Taxmann presents Practical Insights on Ind AS and SAs, a weekly series exclusively for Accounts and Audit Module subscribers of Taxmann.com, focusing on the practical application of Ind AS and Standards on Auditing through structured, issue-based analysis.
Each week features a focused topic with real-world relevance. Continuing our discussion on mandatory exceptions under Ind AS 101, this edition examines additional transition provisions that address practical challenges arising during first-time adoption. The discussion focuses on impairment of financial assets, embedded derivatives, government loans, and deferred tax relating to leases and decommissioning obligations.
1. Introduction
In the earlier part of this discussion, we examined the initial set of mandatory exceptions prescribed under Ind AS 101, highlighting how the standard balances retrospective application with practical implementation challenges during first-time adoption. While retrospective application remains the general principle for transition to Ind AS, certain areas require specific reliefs or modified approaches due to the complexity of historical assessments and the limitations surrounding the availability of information.
This article focuses on additional mandatory exceptions dealing with impairment of financial assets, embedded derivatives, government loans, and deferred tax relating to leases and decommissioning obligations. These areas involve significant estimation, valuation, and contractual assessments, making retrospective application particularly challenging. The discussion, therefore, explores how Ind AS 101 addresses these practical issues while ensuring a consistent and reliable transition framework.
2. Impairment of Financial Assets
Another important mandatory exception under Ind AS 101 relates to impairment of financial assets. Ind AS 109 introduced the Expected Credit Loss (ECL) model, which requires entities to recognise impairment based not only on actual defaults but also on expected future credit losses. Since this model involves extensive use of historical information, forward-looking assessments, and credit risk analysis, retrospective application may become difficult for a first-time adopter.
Accordingly, Ind AS 101 permits certain practical relaxations while still requiring entities to apply the impairment requirements of Ind AS 109 retrospectively to the extent practicable.
2.1 Expected Credit Loss Model under Ind AS 109
Under Ind AS 109, impairment is recognised using the Expected Credit Loss approach. The entity is required to assess whether the credit risk of a financial instrument has increased significantly since its initial recognition.
If credit risk has not increased significantly, the entity recognises a loss allowance equal to 12-month expected credit losses. If credit risk has increased significantly, the entity recognises lifetime expected credit losses.
This assessment requires a comparison between the credit risk at initial recognition and the credit risk at the reporting date.
2.2 Use of Reasonable and Supportable Information
A first-time adopter is required to use reasonable and supportable information available without undue cost or effort for assessing credit risk at initial recognition and at the transition date.
The standard does not require an exhaustive search for historical information. Instead, entities may use internal records, external credit information, portfolio data, and other reasonable approximations to determine whether there has been a significant increase in credit risk.
Illustration – Trade Receivables Portfolio
Suppose a manufacturing company transitions to Ind AS on 1st April 2023 and holds a large portfolio of trade receivables originating over several years.
The company does not possess complete historical credit risk data for every individual customer at the original recognition date. However, it has access to customer payment patterns, ageing information, industry trends, and historical default experience.
In such a case, the company may use reasonable and supportable portfolio-based information to assess whether credit risk has significantly increased instead of conducting a detailed instrument-by-instrument historical reconstruction.
2.3 Low Credit Risk Simplification
Ind AS 109 permits an entity to assume that credit risk has not increased significantly if the financial instrument has low credit risk at the reporting date.
A financial instrument is generally considered to have low credit risk where:
a) the borrower has a strong capacity to meet contractual cash flow obligations and the risk of default is low. Also, the adverse economic conditions are unlikely to significantly impair repayment ability.
b) Importantly, low credit risk is not determined based on collateral value. Further, it does not necessarily mean that the instrument has the lowest credit risk in the market.
Investment-grade instruments are commonly regarded as having low credit risk.
Illustration – Investment-grade Bonds
Assume an entity holds government-backed bonds carrying an external investment-grade rating at the transition date.
Even if detailed historical credit information at initial recognition is unavailable, the entity may conclude that the instruments carry low credit risk and therefore measure impairment using 12-month expected credit losses instead of lifetime expected credit losses.
2.4 Rebuttable Presumption for Past Due Amounts
Ind AS 109 contains a rebuttable presumption that credit risk has increased significantly if contractual payments are overdue for more than 30 days.
However, this presumption may be rebutted where reasonable and supportable information demonstrates that the increase in credit risk is not significant despite the delay in payment.
Illustration – Temporary Payment Delay
Suppose a customer delays payment beyond 30 days due to temporary operational issues, but the entity possesses strong evidence that the customer remains financially stable and has historically maintained a strong repayment record.
In such a situation, the entity may rebut the presumption of a significant increase in credit risk and continue recognising only 12-month expected credit losses.
2.5 Impracticability Exception under Ind AS 101
In certain cases, a first-time adopter may be unable to determine whether credit risk has significantly increased since initial recognition without incurring undue cost or effort. In such cases, the first-time adopter shall recognise the loss allowance equal to the lifetime expected credit loss as on the date of transition. However, if the entity considers that the financial instrument holds low credit risk as on the date of transition, the entity may measure the loss allowance at amounts equal to 12-month expected credit loss.
