Key Financial Items Investors Should Watch For In Companies’ FY21 Balance SheetsBloombergQuintOpinion
It is that time of the year, when corporate India is getting ready to prepare and submit its report card to stakeholders with the March 31, 2021, financial results. Unfortunately, we are also in the middle of the second wave of the Covid-19 pandemic, a situation that is difficult and evolving. As management, boards of directors, auditors, other professionals including regulators are doing their best in these trying times to prepare for the year-end reporting, here’s a look at what investors and stakeholders can expect to see this reporting season.
Impairment Of Non-Financial Assets
Last year, I had mentioned that due to the stock market turmoil causing a significant decline in the market capitalisation of companies and an expected decline in economic performance, there may be impairment in the value of an entity’s property, plant, equipment, and intangibles, in addition to goodwill. However, from April 1, 2020, to March 31, 2021, the leading market indices have improved by around 80%. This spike coupled with the improvement in business performance for entities in certain sectors from varied points through the financial year may be an indicator for potential reversal (full or partial) of any previously recognised impairment of PPE and intangibles. At the same time, due to the recent spate of events from the second wave of Covid-19, for certain companies or sectors, the businesses may continue to be adversely impacted resulting in additional impairment. In summary, the pendulum could swing both ways!
Investment In Financial Assets
In respect of investment in financial assets comprising listed or unlisted equity of other entities, considering the increase in market indices, improved market sentiments from the initial public offering activity, and unicorn investments this past year, some entities may end up reporting gains in the income statement or other comprehensive income depending on how the investments were initially designated. However, at the same time, non-banking financial companies and others involved with lending activities will again need to critically evaluate their provisions for expected credit losses especially if their borrowers are facing liquidity or business concerns.
This will require updating assumptions, including forward-looking scenarios, amounts of provisions for losses, and disclosures.
Disclosure of exceptional items continues to be a judgmental area, in the absence of specific guidance from Ind AS or Schedule III which prescribes the format of the financial statements. This is interpreted to be those items from ordinary activities which are of such size, nature, or incidence that their disclosure is relevant to explain the performance of the entity – therefore they should meet the test of ‘materiality’ (size and nature) and the test of ‘incidence’. As a corollary to this, all material items are not exceptional items. This is important so investors are able to dissect the results and make their own predictions – said differently, disclosure of such items should have predictive value.
Accordingly, entities may end up reporting separately impairment of non-financial assets, provision for onerous contracts, termination penalties paid to suppliers/lessors, and incremental costs directly as a consequence of Covid. However, disclosure of “Sunk Costs” such as salary of employees or depreciation and other facilities costs during a plant shut-down when income was not generated i.e. “Lost Income” should not be presented here. It will be helpful for entities to more fully explain these items to improve their understandability to the users.
During these times, borrowers may have renegotiated or restructured their loans for various reasons such as to reduce interest rates, extend the tenure of loan, avail moratorium, or change in debt covenants. This may require entities to first evaluate whether these changes result in modification or extinguishment accounting causing de-recognition of the existing borrowing. When a borrowing measured at an amortised cost is modified without resulting de-recognition, a gain or loss is to be recognised immediately in profit or loss. The gain or loss is calculated as the difference between the original contractual cash flows and the modified cash flows discounted at the original effective interest rate.
This means when there are concessions and particularly when negotiated during a declining interest rate regime, the difference or the concession benefit cannot be spread over the remaining term of the borrowing but is to be recognised in the income statement immediately. Not to forget, testing of debt covenants will continue to be an important area as non-compliance may require otherwise long-term borrowings to get reclassified as current.
Corporate Social Responsibility
Until now, companies subject to corporate social responsibility provisions of the Companies Act were required to spend during a financial year 2% of the average net profits during the preceding three years. In case of a shortfall, companies would have to disclose the amount and reasons – a ‘comply or explain’ regime. However, due to the recent amendments to the Companies Act and CSR Rules effective from January 2021, now if the above-determined amount of 2% of net profits has not been spent through the year, depending on whether it relates to an ongoing project or not, companies would need to transfer the unspent amount to a special bank account or then to a specified fund.
It is now a ‘comply or contribute’ regime.
This will impact those companies that may not have spent 2% of their net profit through March 31, 2021, as they will need to record a CSR charge and corresponding provision for any unspent CSR amount.
Due to the Covid-19 situation, rent concessions may have been negotiated by lessees including payment holidays and deferral of lease payments. Ind AS was recently amended allowing such entities an optional practical expedient to account for the concessions (as a direct consequence of Covid-19) as variable lease payments in the period in which the related event or condition occurs instead of performing a detailed modification accounting analysis.
What this means is that entities can recognise the benefit of such concessions as a gain in the income statement during the current period instead of spreading over the expected lease term. On the other hand, some entities may have decided to exit or terminate existing lease arrangements pursuant to the restructuring of operations resulting in payment of penalties and so for them, there may be an additional charge in the current period.
Any dialogue will be incomplete without taxes. One significant area to watch out for is the implications of non-allowability of tax depreciation on purchased goodwill. This is likely to increase the tax charge, liabilities and decrease operating cash flows – read my article ‘Goodwill, Not So Good Anymore’.
I hope this is helpful in deciphering corporate India’s March 31, 2021, financial statements and would like to close by saying stay safe, healthy, and take care!
Sumit Seth is a chartered accountant. Views expressed are personal.
The views expressed here are those of the author, and do not necessarily represent the views of BloombergQuint or its editorial team.