Insights on proposed Ind AS 118 Specified Main Business Activities under proposed Ind AS 118 and their impact on classification of Income and Expenses
CA Bhawna Grover Manager - Research and Advisory, Taxmann
Insights on proposed Ind AS 118 Specified Main Business Activities under proposed Ind AS 118 and their impact on classification of Income and Expenses
CA Bhawna Grover Manager - Research and Advisory, Taxmann
Contents 1.
Introduction
5
2. What constitutes a specified main business activity?
5
3. How should an entity assess whether an activity is its main business activity?
6
4. Classification of income and expenses where investing in assets is a main business activity
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5. Classification of income and expenses where providing financing to customers is a main business activity
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6. Disclosure and changes in assessment
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7.
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Implications for financial reporting and audit
8. Conclusion
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1. Introduction Ind AS 118, Presentation and Disclosure in Financial Statements, proposes a revised structure for presenting income and expenses in the Statement of Profit and Loss. Under the proposed requirements, income and expenses are classified into five categories: operating, investing, financing, income taxes and discontinued operations. The objective is to improve the comparability of financial performance and enable users to distinguish the results of an entity’s operations from returns on investments and the effects of financing. However, applying these categories uniformly to all entities may not faithfully represent their business performance. For example, interest income earned by a bank from lending to customers represents the outcome of its principal business activity, whereas interest income earned by a manufacturing company on surplus funds would ordinarily represent a return on investments. Similarly, investment income may constitute a significant part of an insurer’s operating performance. To address these differences, paragraphs 49–58 and 65–66 of the Ind AS 118 Exposure Draft prescribe specific requirements for entities whose main business activities include investing in particular types of assets or providing financing to customers. These requirements can result in income and expenses that would ordinarily be classified under investing or financing being included in the operating category.
2. What constitutes a specified main business activity? Paragraph 49 of the Ind AS 118 Exposure Draft requires an entity to assess whether either or both of the following constitute its main business activities: a.
Investing in assets: Investing in particular types of assets as a main business activity.
b.
Providing financing to customers: Providing finance to customers as a main business activity.
The distinction is important because the assessment determines the classification of specified income and expenses in the Statement of Profit and Loss. An entity may have more than one main business activity. For example, a manufacturer may manufacture products and also provide financing to customers to facilitate the purchase of those products. If both activities qualify as main business activities, the entity applies the specified classification requirements to both. The Exposure Draft identifies investment entities, investment property companies and insurers as examples of entities that might invest in assets as a main business activity. Banks, other lending institutions, entities providing finance to customers to purchase their products, and lessors providing finance through finance leases are examples of entities that might provide financing to customers as a main business activity. The use of the expression “might” is significant. An entity does not qualify merely because it belongs to one of these sectors. The assessment must reflect the facts and circumstances of the entity. Insights on proposed Ind AS 118 Specified Main Business Activities under proposed Ind AS 118 and their impact on classification of Income and Expenses
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3. How should an entity assess whether an activity is its main business activity? Paragraphs B30–B41 of the Ind AS 118 Exposure Draft provide guidance on assessing whether investing in assets or providing financing to customers constitutes a main business activity of an entity. The assessment is based on the entity’s actual business activities and relevant evidence, rather than merely on management’s assertion An entity may have more than one main business activity. Accordingly, the assessment should consider how the entity generates returns, conducts its business and evaluates its operating performance. The following factors are relevant to the assessment.
3.1
Use of subtotals to evaluate operating performance
Under paragraphs B34 and B35, an entity’s use of a subtotal similar to gross profit may indicate that investing in assets or providing financing to customers is a main business activity. This is particularly relevant when the subtotal includes income and expenses that would otherwise be classified in the investing or financing category and is used to explain the entity’s performance to external users or to assess and monitor performance internally. For example, A lending institution regularly monitors net interest income, calculated as interest income from customer loans less the interest expense incurred on borrowings used to fund those loans. It also presents net interest income as a key performance measure to investors. These practices may indicate that providing financing to customers is a main business activity because income and expenses that would otherwise fall within the investing or financing categories form part of the institution’s assessment of operating performance. However, the use of such a subtotal should be considered along with other relevant evidence; it does not, by itself, conclusively establish the entity’s main business activity.