Illustration – Long-term Employee Loans
Suppose an entity had granted long-term concessional loans to employees several years before transition to Ind AS. Due to lack of historical credit data, the entity is unable to determine whether credit risk has significantly increased since the loans were initially granted.
Accordingly, the entity would generally recognise lifetime expected credit losses on transition. However, if the employees continue to have stable employment records and low default risk, the entity may treat the loans as low-credit-risk instruments and recognise only 12-month expected credit losses.
2.6 Practical Significance of the Exception
This mandatory exception reflects the practical challenges involved in applying the Expected Credit Loss model retrospectively. Since impairment assessment under Ind AS 109 relies heavily on historical and forward-looking credit information, complete retrospective reconstruction may not always be feasible.
Ind AS 101, therefore, balances practical implementation with robust impairment recognition by allowing reasonable approximations, portfolio assessments, and transition-date simplifications while still ensuring that expected credit losses are appropriately recognised in the financial statements.
3. Embedded Derivatives
Another important mandatory exception under Ind AS 101 relates to embedded derivatives. Financial instruments and contracts sometimes contain components whose cash flows behave like derivatives even though they are embedded within a larger non-derivative contract. Since identification and separation of embedded derivatives often require assessment at the inception of the contract, retrospective application may become complex for a first-time adopter.
Accordingly, Ind AS 101 prescribes specific transition requirements for assessing whether an embedded derivative must be separated from its host contract.
3.1 Meaning of Embedded Derivative
An embedded derivative is a component of a hybrid contract that causes some of the cash flows of the overall contract to vary in a manner similar to a standalone derivative.
For example, a bond whose repayment amount is linked to an equity index contains an embedded derivative because the cash flows vary based on changes in equity prices.
However, a derivative instrument that is separately transferable or has a different counterparty is not treated as an embedded derivative and is instead accounted for as a standalone derivative.
3.2 Separation of Embedded Derivatives
Under Ind AS 109, an embedded derivative is separated from the host contract and accounted for independently as a derivative if all the following conditions are satisfied:
a) the economic characteristics and risks of the embedded derivative are not closely related to the host contract;
b) a separate instrument with similar terms would satisfy the definition of a derivative; and
c) the hybrid contract itself is not already measured at fair value through profit or loss.
Once separated, the embedded derivative is measured at fair value through profit or loss.
Illustration – Foreign Currency Linked Lease Contract
Suppose an entity enters into a long-term lease agreement where lease rentals are linked to fluctuations in a foreign currency exchange rate, even though the lease itself is denominated in domestic currency.
The foreign currency-linked component may behave like a derivative because the cash flows vary based on exchange rate movements. If the risks associated with this feature are not closely related to the host lease contract, the foreign currency component may require separation and independent accounting as an embedded derivative.
3.3 Reassessment of Embedded Derivatives
Under Ind AS 109, assessment of embedded derivatives is generally performed when the entity first becomes a party to the contract. Subsequent reassessment is prohibited unless there is a significant modification in contractual terms affecting cash flows.
Accordingly, the focus remains on the contractual conditions existing at inception or at the date of any valid reassessment.
3.4 Requirement under Ind AS 101
A first-time adopter is required to assess whether an embedded derivative needs to be separated from the host contract based on conditions existing at the later of:
a) the date the entity first became a party to the contract; or
b) the date when any reassessment was required under Ind AS 109.
Thus, embedded derivatives are not identified using hindsight or based solely on conditions existing at the transition date.
Illustration – Commodity Price-Linked Supply Contract
Assume a manufacturing company entered into a long-term supply agreement several years before the transition to Ind AS. The purchase price under the agreement varies based on changes in international commodity prices unrelated to the underlying product being supplied.
On transition to Ind AS, the company is required to assess whether the pricing feature represents an embedded derivative requiring separation. This assessment is made based on the contractual conditions existing when the agreement was originally entered into, or when the contract was subsequently modified, if applicable.
The entity cannot reassess the contract merely based on current market conditions at the transition date.
3.5 Contracts Measured at Fair Value through Profit or Loss
Where the entire hybrid contract is already measured at fair value through profit or loss, separate accounting for embedded derivatives is generally not required because the entire instrument is already reflected at fair value.
Similarly, where it is clear that separation is prohibited or unnecessary, such as certain prepayment features closely related to the host loan contract, separate identification of embedded derivatives is not required.
3.6 Practical Significance of the Exception
This mandatory exception reflects the practical challenges involved in retrospectively analysing old contractual arrangements for embedded derivative features. Such assessments often require historical contractual terms, market conditions, and detailed analysis at inception dates, which may not always be readily available.
Ind AS 101, therefore, provides a practical transition approach by requiring assessment based on historical contractual conditions existing when the entity originally became party to the contract or when reassessment was previously triggered, thereby avoiding the use of hindsight during first-time adoption.
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