Accounting and Auditing Update

AUDIT
Accounting and Auditing Update

March 2010
KPMG IN INDIA
2010 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (KPMG International), a Swiss entity. All rights reserved.
Editorial
It is with great pleasure we bring forth the March 2010 edition of Accounting and Audit Update.
Over the years, Indias business landscape has constantly changed and Indian companies have started competing on a global scale, the important change being the acquisition of companies abroad. The vast pool of human capital in India and the enormous size of the consumer base have resulted in India being sought as one of the favorable avenues of investment by international investors. Business in both volume and value terms has increased manifold over the years. In this dynamic era, the legal statutes, whether it be the Companies Bill 2009 or Direct Tax Code or Goods and Service Tax or the Takeover Code are all set to be toned up in the short to medium term and we are hopeful that the results are constructive. Further, the fact that IFRS as a primary financial reporting framework is looming on the horizon pursuant to the recent circular of the Ministry of Company Affairs (MCA) at the same time when several legislations are on the anvil clearly highlights the fact that we are truly experiencing
the most important phase of the economic calendar of the country. The MCA has deferred the decision for IFRS convergence in case of Banks until some time. But this is not expected to be for long. While some believe that banks are the most affected considering the composition of their balance sheet, there is also a school of thought that banks are best prepared for incorporating IFRS given that some of the principles of IFRS are already enshrined in the Reserve Bank of India guidelines. In this publication, we have outlined some of the challenges associated with the implementation of IFRS for banks. Indias real estate business is celebrating a revival of fortunes after plumbing the depths during the economic recession with a tentative return to the initial public offerings (IPO) market. The investor interest for real estate IPOs seems to be on the increase from both domestic institutional investors and foreign institutional investors.
In this publication, we have included an overview of the unique revenue recognition and other typical accounting issues impacting that sector. Financing large or small enterprises has not been easy. The entry of venture capitalists and private equity investors has over the years eased Indias transition into the ever-growing global economy. We have attempted to summarize the typical financial reporting issues of a venture fund in this publication. We hope you find the contents of the publication useful and we would look forward to receiving your feedback at aaupdate@in.kpmg.com.
Table of Contents
Accounting challenges for the venture capital industry Revenue recognition A paradigm shift for real estate industry under IFRS IFRS convergence Are banks in India ready to take on the challenges? Regulatory updates
I Corporate governance voluntary guidelines II SEBI may allow listed entities to submit their consolidated financial statements as per IFRS III IFRS roadmap
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19 20 22
Accounting challenges for the venture capital industry

A venture capital fund (the fund) is a pooled investment vehicle (often an LP or LLC) formed for the purpose of making investments in early-stage, high-potential and growth companies with the interest of generating a return through an eventual realisation event such as an IPO or trade sale of the company. These funds generally have a fixed life of 10 years, with the possibility of a few years of extensions to allow for private portfolio companies continuing seeking liquidity. The investing cycle for these funds is generally the initial period of three to five years and thereafter the focus is upon managing and making follow-on investments in the existing portfolio companies. The venture partners or general partners are responsible for setting up of the fund. To raise capital, they interact with the institutional investors and high net worth individuals referred For an India-specific fund, the general partners must ensure compliance with the following matters: 1. The fund has an optimal structure in relation to tax and regulatory aspects 2. Appropriate legal documents are completed satisfactorily like placement documents and investment agreements, etc. to as limited partners. At the end of the capital raising exercise, the limited partners would have agreed for a fixed commitment to the fund that is initially unfunded and subsequently "called down" by the fund over time as the fund makes its investments. The capital raising exercise can take several months. While setting up the fund, the general partners must ensure that:
Securities Law
Exchange Regulations
Policy Investment Foreign Direct
Income and Capital Gains Tax Company Law
Indirect Tax
Accounting Issues
Transfer Pricing
Stamp Duty
The common structure of offshore and domestic funds is shown below:
Common structure of an offshore venture capital fund
General Partners
Investors Overseas II Overseas I Fund Management Fees & Carry
Management Agreement Investment Committee Fund Manager
Advisory Services Indian Advisory Company
Investments Investee Companies
Repatriation
India
Team in India
Common structure of a domestic venture capital fund
Investors Overseas II Overseas I Fund Company
India Management Agreement Funds Manager Management Fees & Carry
Repatriation Domestic Venture Capital Fund (DVCF)
Domestic Investors
Team in India
Investee Companies
The Fund manager which is owned by general partners is responsible for sourcing potential investment and divestment opportunities. General Partners are also responsible for managing, valuing, distributing, carrying due diligence, negotiating, documenting and liquidating of fund assets. For these services, the fund pays management fees to the fund manager. Once potential investment opportunity has been identified, the fund calls capital from the Partners (limited and general). In few instances, it has been observed that the General Partners have an option of irrevocable election of Cashless capital contribution by which they can be able to set-off the capital called by the fund with the management fee. This cashless capital contribution election by the General Partners is beneficial from the tax standpoint. It enables the General Partners to convert management fee income from current ordinary income to deferred capital gains (ordinary income is taxed at a higher rate than captal gains).
The fund invests into the portfolio companies upon infusion of capital by the Partners. The investments made by the funds are illiquid and generally require three to seven years to harvest. The General Partners nurture the portfolio companies, in order to increase the likelihood of reaching the stage of intial public offer (IPO) or a suitable private deal when valuations are favourable. Once a favourable exit option is available either through an IPO or trade sale of the company, the fund would liquidate the investment and distribute the proceeds to the Partners based on the partnership agreement or shareholders agreement. The fund compensates the General Partners for their incremental efforts like set-up of the fund, identifying investment opportunities, performing necessary due diligence, disinvestments, etc. in the following manner: 1. Management fees as a fixed percentage of the capital commitment. The fee reduces at the later stage of the fund, since the funds are fully invested then or committed for further internal rounds of funding
Cashless contribution election enables General Partners to convert management fee income from current ordinary income to deferred capital gains
2. Carried interest of the profits of the fund (typically 20 percent) paid to the General Partners. Carried interest is the returns in excess of the specified hurdle rate at the time of exit of investments. Due to various strategic business and commercial considerations almost all funds are domiciled overseas. Hence, in this article, we have discussed key accounting issues faced by offshore funds i.e., funds which are domiciled overseas and follow International GAAP e.g., US GAAP / IFRS. The domestic funds need to ensure compliance with Indian statutory and regulatory requirements. Indian GAAP does not mandate preparation of consolidated financial statements and the funds in this scenario need to reflect their investments at cost after reducing other than temporary diminution, if any (assuming underlying investments is generally classified as long-term). In the situation where the fund chooses to prepare consolidated financial statements, the Indian GAAP
requirements will be similar to accounting requirements under IFRS except in situations where the domestic funds hold less than 50 percent voting interest in the investee company. In this situation the domestic fund needs to evaluate significant influence as described in AS 23, Accounting for Investments in Associates in Consolidated Financial Statements. In situations where significant influence exists the domestic funds needs to comply with equity method of accounting and if significant influence does not exist then follow AS 13, Accounting for Investments i.e., reflecting underlying investments at cost after reducing other than temporary diminution, if any (assuming underlying investments is generally classified as long-term).
While a fund is exempted from consolidating more than 50 percent owned investees under US GAAP, IFRS provides no exemption. Under Indian GAAP, preparation of consolidated financial statements is not mandatory.
Key accounting issues for offshore funds

