Indian Accounting Standards for NBFCs & ARCs

Ashish M. Shaji

05 Oct, 2020

In India, Accounting Standards come under the Institute of Chartered Accountants of India (ICAI). The primary objective of Accounting Standards is to standardize the diverse accounting policies and practices.

It was implemented with a view to eliminate the non-comparability of financial statements and the reliability to the financial statements.

To which entities do the Accounting Standards apply?

• For financial assets like loans, trade receivables etc. entities will be guided by the requirements of Accounting Standard 4, contingencies and events occurring after the balance sheet date.
• In case of financial assets in the scope of Accounting Standard 13, accounting for investments, entities may require considering the requirements of making provisions for decline in the value of investments, which is other than temporary.
• In case of banks and insurance entities, preparers must consider the impact of Covid-19 on the classification of loans and advances into standard, substandard, doubtful and loss categories in addition to the Prudential regulatory requirements of the Reserve Bank and the IRDAI^[1] (Insurance Regulatory and Development Authority of India).

Implementation of Indian Accounting Standards

Non-Banking Financial Companies covered by Rule 4 of the Companies (Indian Accounting Standards) Rules, 2015 should comply with the Ind AS for the preparation of their financial statements. To increase the quality and to facilitate comparison and better supervision, the RBI has made regulatory guidance on Ind AS which will be applicable on Indian Accounting Standards implementing Non-Banking Financial Companies and Asset Reconstruction Company (ARC) for preparing their financial statements from FY 2019-20 onward.

In case of matters not dealt in the annex, the NBFCs/ARCs should go by accounting standards, application guidance, educational material and clarification issued by the ICAI.

These guidelines focus on the requirement of ensuring consistency in the application of the accounting standards in the specific areas, including asset classification and provisioning and to provide clarification on regulatory capital in light of Ind AS implementation.

Framework

Indian Accounting Standards 109 doesn’t define default explicitly but requires entities to define default in a way consistent with that used for internal credit risk management. The definition of default used for accounting purposes is guided by the definition used for the regulatory purposes. The Audit Committee of Board is required to approve the classification of accounts that are due beyond 90 days but are not treated as impaired, with the rationale for it documented clearly.

Irrespective of the way Non-Banking Financial Companies and Asset Reconstruction Companies assess significant increase in credit risk, there is a rebuttable presumption in Ind AS 109 that the credit risk on a financial asset has increased considerably since initial recognition when contractual payments are more than 30 days past due.

Under Ind AS 109, an NBFC/ARC can rebut this presumption if it has reasonable and supportable information that shows that the credit risk hasn’t increased considerably after recognition when contractual payments are more than 30 days past due.

NBFCs/ARCs are required to educate their customers on the need to make payments in a timely way. However, in limited circumstances, where NBFCs/ARCs rebut the presumption, it must be done only with clear documentation of the justification. All such cases would be placed before the Audit Committee of Board. NBFCs/ARCs will not defer the recognition of significant increase in credit risk for any exposure which is overdue beyond 60 days.

Prudential floor for Expected Credit Losses

According to the guidelines of Reserve Bank, NBFCs/ARCs are required to hold impairment allowances as required by the Indian Accounting Standards. In parallel NBFCs/ARCs will also maintain the asset classification and compute provisions according to the extant prudential norms on the Income Recognition, Asset Classification and Provisioning including borrower/beneficiary classification, provisioning for standard and restructured assets, NPA ageing etc.

In case of impairment allowance lower than provisioning required under Income Recognition, Asset Classification and Provisioning, NBFCs/ARCs shall appropriate the difference from their net profit or loss after tax to a separate impairment reserve. The balance in impairment reserve will not be reckoned for regulatory capital. Moreover, no withdrawals will be permitted from this reserve without the permission from the Department of Supervision, Reserve Bank of India.

Computation of Regulatory Capital

The notification released by the RBI provides clarifications with respect to calculation of owned funds, net owned funds and regulatory capital.

• Impact of unrealized gains or losses arising on fair valuation of financial instruments

Ind AS 109 require fair valuation of all financial instruments. How then these gains or losses on fair valuation would be treated for the purpose of capital computation. Well, none of these gains would be considered for the purpose of regulatory capital computation but in case of losses, if any, will be considered.

It may be noted that the RBI talks about all unrealized gains arising out of fair valuation of financial assets. In case of assets that are fair valued by profit or loss, the gains or loss once booked are taken to the statement of profit or loss and once taken to the statement of profit and loss, it loses their individuality. Moreover these gains or losses are not displayed separately in the balance sheet and are blended with accumulated profits or loss of the company. Monitoring of unrealized gains from the individual assets will mean maintenance of parallel accounts and it may have severe administrative implications.

Conclusion

Read our article:IND Accounting Standard Guidelines for NBFC for the Preparation of Financial Statement