How NBFCs And ARCs Need To Implement Ind AS

In order to promote high quality and consistent implementation of Indian Accounting Standards, as well as facilitate comparison and better supervision, the Reserve Bank of India has framed regulatory guidance on Ind AS which will apply to non-banking finance companies and asset reconstruction companies for preparation of their financial statements from the financial year 2019-20 onwards.

Considering the already existing mayhem in the financial services sector exacerbated by the unfortunate COVID -19 pandemic, there could be added stress in the economy and consequently on the lending business. This guidance from RBI is timely and has something in store for everyone i.e. board of directors, audit committees, management, auditors and investors.

Here is what each constituent should look out for going into the ensuing financial reporting cycle.

Board of Directors And Audit Committees

Boards of directors and audit committees have a responsibility to contribute to and oversee high-quality corporate governance at their company. In this regard, the RBI has now detailed the following specific responsibilities of boards and audit committees of an NBFC or ARC in context of Ind AS financial reporting:

• Responsibility of preparing and ensuring fair presentation of the financial statements of a vest primarily with its board of directors;
• Approval of policies that clearly articulate and document the business models for the portfolios of financial assets of an NBFC or ARC. This is important because the subsequent measurement of such assets at an amortised cost or fair value through other comprehensive income or profit and loss depends on whether the business model is to hold and collect cash flows of the underlying financial asset until maturity or to hold and collect and sell or trade-in those assets. Such policies shall also articulate the objectives for managing each portfolio and restrictions on subsequent reclassification;
• Approval of sound methodologies for computation of 'expected credit losses' or ECL addressing policies, procedures, and controls for assessing and measuring credit risk on all lending exposures, commensurate with the size, complexity and risk profile specific to the NBFC/ARC;
• The parameters and assumptions considered, as well as their sensitivity to the ECL output, are to be documented. The rationale and justification for any change in the ECL model to be documented and approved by the board;
• Any adjustments to the model output (i.e. a management overlay) to be approved by the audit committee and its rationale/basis should be clearly documented;
• The classification of accounts that are past due beyond 90 days but not treated as impaired, to be approved by the audit committee with a clearly documented rationale;
• Under Ind AS 109, there is a rebuttable presumption that when accounts are more than 30 days past due it signifies a significant increase in the credit risk for that financial asset. This would typically result in a higher impairment loss provision from “12-months ECL” to “Lifetime ECL”. This presumption can be rebutted if the NBFC and ARC has reasonable and supportable information that demonstrates otherwise. However, per RBI guidance, such presumption can be rebutted only with clear documentation of the justification for doing so and all such cases are to be approved by the audit committee;
• Additionally, RBI has now prescribed a stricter rule than Ind AS, prohibiting NBFCs and ARCs to defer the recognition of the significant increase in credit risk (consequently higher provision for ECL) for any exposure that is 60 days overdue.

Accordingly, the board and audit committee may now need to spend more time with the management to understand these detailed requirements before approving, including interactions with the auditors.

Management

As seen above, for the board of directors and audit committee to effectively discharge these responsibilities, the management of NBFCs and ARCs will need to ensure these various policies, processes, controls, models, assumptions and related documentation are timely implemented, prepared and provided to the board and audit committee for their review and approval.

The RBI has also advised NBFCs and ARCs to not make changes in the parameters, assumptions and other aspects of their ECL model for profit smoothening, the definition of default adopted for accounting purposes is to be guided by the definition used for regulatory purposes and has provided guidance on determining ‘owned funds’, ‘net owned funds’ and ‘regulatory capital’.

Further, the management of an NBFC or ARC will now have to include the following additional disclosures in their financial statements:

• Policy for sales out of amortised cost business model portfolios – Under Ind AS 109 sales that are frequent or high value or without specific reasons such as an increase in credit risk may not be consistent with the amortised cost business model;
• The number of accounts that are past due beyond 90 days but not treated as impaired, their total amount outstanding and the overdue amounts; and
• Comparison in a specified template between provisions required under extant prudential norms on income recognition, asset classification and provisioning vis-a-vis impairment allowances made under Ind AS 109 (discussed in detail below).

Prudential Floor For ECL

Per these RBI guidelines, NBFCs and ARCs shall continue to record the impairment allowances as required by Ind AS, 109 using the three-stage ECL model. However, in parallel, they shall also maintain the asset classification and compute provisions as per income recognition, asset classification, and provisioning; including borrower/beneficiary wise classification, provisioning for standard as well as restructured assets, NPA ageing, etc.

Where the impairment allowance under Ind AS 109 is lower than the provisioning required under income recognition, asset classification and provisioning (including standard asset provisioning), NBFCs and ARCs shall appropriate the difference from their net profit or loss after tax to a separate ‘impairment reserve’. The objective of this requirement is to provide a benchmark to the board of directors, RBI, and other stakeholders, on the adequacy of provisioning for credit losses.

This is an important new requirement, serving the dual purpose of ensuring that the net profit after tax (and consequential earnings per share) continues to be determined as per Ind AS, and at the same time, the NBFC or ARC will set aside or appropriate amounts from profits into a separate reserve if Ind AS 109 ECL provision is lower than income recognition, asset classification, and provisioning prudential norms.

This is a balanced and conservative approach suggested by RBI as the amounts in such impairment reserve shall not be counted for regulatory capital, prohibited to be withdrawn without prior RBI permission and shall be reviewed by RBI going forward.

It appears this may limit the dividend-paying capacity of an NBFC and it is not clear whether the amounts once transferred to such impairment reserve can be subsequently withdrawn when the impairment allowance under Ind AS, 109 is equal to or a greater than that required per income recognition, asset classification, and provisioning prudential norms without RBI approvals.

Auditors And Investors

Now for the auditors, they will have to consider the impact of the above RBI guidance and requirements in their audits of an NBFC’s or ARC’s financial statements, their opinion over internal financial controls over financial reporting and interactions with the audit committee.

Finally, the investors and users of financial statements will have access to additional financial information or disclosures and can take solace that effective implementation of the above measures would result in improved financial reporting and corporate governance.

The Way Forward

This is a welcome move from our regulator and now it is up to NBFCs and ARCs to embrace and effectively implement these measures both in letter and spirit.

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.