From the inception of the fund till liquidation, at every stage, there are accounting issues that need to be addressed. We have summarised certain key accounting practices in accordance with the US GAAP (AICPA Investment Company Audit and Accounting Guide) and have highlighted the key differences with IFRS on a need basis: 1. Organisational and offering costs As the fund is being set-up, certain costs are incurred. Accounting for these costs requires careful evaluation in respect of classification of these costs into offering costs and organisational costs. Organisational costs are expensed in the income statement and the direct offering costs are reduced from the capital proceeds. Examples of organisational costs include incorporation fees, legal services pertaining to the organisation and incorporation of the business, drafting of by-laws, administration, custody and transfer agent agreements and performing research and consultation services in connection with the initial meeting of directors, etc. Examples of offering costs include legal fees pertaining to companys shares offered for sale, underwriting and other similar costs, costs of printing prospectuses for sales purposes, tax opinion costs related to offering of shares, travel costs to raise capital, etc. 2. Management fees - Management fee is paid to the fund manager owned by General Partners as a fixed percentage of the capital commitment. This percentage reduces as the years progress due to decreasing investment activity as the fund approaches its full capital commitment. Evaluation should be performed on whether the management fee payable over the life of the fund needs to be accounted on a straight line basis. There is a general consensus that these fees should not be straight lined since the percentages are directly proportional to the level of activity. 3. Cash less capital contribution - In relation to an irrevocable election by General Partners for cashless capital contribution when capital is called by the fund, evaluation needs to be performed on whether the management fees should be presented on a gross basis or a net basis i.e., with or without the waived portion of fees. We have seen varied industry practice in this area. It may be noted that the option to present management fees on gross basis or net basis is only available if documented in the partnership or shareholders agreement. Example: In 2009, a USD 101 million fund has been set-up which includes commitment by limited partners and general partners of USD 100 million and USD 1 million, respectively. The fund pays annual management fees (2 percent of limited partners capital commitment) to the fund manager. The general partners can opt for a set
off of the management fee receivable with their capital commitment on a cashless basis when the capital is called. Lets say that in Q2 2009, a capital call of USD 11 million is made which includes limited partners (USD 10 million) and general partners (USD 1 million). The general partners can exercise the cashless option of setting off the management fees receivable of USD 1 million with their capital commitment. Accordingly, the key accounting question is presentation of management fees on a gross basis (i.e., USD 2 million) or net basis (i.e, USD 1 million which is net of waived amount) in the income statement. 4. Audit and GAAP requirements The fund needs to circulate audited financial statements at each reporting period to the limited partners in accordance with the partnership agreement or shareholders agreement. In the case of the funds domiciled in Mauritius, the financial statements need to be prepared under IFRS. However, financial statements prepared under the UK GAAP the US , GAAP and the South African GAAP are also acceptable to Financial Service Commission (FSC) in Mauritius based on their prior approvals. In case of the funds domiciled in Cayman Islands, the financial statements need to be prepared under the US GAAP . 5. Comparatives Under IFRS, the fund needs to present comparative of at least one year whereas under the US GAAP the fund (non-SEC , listed) has an alternative of not presenting comparatives.
6. Fair values - Under the US GAAP at , each reporting date, the fund needs to classify their investments as Level I, Level II or Level III based on the inputs used and determine the fair value of these investments held as prescribed in ASC 820 (SFAS 157), Fair Value Measurements with the movement in fair value reflected in the statement of operations after net investment loss. Level I inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date. Level II inputs are inputs other than quoted prices included within Level I that are observable for the asset or liability, either directly or indirectly. If the asset or liability has a specified (contractual) term, a Level II input must be observable for substantially the full term of the asset or liability. These generally include publicly traded equity securities with restrictions and certain derivative contracts. Level III inputs are unobservable inputs for the asset or liability. Since, the funds typically invest in early-stage, high-potential and growth companies; most of its investments are classified as Level III. While determining the fair values (level III), the fund must use the most appropriate valuation methodologies based on their judgment such as price of recent investments, multiples (revenue or profits), net assets, etc. Generally valuations based on inputs derived from market comparables have higher acceptability. While identifying comparable companies, the fund must take into account the size and diversity of the entities, growth rate
of earnings, diversity of product range, diversity and quality of customer base, risk arising from lack of marketability of shares and apply appropriate discount to the multiples of comparable companies. In case of a recent investment, the fair values can be determined by using the price of recent transactions (generally up to a period of one year is acceptable). However, the qualitative aspects of the recent investment need to be understood such as distress sale, differential rights, etc. Investments for which fair value is determined using discounted cash flow method (DCF), the inputs used require substantial judgment and the derived value is often sensitive to small changes in these inputs. DCF-based valuations are useful as a cross-check of values estimated under marketbased methodologies and are not generally accepted as a sole method of valuation. In the situation of early stage companies where market-based comparables are not suitable for valuation purposes the fund needs to assess the portfolio company based on qualitative factors. These qualitative factors are financial measures (like budget vs. actual, revenue growth, profitability expectations, cash burn rate and covenant compliance), technical measures (like phases of development, testing cycle, patent approvals) and other measures (like testing phases, market introduction). The comprehensive study of these factors should be applied in valuing these investments by arriving at an appropriate discount rate that needs
to be applied to the last reported fair values. The discount rate is generally in the range of 5 percent to 25 percent of the last reported fair values. The qualitative factors are useful only in situations of a down valuation. The funds need to be cautious during up valuations (beyond cost of investment) which should be based on market comparables or recent transactions. Use of these valuation methodologies are subject to significant judgments and can yield a range of fair values. Appropriate weights can be assigned to different methodologies that are adopted. The foreign currency movement impact needs to be factored for investments in currencies other than the functional currency of the fund. We have seen significant challenges in identifying market based comparables and in evaluating qualitative factors which is resolved with involved discussion between Partners and the in-house accountants. In few situations funds have taken assistance from reputed independent valuers. 7. Consolidation - Under the US GAAP , when a fund holds more than 50 percent of voting interest in the investee company, it is exempted from consolidation. This exemption is available since specialised accounting rules have been prescribed by AICPA and these investments are only required to be reflected at fair values. However, under IFRS, this exemption is not available and consolidation is mandated in these situations instead of fair value accounting. We believe that this increases the cost of
compliance and hence is one of the primary reasons why IFRS is not popular in the fund industry. Where the fund holds less than 50 percent of voting interest in the investee company and has significant influence, then under IFRS there is an option to either reflect such investments at fair value or follow equity method of accounting. The General Partners are responsible for the day to day management of the fund. Generally, we have seen that the Limited Partners have only protective rights and do not have rights to remove the General Partners (without cause) based on a simple majority. Hence, while preparing financial statements of the general partner EITF 04-05, Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights, needs to be analysed to conclude whether the General Partner is required to consolidate the fund. Generally, we have seen that General Partners have consolidated the fund. 8. Assign carry or carried interest Employees assist the general partners in rendering various management services to the fund. Once, investments of the fund are sold and returns in excess of the specified hurdle rate are made, the fund distributes carried interest share of profit (typically 20 percent) to the general partners. The general partners, in turn would have committed to distribute specified portion of the carried interest to the
employees in lieu of their past services. The timing and recognition of compensation cost needs to be evaluated by the fund manager. Example: In 2008, a USD 101 million fund has been set -in Mauritius. Over two years, the fund has invested USD 25 million in 4 portfolio companies. As of Dec 2009, based on fair values the fund has up valued their investment by USD 20 million. Given hurdle rate of 10 percent as specified in the agreement has been crossed, the fund will allocate a carry of USD 4 million (20 percent * USD 20 million) to the General Partners. The General Partners may have contractually agreed to share USD 0.4 million (10 percent * USD 4 million) with the employees of the fund manager. Accordingly, the fund manager needs to evaluate the timing of recognition of this compensation cost of USD 0.4 million i.e., at the time of accrual of carry or at the time of actual disposition of investments. We believe that accrual of compensation cost should be at the time of accrual of carry.
Summary
We have attempted to discuss the significant aspects of accounting that may be faced during the life of the offshore fund. The most important of these is determining fair values of the investee companies which require a fair degree of rigor and management judgment. One also needs to make an appropriate choice of GAAP (US GAAP or IFRS) as there is a significant difference in relation to the requirement of consolidation when the fund holds more than 50 percent voting interest in the investee company. The IASB and FASB are jointly working towards the convergence project on consolidation and it could be possible that this GAAP difference might be eliminated in the near future and facilitate a uniform accounting framework across the fund industry.
Revenue recognition - A paradigm shift for the real estate industry under IFRS
The Indian real estate sector has undergone a rapid transformation during 2008-09 due to the global economic crisis. The high growth trajectory of the previous years saw a setback during this period. Inherently strong economic fundamentals, low exposure to debt and state intervention, however, have helped the sector to gradually return to the path of recovery. As per a report by Cushman and Wakefield, the pan India demand for office space is estimated to be 196 million sq. ft. by 2013, with seven major cities accounting for approximately 80 percent of the total demand. Further, India has an unmet housing shortage of approximately 25 million units, which alone offers a huge growth potential for the realty sector in India; besides a growing acceptance for low-cost and affordable housing projects even in a downtrend. Construction is the second largest economic activity in India after agriculture, and has been growing rapidly. Operating in India requires a thorough understanding of the local market. Real estate entities need to comply with a host of laws and regulations, including Foreign Direct Investment (FDI) regulations, Companies Act rules and regulations, stamp duty, property taxes, income taxes etc. Further, some of the major issues affecting land acquisition in India include fragmented land holding, title issues, zoning of land and conversion of use, high transaction cost due to complicated tax structure, valuation, etc.
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Key accounting issues

