Implications of new accounting standards for Indian auto companies

Soon, companies in India will have to report their financial statements in accordance with the new Indian Acounting Standards (Ind-AS). Indian Accounting Standards are financial reporting standards in India (converged with IFRS (International financial

Reporting Standards)) and their application is mandatory for financial reporting by the prescribed Indian entities from financial year ended 31 March 2017 onwards, in a phased manner.

Prescribed listed companies shall report under Ind-AS for the quarter ending 30 June 2016, for the first time, as they progress towards full year reporting under Ind-AS for 31 March 2017.

The Ind-AS conversion is mandatory for reporting entities that meet the prescribed threshold of net worth and would include all subsidiaries, joint ventures and associates of such reporting entities. This is irrespective of whether the standalone network of the subsidiary, associate or joint venture does not meet the prescribed threshold.

Within the automobile industry, Original Equipment Manufacturers (OEMs), are strategically invested across the automotive ecosystem, especially in most of the ACS (especially tier I, II). Such investments interests vary from a holding-subsidiary, to associate, to joint venture relationship. Accordingly, Tier I, II ACS, are 
compulsorily required to comply with Ind-AS implementation, either in phase I (reporting date: 31 March 2017, transition date: 1 April, 2015) or phase II (reporting date: 31 March 2018, transition date: 1 April, 2016) per the MCA (Ministry of Corporate Affairs) roadmap for Ind-AS implementation in India.

Many companies in the automotive sector (including the OEMs and their vendors) shall experience the significant impact on their balance sheet and income statement, post implementation of the new Indian Accounting Standards (Ind- ASs).

Some key Ind-AS considerations for the component manufacturers:

Many companies in the automotive sector (including the OEMs and their vendors) shall experience the significant impact on their balance sheet and income statement, post implementation of the new Indian Accounting Standards

Customer related assets (Tools,moulds and dies): Components manufacturers would need to carefully examine whether they control the tools/dies provided by the OEMs on free of cost (FOC) basis. Under the current accounting rules, the ACS usually do not account for the tools/dies provided on FOC basis by the automobile company – In substance, these tools and dies could be controlled by the ACS. In such situations, the automobile company shall de-capitalise the tools and dies from its balance sheet and the ACS shall need to capitalize these tools and components on their balance sheet with a corresponding amount recognized as revenue.

Embedded leases: There are long term supply arrangements between the auto manufacturers and their ACS, where the ACS builds/uses a dedicated facility to manufacture the components primarily for the auto company – In substance the auto manufacturer may be controlling the use and physical access of such facility. At present, these arrangements are accounted for as normal sale/purchase contracts.

Under Ind-AS, there may be a need to separate the underlying assets from the sale of the components parts and record those assets as assets under operating or a finance lease. In case of the latter (a finance lease), this could result in the ACS de-capitalizing the asset from its balance sheet and the OEM capitalizing the same, as a finance leased asset. Separation of the total sale price into sale of components and lease of the asset could also be a complex task that shall involve judgement and subjectivity.

Contract modifications: Pricing adjustments are common in the automotive industry, including changes in the amount of goods to be transferred or previously agreed pricing. It is also a prevalent practice where an entity may receive price concessions on existing contracts in connection with the negotiation of new contracts.

Insuch cases, entities need to evaluate whether a price concession/ revision is a modification of a previous contract or if it relates to a new contract.Under the new standards, contract modification could impact retained earnings and reduce the revenue to be recognised in subsequent periods.

Other accounting implications: In addition to some of the industry specific issues above, the component manufacturers would also need to evaluate the impact of past business combinations, consolidation requirements, identification of embedded derivatives, accounting for decommissioning obligations, accounting of joint arrangements, fair valuation and impairment assessment of financial assets (in particular funding arrangements within the group or with promoters). All of these shall need careful examination and analysis.

Closing comments: Most ACS are required to report their financial results to the OEMs quarterly and annually for consolidation of financial results. An early identification of key accounting issues, their impact, available alternatives, if any within Ind-AS, decision over key impact and transition areas can help restrict unnecessary surprises for senior management of ACS and the OEMs.

Some of the issues above could have a substantial impact on -

a) Funding arrangements with banks (particularly, where the assets have been mortgaged/hypothecated by the OEM for seeking financing but the assets get de-capitalised; b) Tax implications (direct and indirect tax implications in case the ACS records revenue in relation to the tools/dies provided on FOC basis by OEMs; c) Overall business model of the company, in particular for the OEM. For instance, new stream of taxable revenue being recognized by the ACS with respect to the tools and dies worth crores of rupees, provided on FOC basis by the auto manufacturer); and d) IT systems and business processes would also have a significant impact considering that reporting under new standards would need updation of the chart of accounts, updation/development of new standard operating procedures as well as review of the existinginternal financial controls over financial reporting.