insight US GAAP vs. Indian standards: accounting for the credit impact June

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1 insight US GAAP vs. Indian standards: accounting for the credit impact Analytical Contact : Shruti Gupta Jyotirmay Pingat shgupta@crisil.com jpingat@crisil.com Indian companies sometimes report significantly different numbers under US GAAP and Indian Accounting Standards but such differences have so far not materially impacted CRISIL s opinions on its rated credits. This opinion piece analyses the main reasons for the divergences seen so far in accounts presented by companies under both systems. We conclude that, by and large these differences have had few implications for debt servicing capability, and have therefore not led to any changes in CRISIL s views on its rated credits. CRISIL will continue to compare the numbers reported by rated entities under both systems, and will appropriately factor any analytically significant divergences into its credit opinions. Background The focus of Indian companies is shifting towards the global markets, with several corporates coming out with ADR/GDR issues, making 10

2 acquisitions abroad, and expanding their business presence worldwide. It therefore becomes increasingly pertinent to analyse these companies on international parameters with respect to their global peers. Several Indian companies have begun to report a reconciliation of their accounts prepared under Indian standards, with those prepared under U.S. GAAP. Since consistent financial statements form the basis of the entire analytical process, CRISIL believes that there is a need to understand major differences between Indian Accounting Standards and U.S. GAAP, to form the basis of a decision on the materiality and consequent analytical impact. CRISIL is uniquely positioned in this respect with the extensive experience of its strong international research team, and access to global practices by virtue of its association with Standard & Poor s. Comparative analysis between the Indian Standards and US GAAP We begin by illustrating a few major accounting differences between the Indian Accounting standards and U.S. GAAP, and their impact on a company s profitability. These observations are based on a study of sample of Indian companies, which provide a reconciliation of their accounts prepared in line with prescribed Indian Accounting standards, with U.S. GAAP financials. The following table provides an overview of the differences in net profit figures for some of these companies along with major reasons. Table 1: Comparison of profits under Indian standards v/s U.S GAAP (Rs in Million for ) Company Indian U.S Variance* Variance as a % Major reconciliation of profit under items Indian standards Bajaj Auto Ltd (AAA/Stable) 7,603 7, % Equity method accounting, Depreciation, Impairment of investments Infosys Technologies Ltd (AAA/Stable) 19,043 18, % Forward exchange contracts Intangibles Ranbaxy Laboratories Ltd Dec 2004(P1+) 6,986 7,067 (81) 2% Depreciation, Forward exchange contracts Reliance Industries Ltd (AAA/Stable) 75,720 69,870 5,850 8% Deferred taxes, Depreciation, Affiliates and subsidiaries Wipro Ltd (NR) 16,285 15, % Loss on direct issue of shares, Intangible assets Dr Reddy s Laboratories Ltd (NR) % Intangibles, Forward exchange contracts I Gate Global Solutions Ltd (NR) (43.7) % Stock based compensation, Intangibles figures in brackets indicate higher profit in US GAAP accounts as compared with Indian accounts NR: not rated by CRISIL Prominent areas of divergence between Indian Accounting Standards and U.S. GAAP The major heads under which differences can arise are: 1. Depreciation: Indian standards provide depreciation rates for various categories of assets, whereas US GAAP is more directional in this regard, and leaves the estimate of useful life more as a matter of management discretion. This could result in a timing difference in profits reported under the two systems. 2. Stock based compensation: Indian standards require companies to expense the difference between market and exercise price as of the day of grant; US GAAP on the other hand mandates the use of the Fair Value Method. In most cases, therefore, the US GAAP 11