The key accounting issues of the real estate companies are illustrated below: In our view, a majority of the sale of residential units in India would qualify the above criteria set by the Guidance Note and hence the real estate companies (developers) can recognise revenues on stage of completion basis. However, as companies transition to IFRS as per the convergence plan laid down by the Ministry of Corporate Affairs, real estate companies are expected to be impacted by the guidance prescribed in IFRIC 15, Agreement for the Construction of Real Estate. Prior to the issuance of the IFRIC guidance, under IFRS there was diversity in practice - some developers accounted for such agreements under IAS 18, Revenue, i.e., revenue is recognised when the completed real estate is delivered to the buyers - while the other developers accounted for these transactions in accordance with IAS 11, Construction Contracts, i.e., revenue is recognised by reference to the stage of completion as construction progresses. The International Accounting Standards Board (IASB) acknowledged this divergence in practice with regard to the identification of the applicable accounting standard for the construction of the real estate and the timing of the associated revenue recognition. To address this, IFRIC 15 was issued on 3 July 2008 and is effective for annual periods beginning on or after 1 January 2009. IFRIC 15 provides guidance on the accounting The buyer has a legal right to sell or transfer his interest in the property, without any condition or subject to only such conditions which do not materially affect his right to benefits in the property. the appropriate accounting standard to be applied (IAS11 or IAS 18) and the timing of revenue recognition. for agreements for the construction of real estate with regard to: IAS 11 i.e., stage of completion approach is applied to agreements for the construction of real estate that meet the definition of a construction contract. An agreement meets the IAS 11 definition of a construction contract, if, the buyer is able to specify the major structural elements of the design of the real estate either before or during construction, regardless of whether or not this ability is exercised. Revenues from agreements for the construction of real estate are recognised with reference to the stage of completion of the contract activity in the following category of agreements: the agreement meets the definition of a construction contract in accordance with IAS 11 The scope of the interpretation also includes agreements that are not solely for the construction of real estate, but which also include a component for the construction of real estate.
1. Revenue recognition
Around the world, real estate development and sale transactions are structured in a variety of different ways, to comply with local tax regulations, local practices and other market conditions. As a result, a sale deed may be entered on the date of allotment or it may be entered into on the date of delivery. Various geographies also permit the developers to sell the underlying land first to be followed by the development on the land. Currently, under Indian GAAP (IGAAP), the Guidance Note on recognition of revenue by Real Estate Developers, issued by the Institute of Chartered Accountants of India (ICAI), stipulates the revenue recognition criteria for real estate sales. As per the guidance note, companies can recognise revenues on a stage of completion in accordance with the requirements of AS 7 , Construction Contracts, provided the seller has entered into a legally enforceable agreement for sale with the buyer and all the following conditions are satisfied even though the legal title is not passed or the possession of the real estate is not given to the buyer: The significant risks related to real estate have been transferred to the buyer. In case of real estate, price risk is generally considered to be one of the most significant risks
The newly issued IFRIC 15 attempts to provide guidance on the appropriate revenue recognition model (immediate recognition versus application of a percentage of completion method).
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All the relevant facts and circumstances should be considered before reaching a conclusion on revenue recognition.
the agreement is only for the rendering of services in accordance with IAS 18, e.g., the entity is not required to supply construction materials the agreement is for the sale of goods, but the revenue recognition criteria of IAS 18 are met continuously as construction progresses.
recognition of revenue and the associated expenses for such a transaction . Our experience suggests that, one has have to consider the following indicators for identifying continuous transfer: Which party owns land on which construction activity takes place; Can buyer put the incomplete
As mentioned above, it is important to consider all the relevant facts and circumstances of the agreement before reaching a conclusion as to the most appropriate category of the agreement. More often than not, under IFRS revenue recognition could get delayed, and hence, will have a significant impact on the financial position and financial performance, directly affecting the outcomes of valuation metrics that analysts use to measure and evaluate company's performance.
In all other cases, revenue is recognised upon completion of construction or upon delivery. Further, with regard to continuous transfer of risks and rewards, Paragraph 17 of IFRIC 15 states the following: The entity may transfer to the buyer control and the significant risks and rewards of ownership of the work in progress in its current state as construction progresses. In this case, if all the criteria in paragraph 14 of IAS 18 are met continuously as construction progresses, the entity shall recognise revenue by reference to the stage of completion using the percentage of completion method. The requirements of IAS 11 are generally applicable to the
property back to the developer; Which party bears the market risk related to the value of the property; Who bears the risk of loss or damage to the construction in progress and who pays the insurance cost to damage to the construction work; Which party has the right to cancel/withdraw from the contract; Ability of the buyer to complete the construction by replacing the developer; and Which party is able to mortgage the land while the construction activity is still in progress?
2. Joint Development
A common facet of the real estate industry is the joint development of properties between owners of the land and the developers. Typically, developers do not necessarily invest in land, and instead, in many occasions, prefer to co-develop the land with the owners. In consideration, the developer parts with a share in revenue or share in the developed property to the owners. Transfer of title in land takes place post development from the owner of the land to the developer.
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There is considerable diversity in practice with regard to the accounting treatment in the books of the developer for arrangements involving joint development. Most of the developers do not recognise any asset or a liability upon commencement of the development. We do not believe that the above practice is in accordance with the requirements of IGAAP However, . where the arrangements require the developer to part with a portion of the development in favour of the owner, the risks and rewards of ownership in land passes on to the developer upon obtaining possession of the land, provided, there are no significant uncertainties in obtaining the regulatory approvals/clearances. Accordingly, the developer recognises the obligation to develop the property which needs to be transferred in favour of the owner with a corresponding asset in the form of land. This obligation is initially recognised at the estimated cost of construction which is trued up on revision of estimates. In case of arrangements which are in the nature of revenue share i.e., where the owner and the developer agree to share revenues post development and sale, the developer recognises the costs incurred towards development as an asset i.e., either as capital work in progress or inventory (and not the land). On sale or lease of the asset, the developer recognises only its share in revenue.
investment properties. Definition of investment property under IAS 40, Investment Property includes land and/ or building held by an entity for capital appreciation or held by the lessor to earn rental income under operating lease. Investment properties also include properties under development. Under IGAAP measurement of assets , leased is governed by AS 19, Leases
4. Transactions with shareholders / related parties

