement and litigation 21.Frequency and impact of financial statement restatements for errors 22. Fraud and other financial reporting misconduct 23. Inferring audit quality from measures of financial reporting quality 24.Timely reporting of internal control weaknesses 25.Timely reporting of going concern issues 26. Results of independent surveys of audit committee member 27.Trends in PCAOB and SEC enforcement proceedings 28. Trends in private litigation 14 PwC

22 The concept release illustrates how each possible AQI can be calculated at both the engagement level and the audit firm level to meet various stakeholders needs. The PCAOB emphasised that the indicators have inherent limitations. They are not intended to provide scores or grades for audits and will require the context to be understood and evaluated. The concept release also seeks comments on how AQI data should be obtained and distributed, whether auditors should be required to provide AQIs, or whether providing the information should be voluntary, which audits and audit firms should be subject to AQI reporting. The above AQIs will enhance focus on audit quality. AQIs will facilitate audit committees in making more informed and transparent decisions on auditor selection/retention. AQIs will also assist audit committees and auditors in identifying the factors relevant to the performance of a quality audit. Conclusion The PCAOB has emphasised that auditor selection and retention should be based on the audit quality. The AQIs suggested by PCAOB measure quality in terms of an audit firm s audit professionals, audit process and audit results. The AQIs will provide useful information to the board of directors and audit committees to discharge their responsibilities towards the auditor selection/retention and review, and montior auditors performance in a more informed and transperent manner. PwC ReportingPerspectives 15

23 Recent technical updates Companies Act, 2013 Alterations to Schedule III of the Companies Act, 2013: Regarding MSME disclosures The central government has now restored the disclosures relating to micro and small enterprises as defined under the Micro, Small and Medium Enterprises Development (MSMED) Act 2006, in Schedule III of the Companies Act, While these disclosures were specifically covered under Schedule VI of the Companies Act, 1956, they were not included in Schedule III earlier. The Companies (Accounts) Second Amendment Rules, 2015 This amendment essentially draws on Ind AS with respect to preparation of financial statements. The definition of Indian Accounting Standards (Ind AS) has now been included in the Rules. The Rules specifically state that the financial statements shall be in the form specified in Schedule II of the Act and comply with the AS or Ind AS. Items in the financial statements shall follow the definition and other requirements of AS or Ind AS. Also, the consolidated financial statements will need to be filed along with Form AOC-4 CFS. Clarification with regard to circulation and filing of financial statement under relevant provisions of the Companies Act, 2013 MCA has clarified that a company holding a general meeting after giving a shorter notice as provided under section 101 of the Act may also circulate financial statements (to be laid/considered in the same general meeting) at such shorter notice. In consultation with ICAI, it is also clarified that in case of a foreign subsidiary, which is not required to get its accounts audited as per the legal requirements prevalent in the country of its incorporation and which does not get such accounts audited, the holding/parent Indian may place/file such unaudited accounts to comply with requirements of section 136(1) and 137(1) as applicable. These, however, will need to be translated in English if the original accounts are not in English. Furthermore, the format of accounts of foreign subsidiaries should be, as far as possible, in accordance with requirements under the Companies Act, In case this is not possible, a statement indicating the reasons for the deviation may be placed/filed along with such accounts. SEBI SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 SEBI has notified Securities and Exchange Board of India (Listing Obligations and Disclosure Requirements) Regulations, 2015 (hereinafter referred to as Regulations ). These Regulations will become effective on the 19th day from the date of the notification in the official gazette, i.e. 1 December 2015, except the regulation relating to disclosure of class of shareholders and conditions for reclassification. Guidance Note on SEBI (Prohibition of Insider Trading) Regulations, 2015 SEBI has provided guidance to remove difficulties in the interpretation or application of the provisions of SEBI (Prohibition of Insider Trading) Regulations, 2015, which was issued on 15 January 2015 and came into effect on 15 May PwC

24 ICAI Quality Review Board: A Report on Audit Quality Review Findings ( ) The Quality Review Board has brought out A Report on Audit Quality Review Findings ( ) providing an analysis and summary of observations made by the technical reviewers in review reports completed during the financial years The report is accessible at: uploads/2015/07/qrb28179.pdf. Global updates IFRS IASB proposes clarifications to IFRS 15 The International Accounting Standards Board (IASB) has proposed amendments to IFRS 15 in some of the areas discussed by the Transition Resource Group (TRG). These areas include accounting for licences, principal versus agent guidance and practical expedients on transition. The proposed amendments differ from those suggested by the Financial Accounting Standards Board (FASB). These areas were previously discussed by the TRG and subsequently at joint meetings with FASB. Some of the issues were jointly deliberated, but the proposed changes are not the same as those proposed by FASB. The revenue standards might therefore diverge before the 2018 effective date. However, the proposals are subject to the board s due process requirements which include a period for public comment that closes on 28 October IASB issues Exposure Draft (ED) on pensions The IASB has proposed narrow scope amendments to IAS 19 and International Financial Reporting Interpretations Committee (IFRIC) interpretation 14 to clarify how the recognition of changes that take place during the year impacts the income statement. The proposals also expand the guidance in IFRIC 14. IFRIC 14 has proved difficult since it was issued in Divergent views on how it should be interpreted have evolved and at least one regulator has been looking hard at how entities have been applying it. Even before this, IFRIC 14 accounting for asset ceiling was one of the most challenging aspects of IAS 19. When IAS 19 was revised in 2011, incorporating IFRIC 14 into the standard (as is the normal practice with interpretations) was put in the too difficult box. The current ED amends IFRIC 14 rather than incorporating it into the standard. The comment period for these proposals closes on 19 October Although the changes to IFRIC 14 may impact relatively few preparers, when they do, the impact can be very significant, moving from a balance sheet asset position to recognising an additional liability. US generally accepted auditing standards (GAAS)/ GAAP FASB proposes clarification to principal vs agent guidance in revenue recognition standard On 31 August 2015 FASB issued a proposed Accounting Standards Update (ASU) to clarify the implementation guidance on principal versus agent considerations contained in the new revenue recognition standard. Stakeholders are encouraged to review and provide comment on the proposal by 15 October PwC ReportingPerspectives 17