3 results would report a significantly higher compensation expense. 3. Goodwill and Intangible assets: There are differences between Indian and US standards both in terms of recognition and expensing of these assets. Under Indian standards, goodwill needs to be expensed, whereas US GAAP only requires that it be tested annually for impairment. Similarly, Indian standards require that intangible assets be expensed over ten years, whereas the treatment under US GAAP depends on whether the asset is judged to have a definite or an indefinite life. Consequently, there can be significant differences between the profits reported under both systems. 4. Forward foreign exchange contracts: Indian standards require the amortisation of any premium or discount over the term of the contract, whereas the treatment under US GAAP takes the nature of the hedge into account. Given the increasing volume of foreign business that Indian entities are transacting, the differences under this head can be significant. The Indian accounting standards are issued by the Institute of Chartered Accountants of India (ICAI) a statutory body established under an act of Parliament mandating the use of these Standards by all listed Companies. In the US the Securities Exchange Commission (SEC) has statutory authority to establish financial accounting standards for public companies. To this end the SEC relies on Financial and Accounting Standards Board (FASB) which is the primary accounting standard-setter for the private sector. There is a separate set of standards for government entities. In Annexure 1, we have elaborated on these heads, explaining variances in accounts as per the Indian standards and U.S. GAAP. None of the adjustments seen so far in rated companies has had significant implications in terms of cash flows, the quantum of leverage on the balance sheet, or debt servicing obligations. Therefore, these adjustments have not led to any change in CRISIL s rating view on rated credits. Future Trends Although Indian accounting standards currently differ considerably from US GAAP, ICAI is making efforts to streamline these standards, and is considering revision of the old accounting standards along the lines of international accounting practices to harmonise the accounting practices in India with global standards. This is evident from the new standards being introduced, and recent amendments in standards like AS-15 Employee benefits and AS-10 Fixed assets in alignment with the respective U.S. GAAP provisions. However, for effective implementation, other legal and statutory provisions should also be suitably amended. For example, ICAI has revised AS-11 Foreign exchange which mandated that the foreign currency gains or losses arising out of foreign currency borrowings for acquisition of fixed assets should be expensed in line with the US accounting practice in this regard, as opposed to the previous practice of capitalising them. However there is no similar amendment in the Schedule VI of the Companies Act 1956 which still requires such gains or losses to be capitalised. Since the accounting standards cannot override the provisions of law, ICAI suggested that auditors should not qualify their audit report if the new provisions of AS-11 are not followed as a stopgap measure. Similarly, in certain cases, ICAI has issued guidance notes that are recommendatory in nature. It can consider making these mandatory. Conclusion With the changing face of Indian business, CRISIL strongly feels that a greater understanding of international accounting practices is becoming increasingly important for the financial sector and investor community. CRISIL in its analysis always understands the implications of the application US GAAP and will duly incorporate the impact if relevant. Annexure 1 Prominent areas of divergence Depreciation Indian accounting standards regarding depreciation are more rigid than US GAAP, and provide for definite rates for depreciation across asset types. U.S. GAAP is more directional and leaves the decision of estimates useful life of the asset to the individual companies. Although, in the long term, this leads only to a timing difference in recognition of the expenditure, on a year to year basis there is need to reconcile differential depreciation charged under the two accounting standards. Depreciation in India is governed by Section 350 and Schedule XIV of the Companies Act 1956, which prescribes minimum rates of depreciation depending on whether the Company uses Straight Line Method or Written -Down Value. A company can only claim higher 12