One of the distinctive features of the real estate sector is with regard to the multiple legal entity structure to develop properties. This is adopted primarily to facilitate development, financing and legal compliance. However, it is pertinent to note that transactions between the entities may
Under IFRS, when an entity chooses to measure investment properties at fair value, the resultant appreciation/decline is recognised in the income statement.
Such assets, in the books of the lessor are recognised as fixed assets and are measured at cost less depreciation. Under IFRS, entities have an option to recognise investment property at cost or at their fair value. When an entity chooses to measure investment properties at fair value, the resulting appreciation / decline is recognised in the income statement. The benefit of adopting the fair value approach is that assets are measured at values which are relevant considering the current market values. However, it is important to note that entities will need to manage external shareholders reaction to volatility in results due to movement in fair values and its potential impact on debt covenants. On convergence of IGAAP with IFRS, it not necessarily be at an arms length. As per the Framework to the IFRS, the definitions of income and expenses exclude capital transactions with equity participants. For example, an entity may sell inventory (e.g., dwelling unit) without consideration/ below market value to a shareholder. In this case, it can be argued that the shareholder has received a benefit from the entity in its capacity as a shareholder because the entity may not have transacted with an independent third party on same terms. Accordingly, this transaction may need to be recognised in equity as a distribution to shareholders. Continuing with the above example, assume a scenario where the shareholder agrees for a consideration significantly above market value, in such a scenario, it may be appropriate to split the transaction into a capital transaction and a revenue transaction. Proceeds equal to the market value of the inventory would be recognised in income statement, while remaining proceeds being recognised in equity as a contribution from shareholder.
3. Investment property and its measurement at fair value

