Sumit Seth, Partner, Price Waterhouse & Co explains how the introduction of the new accounting standards will impact the financial and net-value of pharma companies
Indian Accounting Standards (Ind AS) converged with International Financial Reporting Standards (IFRS) is now the new Generally Accepted Accounting Policies (GAAP) for many companies. As a result, commencing June 2016 quarter, Phase I companies reported their results under Ind AS.
The shift from the historical cost convention to increased use of fair value and increased focus over substance rather than the legal form of the underlying transaction has impacted every company and industry sectors, including pharmaceutical businesses. The adoption of Ind AS has shown a variety of changes to a company’s key metrics, including reported top line, bottom line, financial position and net worth. The significant areas of impact for the pharma sector are discussed below.
Revenue guidance under Ind AS is quite exhaustive as compared to the current Indian GAAP providing detailed guidance on customer arrangements e.g. multiple element deliverables, service transactions etc. Adoption of Ind AS has resulted in reduction of reported revenue due to netting of awards and incentives, discounts and other consideration paid to customers such as provision for expected sales returns. Revenues have also declined due to Ind AS impact on accounting of ‘linked transactions’ generally involving sale and subsequent repurchase from suppliers. A typical example is a toll manufacturing arrangement, where a manufacturing entity sells intermediate products to a tolling entity which then completes the finished products and sells it back to the manufacturing entity. Finished products are finally sold to the end customers by the manufacturing entity. Under Indian GAAP, on the basis of legal form of such transactions, the manufacturing entity may have recorded revenue at the time of sale of intermediate products to the tolling entity and also subsequently on sale of its finished product to end customers. Under Ind AS, revenue in respect of such transactions would get recorded once the finished products are sold to the end customers (the sale of intermediate products to the tolling entity would get reversed). Revenue may also decline due to gross vs net presentation of revenue based on whether the reporting entity is acting in the capacity of a principal or an agent. If it is an agent then only the net commission or fee is recognised as revenue vis-à-vis the entire amount of billings. On the other hand, reporting of revenue gross of excise duty, with a corresponding adjustment to expense may lead to increased reporting of revenue with no impact on profits.
Financial instruments and fair value
India has decided to be the first to adopt IFRS 9 equivalent— Ind AS 109, the new standard on financial instruments. Ind AS 109 provides extensive guidance on identification, classification, recognition and measurement of financial instruments. Additionally, it provides guidance on de-recognition of financial instruments and hedge accounting, and has extensive disclosure requirements. Presently, there is no comprehensive mandatory guidance on financial instruments under Indian GAAP. At a high level, the use of fair value and present value in recording financial instruments such as investments, derivatives, long-term deposits and provisions has increased. Additionally, the new model for the recognition of impairment losses i.e. the ‘expected credit loss’ model as compared to the ‘incurred losses’ model under Indian GAAP has also lead to an increased charge on impairment loss –especially when the receivables have a longer credit period.
Under Ind AS, deferred taxes are recorded based on the temporary difference as opposed to timing differences under Indian GAAP. This approach under Ind AS is broader resulting in deferred taxes on more items such as undistributed earnings from subsidiaries and joint ventures and unrealised profits on intra-group inventory transactions. Moreover, the lower recognition threshold under Ind AS compared to the virtual certainty supported by convincing evidence presently required to recognise deferred tax assets on carried forward losses under Indian GAAP may also increase reported deferred tax assets/ tax credits under Ind AS.
Finally, impact is noted in the area of employee benefits, generally resulting in higher expense due to recognition of stock compensation using fair value of the share-based awards. Adjustments due to actuarial gains/ losses on defined benefit obligations are now getting accounted in other comprehensive income under Ind AS instead of the income statement under Indian GAAP.
The impact of Ind AS adoption is pervasive beyond accounting, cutting across organisation and various functions/ areas such as direct and indirect taxes, contractual arrangements with customers, suppliers, lenders, HR and incentive policies, IT systems and controls, including requiring timely communication with various stakeholders. The quantum of disclosures will also increase multifold, though it will surely allow companies to tell their story to investors and provide more meaningful information for informed users of financial information.
Based on experience of companies that have already adopted Ind As, others preparing now for Ind As transition will have to invest time and effort and meticulously plan for consequential accounting and organisational changes, extensive data requirements including disclosures. They will have to start discussing disclosures on significant judgments and estimates in more detail, including what goes behind the reported numbers.