4 rates with the prior approval of relevant statutory authorities. U.S. GAAP (as per the Accounting Research Bulletin 43) simply requires the depreciation to be provided based on management s estimate of the useful lives of assets. This aligns the book value of assets more closely with their economic estimate of remaining life. As an example, the depreciation charged by Ranbaxy Laboratories (P1+) as per Indian standards was Rs.850 million for the year ended December 2004, almost 23 per cent lower than the depreciation under the U.S. GAAP (Rs.1, 047 million). This essentially indicates that in Ranbaxy s estimation the actual useful life of its assets is lower than mandated under Indian accounting standards. In other words, the Indian standards in this case require charge-off over a longer period compared to US GAAP. Stock based compensation Accounting for stock based compensation in India is governed by the SEBI guidelines, which requires companies to expense the difference between the market price and exercise price on the date of grant, over the term of the options. This differs from the recently mandated U.S. GAAP provisions (as per the Statement of Financial Accounting Standards 123R) 1 that mandate adopting Fair value method for stock based compensation expense. As per this provision, companies have to expense the cost of stock options issued on the basis of Black and Scholes model (or Binomial model) over the term of the options. Prior to this change in U.S. accounting standards, companies used to follow Accounting Principles Board Opinion No. 20 (called the intrinsic value method). As an example, the amortisation of deferred stock compensation for Infosys Technologies Ltd (AAA/Stable)as per U.S GAAP was Rs.129 million for year ended March There was no charge in this respect under Indian accounting rules. In another example, the impact of this difference was much more material, and profits reported under the Indian accounts turned to loss after adjusting for stock based compensation as per the U.S. GAAP. In case of I Gate Global Solutions Ltd (not rated by CRISIL), the stock compensation expense recorded for year ended March 2005 under the SEBI guidelines was Rs.10 million; however under U.S. GAAP, the company recorded a stock compensation expense of Rs million. Due to this vast disparity, profits to the tune of Rs million under Indian accounting standards were converted into a loss of Rs.43.7 million. Goodwill and Intangible assets Goodwill and Intangible assets are an area where there are significant variations between the U.S. GAAP and the Indian standards. This can lead to material impact on a company s income statement. Under the Indian Accounting Standard 26, goodwill is amortised, while it only needs to be tested annually for impairment according to the U.S. GAAP (Statement of Financial Accounting Standards SFAS 142). For intangibles, the Indian Accounting Standard assumes that the life of the intangible asset will not exceed ten years; the asset is amortised accordingly. Under U.S. GAAP, intangibles are further classified, and their treatment varies: a) Definite life. An intangible asset with a definite life is amortised based on estimate of its useful life of as determined by the company. b) Indefinite life. The indefinite life intangibles only need to be tested for impairment annually, as in case of goodwill. Also the recognition norms for goodwill and intangible assets differ between the two standards. In Indian Accounting Standard AS-14, the amount of the consideration paid for acquisition is deducted from the value of the net assets of the transferor company. If the result of the computation is negative, the difference is debited to goodwill arising on amalgamation. Under the U.S. GAAP, a portion of the purchase consideration meeting the criteria for being recognised as an intangible in a business acquisition is allocated as an intangible asset apart from goodwill. The value assigned to these intangible assets is amortised over their useful lives, in proportion to the economic benefits consumed during each reporting period. The case of Infosys Technologies Ltd. is a good illustration of this difference. In 2004, Infosys acquired Expert Information Services Limited, Australia. The company recognised intangibles of $2 million (approximately Rs million) 1 under the U.S. GAAP. The difference in recognition norms led to additional intangible amortisation of Rs.81 million and Rs.1 million under the U.S. GAAP (as compared to Indian accounting standards) in 2005 and 2004 respectively. 1 The FASB issued SFAS 123 R in December 2004 and a recent clarification provides that the application will be from 1st quarter 2006 for calendar end companies 13

5 Forward foreign exchange contracts Given the significant and increasing volume of international business that Indian businesses are conducting, there is a high incidence of foreign exchange contracts. Any difference in accounting under this head can have a significant impact on the income statement. The Indian accounting standard AS-11 requires that any premiums or discounts on any forward foreign exchange contracts should be amortised as an expense or income over the period of the contract. Under the U.S. standard (SFAS 133), the treatment depends on the type of hedge that this derivative contract represents. Under certain situations (such as when the forward foreign exchange contracts are not effective hedges), the resultant gain or loss is recognised immediately in the income statement. In case of Wipro Ltd (not rated by CRISIL), the additional resultant forex loss as a result expensing provisions under the U.S. GAAP was Rs.45 million in 2005.contract. It is pertinent to note that ICAI is considering this issue in the Accounting Standard on Financial Instruments: Recognition and Measurement, which is currently under formulation. Others Apart from these regular items as listed above there can be other minor differences relating to various accounting principles as highlighted by the table: Table 2:. Other minor differences in accounting principles Item Indian AS US GAAP Upward revaluation of fixed assets Allowed Not allowed Reversal of impairment of fixed assets Allowed Not allowed Indirect expenditure during Capitalised Expensed construction stage Prior period items Expensed in Adjustment current year through retained earnings Interest expense classification in Financing Operating cash flow statement activities activities Inventories FIFO, WAM Any method