Another emerging issue in the real estate sector as companies transition to IFRS in India is with regard to identification and measurement of
seems that real estate companies in India will be able to avail fair value alternatives for measuring investment properties.
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Under IGAAP apart from providing , detailed disclosures with regard to related party transactions, there is no requirement to analyse a related party transaction and account for portions which are above or below fair values as capital contributions or distributions.
assets may be impaired except in the case of goodwill where a test for impairment is carried out every year. Assessment of value in use requires a detailed cash flow model over the life of the project. The model will contain several assumptions, key being: While computing the value in use
5. Impairment and valuation

In the context of the global meltdown and downturn in the real estate sector, valuation and impairment of real estate assets has turned particularly challenging and judgmental. Real estate assets that are typically tested for impairment comprise land and buildings including those under construction.
of an asset under construction, assumptions such as expected project completion date, expected cost to complete, expected future revenues, vacancy allowances and estimation of incremental growth in base rental (investment property) are required to be used. The other key attribute is the rate of discount factored in the model. Discount rate is a factor of the risks associated with the industry/ sector.
Impairment The accounting standard on impairment requires an assessment of the recoverable value of the asset. Recoverable value is higher of the fair value less cost to sell and value in use. Impairment arises when the carrying value is higher than the recoverable value. In accordance with AS 28, Impairment of assets, assets are tested for impairment when there is an indicator, external or internal, that
Valuation models in the real estate sector are generally based on returns to equity holders (i.e., post repayment of debt and interest). Accordingly, a return of over 20 percent to equity holders is generally considered.
Impairment considerations involve assessment of both external and internal indicators. Wherever there are triggers, recoverable value should be computed as the higher of the fair value less cost to sell and value in use.
realisable value. Assessing net realisable value also requires validation of assumptions used which are similar to the assumptions used in the model used for impairment.
Valuation Real estate properties held for sale are valued at the lower of the cost or net
Taking the example of land held for development, in accordance with the requirements of AS 2, Valuation of Inventories, while net realisable value of bare land is easily available, the developer is required to assess the net realisable value post development, which would mean assessment of expected project completion date, expected cost to complete and expected future revenues. Also, it is key to note that while assessing the net realisable value of inventories, the AS 2 does not require any adjustments for the time value of money.
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Summary
As we move towards convergence with IFRS, it is pertinent to note that the impact of change in recognition and measurement principles will have significant impact on results in the real estate sector. Real estate companies will need to gear up in terms of skill sets of its finance team to ensure compliance with the new accounting rules and regulations. Further, certain new accounting requirements which are based on fair value are likely to increase the volatility in the results of these companies and accordingly companies might need to start having conversations with the investor community on the impact these new accounting regulations will have on the expected results of the entity going forward.
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IFRS convergence Are banks in India ready to take on the challenges?

Recently the Ministry of Corporate Affairs (MCA) has announced the timelines for convergence of the Indian Generally Accepted Accounting Standards (Indian GAAP) with International Financial Reporting Standards (IFRS) in a phased manner effective 1 April 2011. This has finally put to rest the uncertainty around the timelines and the seriousness with which convergence to IFRS was being pursued. Now it is for certain!! The focus will now shift to how rather than when for most of the companies. However, the question of when still remains for the Banking companies in India. The Ministry has deferred the decision for IFRS convergence in case of Banks to later date. But given the scenario, it is for sure that it is not long before the Banks will have to gear up for this big transformation. Accordingly, as reality dawns upon us that IFRS will be the order of the day soon, in most proactive banking entities, board room discussions today have a permanent agenda discussing when, how, who in connection with IFRS implementation. While regulators, standard setters and law makers are still grappling with what should be the time frame for Banking companues for the roll out of the road map for implementation of IFRS in India, a wide section of the banking community are already assessing the areas of impact and the implementation challenges of transitioning into IFRS. While some believe that banks are the most affected considering the composition of their balance sheet, another school of thought is that they are best prepared for the IFRS era. This view emerges from the fact that the current Reserve Bank of India (RBI) accounting guidelines imbibes certain principles of IFRS, specifically, the fair value of derivatives as required under IAS 39 on Financial Instruments Recognition and measurement. The next big step would be for RBI and the MCA to agree a timeline for convergence, which is expected to be announced very soon and the manner of implementation of IFRS as adopted in India.
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How is it going to impact the financial statements for banks in India?

Banks will have to soon adjust to accounting changes which are enforced by IFRS. Under IFRS regime, a complete set of financials statements, in addition to balance sheet, an income statement, a cash flow statement and notes, will now include a statement of changes in equity. Further the convergence is likely to impact a number of areas of accounting and a significant portion of the key balance sheet and income statement components of banks are slated to undergo measurement and recognition changes. In addition there are to be extensive requirements regarding disclosures, which hitherto the banks have not been required to publicly disclose these disclosures range from NPA profiles to sensitivity analysis of Value at Risk. This possibly could pose some initial discomfort as these have been historically sensitive / competitive information which have never been put in public domain.
Though internationally, banks which publish IFRS financial statements - do make such disclosures as per the requirement of IFRS 7 . Key accounting areas which are expected to have a significant impact on the way the economic value of banks is reflected in the financial statements post adoption of IFRS are as follows1) Loan loss impairment; 2) Investment valuation and classification; 3) Fair Value measurement; 4) Fee Income 5) Derivatives and hedge accounting; 6) De-recognition of financial assets; 7) Consolidation
that their business will be measured by a different index performance, profitability and capital would be determined on a different yardstick. This would involve a significant change of mind set and could lead to shift in the business thought process. For example traditionally banks have developed strategies wherein success is measured on revenues which are recognised upfront, i.e. concept of deferment and amortization is not very prevalent. Businesses, under IFRS reporting would have to accept revenues being spread over tenors. Implementing IFRS impacts several processes in an organisation and not only the finance and accounting function as depicted below.
All of the above areas are likely to have a significant impact on the financial position and financial performance of banks, directly affecting key parameters such as capital adequacy ratios. CEOs and business heads of banks will have to adjust to the fact
Implementing IFRS - Global Experiences: IFRS changes processes in other departments

Treasury management Internal/external audit Risk management
Trading desk/ back office
Finance & Accounting
Business controlling
IT Systems
Subsidiaries/Joint ventures
CEOs and business heads of banks will have to adjust to the fact that their business will be measured by a different indexperformance, profitability and capital would be determined on a different yard stick.
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Further, based on our global experience, the following table gives a good overview of some of the key success factors and pitfalls for successful transition. should commence sufficiently in advance of the actual transition to enable stakeholders to familiarise themselves with IFRS accounting concepts and their implementation. Similarly, auditors would need to spend relatively more time with the management educating them on IFRS interpretation and judgmental matters as they affect the bank.
Lack of clarity about strategies for selecting the various accounting options Inability to provide information on all areas impacted by IFRS (e.g. to analysts)
Key success factors

Sponsorship of the project by the Executive Board Define and agree on clear responsibilities
Pitfalls
Rapid start to implementing work without a structured assessment; Accounting rules are seen as pretty similar but small differences can matter , a lot Impacts of IFRS conversion are not addressed with stakeholders
Make necessary management decisions promptly Communicate business impacts to investors or other stakeholders as soon as possible educate the community, specifically customers Data gathering should be assisted by efficient tools and templates Involve professionals with the right subject matter expertise relating to IFRS, local GAAP systems and , processes
Are banks in India ready for convergence?

Global experience, as mentioned above reveals convergence to IFRS is likely to pose significant challenges for banks in India. The convergence process is likely to entail changes to current systems and processes of the banks. Certain large Indian banks, which have the benefit of going through the process of international GAAP such as US GAAP in the past, have recognised the challenges of convergence and have already started planning their detailed roadmap to achieve this convergence in a smooth and timely manner. It is time for other banks to take the cue and follow suit. Banks, particularly with large branch networks with decentralised accounting structure are likely to have to undertake significant upgrading of information system infrastructure and be geared to extract adequate reliable information to prepare IFRS financial statements. Challenges relating to systems
How will stakeholders react to this change?

Banks being the backbone of the economy have many stakeholders Governments, regulators, customers, investors small and large and others. These agencies and individuals have over the years evaluated the functioning of banks based on set parameters and yardstick, a change in measurement of the key indicators to determine these parameters/yardstick can be of some discomfort to the users. Internationally, the experience has been that entities migrating to IFRS for the first time have had to invest considerable amount of time educating
the various constituents of stakeholders, including the investor community. Banks should consider beginning early in the process and managing expectations around the indicative impact on earnings and equity and explain why there may be movements in these numbers from Indian GAAP compared to those based on IFRS. As compared to formal classroom-type training, a preferred approach in the Indian context would be for bank management to spend sufficient time in advance with stakeholders on key changes to accounting policies of the company and their implementation upon adoption of IFRS. This process
As compared to formal classroom-type training, a preferred approach in the Indian context would be for bank management to spend sufficient time in advance with stakeholders on key changes to accounting policies of the company and their implementation upon adoption of IFRS.
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changes resulting from IFRS can be quite significant, especially for banks, which are IT dependent. The mapping of the chart of accounts to take into consideration the new format of reports and accounts can also be considerable challenge. The activity hence warrants a kick off at a conceptual level as early in the process as possible. There may be a requirement for significant investment to be made on IT infrastructure. An early assessment of the same is likely to benefit in planning for the same. Based on experience of other countries, two dominant themes emerge as key areas of concern, resource and time constraints, and the education and training of those who will be evaluating and implementing the conversion to IFRS.
Critical to the successful implementation of IFRS in the Indian context is likely to be the level of regulatory sponsorship, the appropriate level of investment in systems and processes and consistency in market practices for areas where judgment is critical. Dearth of experienced IFRS trained resources would also pose a major hurdle to banks for strategising, assessing and finally implementing IFRS. The importance of extensive and regular IFRS training to bank employees cannot be undermined. The process will be lengthy and will require commitment from the management to invest time and resource. A move to IFRS can be a compared to the mountain peak which can certainly be scaled if well planned and appropriately executed! There are no two views that convergence is imminent and time is limited so the journey has to begin NOW!
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Regulatory updates
I. Corporate governance voluntary guidelines
Good corporate governance is essential for the integrity of corporations, financial institutions and markets. Indias corporate sector is diverse in nature. Although there are corporate governance guidelines for listed companies in India there are no similar guidelines for unlisted companies. Accordingly, these companies are generally managed by promoters except for certain companies which have nominee directors to meet the requirement of financial institutions/ bankers/ other external investors. The Ministry of Corporate Affairs (MCA) has been working towards strengthening of the corporate governance framework through a two pronged strategy. Some aspects which needed to be incorporated in the law have been included in the Companies Bill, 2009 now under review by the Indian Parliament. However, keeping in view the objective of encouraging the use of better practices through voluntary adoption, the Ministry has also decided to issue Corporate Governance Voluntary Guidelines 2009 (the Guidelines) which not only serve as a benchmark for the corporate sector but also help them in achieving the highest standard of corporate governance. The key recommendations are summarised below: A Nomination Committee and Remuneration Committee should be considered to oversee the appointment of directors, composition of board, and remuneration of Board members; Consider rotating the independent directors every six years with a cooling off period of three years before such an individual is inducted in the same company in any capacity. An individual can serve as independent director in not more than seven companies. An independent director may not be allowed to be paid stock options or profit-based commissions, so that their independence is not compromised;
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Consider forming an Audit Committee to monitor the financial reporting process, review of internal controls, internal audit and risk management systems, monitoring of related party transactions, make recommendations in relation to appointment, removal, remuneration and terms of engagement of external auditor; Emphasise on the independence of statutory auditors, and the role of audit committee in selection, appointment, fixing remuneration and monitoring the independence of statutory auditors. Consider obtaining a certificate from the external auditor certifying the independence and arm's length relationship with the client company. The certificate of independence should clarify that the auditor has not entered into any prohibited non-audit services for the Company including subsidiaries and affiliates. Consider rotating the auditors once in 5 years and/or audit partners once in every 3 years in order to ensure that the statutory audit is carried out with a fresh outlook. A cooling off period of 3 years should elapse before a partner can resume the same audit assignment. This period should be 5 years for the firm; In order to ensure the independence and credibility of the internal audit process, the Board may appoint an internal auditor and such auditor, where appointed, should not be an employee of the company; and
Consider instituting a whistle-blower mechanism so that employees can log in concerns about instances of unethical behavior, actual or suspected fraud, or violation of companys code of conduct or ethics policy. These guidelines would serve as best leading practices which Companies in India should embrace and provide Corporate India a framework to govern themselves voluntarily as per the highest standards of ethical and responsible conduct of business. MCA has expressed in the preface of the guidelines that while it is expected that more and more corporates should make sincere efforts to consider adoption of these guidelines, if some companies are not being able to adopt them completely they should inform their shareholders about the guidelines which the companies have not been able to apply either fully or partially.
listing agreement or other relevant pronouncements of SEBI). The SEBI believes that the alternative will help in preparing Corporate India well in advance for compliance with IFRS which is planned by 2011 and thereafter in phases as per the subsequent announcement by Ministry of Corporate Affairs (MCA). These companies shall continue to file their stand-alone financial statements as per Indian GAAP in line with the local statutory requirements. There are several listed companies in India which also have their securities listed in the overseas markets. Many of these companies are filing financial statements as per IFRS with the overseas regulators. Accordingly, it would be cost beneficial for such companies to prepare one set of consolidated financial statements under IFRS which can be filed with all the regulators. We believe that these companies can face the following implementation
II. SEBI may allow listed entities to submit their consolidated financial statements as per IFRS
The Securities and Exchange Board of India (SEBI) vide press release dated 9 November, 2009 expressed its intention to provide an alternative option to all listed companies to submit their consolidated financial statements as per IFRS. These changes are yet to be notified (through amendment of the
challenges summarised below: Transition date IFRS 1 exemptions Applicable version of IFRS Presentation currency Auditing standard
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Transition date
Under IFRS as issued by the IASB, a company can benefit from several onetime mandatory and optional exemptions available in IFRS 1, Firsttime Adoption of International Financial Reporting Standards, on the transition date. These exemptions are not available to a company thereafter. It is unclear on how this matter will be dealt with once, Indian accounting standards converged with IFRS become mandatory to these companies based on the criteria laid-out by MCA.
be presenting in the US Dollars. In India, the presentation currency necessarily needs to be INR. One question that arises is whether these entities can have multiple presentation currencies depending on the regulators. We believe that IFRS permits multiple presentation currencies. A change in presentation currency could impact balances of assets, liabilities and retained earnings. For example, if a company with functional currency of the INR and presentation currency of the US Dollar changes its presentation currency to the INR the
of specific legal needs e.g., for audit of financial statements of an Indian company to be filed with the US Securities Exchange Commission the auditor is legally required to follow Public Company Accounting Oversight Board (PCAOB) auditing standards and accordingly, departure from Indian GAAS will be appropriate. While there could be a basis to conclude that for the purpose of filing with SEBI the auditor needs to follow Indian GAAS, divergent views could be possible.
Applicable version of IFRS

Further clarification need to be provided relating to the version of IFRS which an entity should follow if it elects to submit its consolidated financial statements as per IFRS. The Institute of Chartered Accountants of India (ICAI) and National Advisory Committee on Accounting Standards (NACAS), the two bodies, involved in formulation and notification of accounting standards in India are still in the process of issuing IFRS converged accounting standards. It is uncertain whether pending the issuance of IFRS converged accounting standards, the companies would be able to prepare and publish consolidated financial statements as per IFRS as issued by the IASB.
currency translation reserve would become nil and the value of assets and liabilities will change.
Auditing standard
A member of the ICAI is required to follow the auditing pronouncements issued by the ICAI (representing the Indian generally accepted auditing standards (GAAS)) for the purpose of any audit to meet the local requirements. Departure from the local standards is only possible in situations
Presentation currency
The financial statements that are filed with the local regulators are required to be presented in Indian Rupees (INR). The entities filing IFRS financial statements overseas may have chosen a different presentation currency than INR e.g., an entity listed in the US may
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III. IFRS roadmap

The recent MCA announcement lays down timelines for achieving convergence with IFRS in India in the following three phases: Companies covered (other than banking and insurance companies)
Companies included in the NSE Nifty 50 Companies included in the BSE Sensex 30 Phase I Opening balance sheet as at 1 April 2011 Companies with shares or other securities listed on stock exchanges outside India Companies (listed or not listed) which have a net worth in excess of INR 1,000 crore Phase II Opening balance sheet as at 1 April 2013 Companies having net worth exceeding INR 500 crore (not covered in phase I) Listed companies having a net worth of INR 500 crore or less
Key success factors
Effective date
Phase III
Opening balance sheet as at 1 April 2014
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KPMG Contact
Vikram Utamsingh Head of Markets eMail: vutamsingh@kpmg.com Tel: +91 22 3090 2320
The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation.
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AUDIT

Accounting and Auditing Update

Accounting challenges for the venture capital industry

Policy Investment Foreign Direct

Income and Capital Gains Tax Company Law

The common structure of offshore and domestic funds is shown below:

Common structure of an offshore venture capital fund

Investors Overseas II Overseas I Fund Management Fees & Carry

Management Agreement Investment Committee Fund Manager

Advisory Services Indian Advisory Company

Investments Investee Companies

Common structure of a domestic venture capital fund

Investors Overseas II Overseas I Fund Company

India Management Agreement Funds Manager Management Fees & Carry

Repatriation Domestic Venture Capital Fund (DVCF)

Key accounting issues for offshore funds

Key accounting issues

4. Transactions with shareholders / related parties

3. Investment property and its measurement at fair value

5. Impairment and valuation

IFRS convergence Are banks in India ready to take on the challenges?

How is it going to impact the financial statements for banks in India?

Implementing IFRS - Global Experiences: IFRS changes processes in other departments

Trading desk/ back office

Finance & Accounting

Key success factors

Are banks in India ready for convergence?

How will stakeholders react to this change?

Applicable version of IFRS

III. IFRS roadmap

Key success factors

Opening balance sheet as at 1 April 2014

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