3.2
Segment information
Paragraph B36 identifies information about operating and reportable segments as another source of evidence. A reportable segment comprising a single business activity indicates that the activity is an important indicator of the entity’s operating performance. Similarly, an operating segment comprising a single business activity may provide evidence when the performance of that activity is an important indicator of the entity’s overall performance. For example, a diversified group operates through separate segments engaged in manufacturing and customer financing. If customer financing constitutes a separate reportable segment and its performance is used as an important indicator of the group’s operating performance, this may support the conclusion that providing financing to customers is a main business activity. The conclusion should nevertheless be based on the overall facts and circumstances, rather than on the existence of a separate segment alone.
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Insights on proposed Ind AS 118 Specified Main Business Activities under proposed Ind AS 118 and their impact on classification of Income and Expenses
3.3
Assessment at the reporting-entity level
Paragraph B37 requires the assessment to be made for the reporting entity as a whole. Consequently, the conclusion for a consolidated group may differ from that for an individual subsidiary within the group. For example, a manufacturing group has a subsidiary whose principal business is financing purchases of products manufactured by the group. Providing financing to customers may constitute a main business activity of the subsidiary. However, the same conclusion does not automatically apply to the consolidated group, whose activities may primarily comprise manufacturing and sales. The assessment for the consolidated financial statements must reflect the activities of the group as a whole.
3.4 Assessment of investments and other relevant assets Paragraphs B38–B40 provide specific guidance on assessing investments in associates, joint ventures and unconsolidated subsidiaries, as well as other assets that generate returns individually and largely independently of the entity’s other resources. Under paragraph B38, an entity assesses whether investing is a main business activity in relation to investments that are not accounted for using the equity method. The assessment may be performed for individual investments or groups of investments with shared characteristics. Where an entity prepares separate financial statements under Ind AS 27, the groups used for this assessment must be consistent with the categories used to determine the measurement basis under paragraph 10 of Ind AS 27. An assessment is not required for investments in associates and joint ventures accounted for using the equity method because the exposure draft requires the related income and expenses to be classified in the investing category. Under paragraph B40, the assessment for other assets that generate returns individually and largely independently of the entity’s other resources may be performed for individual assets or groups of assets with shared characteristics. For groups of financial assets, the grouping must be consistent with the classes of financial assets specified in paragraph 6 of Ind AS 107. For example, a company holds investment properties, equity investments and debt investments. The investment properties generate rental income, the equity investments generate dividend income and gains or losses from changes in share prices, and the debt investments generate interest income. The company needs to assess whether investing is one of its main business activities. For this purpose, the company may assess each investment separately or group investments that have similar characteristics. For instance, if the company holds shares in several companies for earning dividends and benefiting from increases in share prices, it may assess those equity investments individually or as an appropriate group. Similarly, it may assess its debt investments, which generate interest income, as a separate group. However, when grouping financial assets, the company must ensure that the grouping
Insights on proposed Ind AS 118 Specified Main Business Activities under proposed Ind AS 118 and their impact on classification of Income and Expenses
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is consistent with the classes of financial assets specified in Ind AS 107. Investment properties may also be assessed individually or grouped with other properties having similar characteristics. The assessment should reflect how the company manages these investments and the role they play in its business. For instance, if the company regularly purchases and sells securities and manages its investment portfolio as a principal source of its business income, this may indicate that investing is one of its main business activities. In contrast, if a manufacturing company holds surplus funds in shares and bonds merely to earn additional returns while its principal business remains manufacturing, investing may not be a main business activity. The conclusion should be based on the company’s specific facts and circumstances rather than solely on the types of investments it holds.
3.5
Circumstances in which assessment is not required
Paragraph B39 provides that an entity need not assess whether investing in cash and cash equivalents is a main business activity. Income and expenses from cash and cash equivalents are classified in the investing category unless the exceptions specified in paragraphs 56(a) or 56(b) apply. This exception is distinct from the assessment required for other assets that generate returns individually and largely independently of the entity’s other resources.
3.6
Changes in the assessment
Under paragraph B41, an entity assesses whether investing in assets or providing financing to customers is a main business activity based on the facts and circumstances existing at the time of the assessment. If those facts and circumstances subsequently change, the revised assessment affects classification prospectively from the date of the change. Amounts presented before that date are not reclassified. Unless it is impracticable to do so, paragraph 51(c)(ii) requires the entity to disclose the amount and classification of affected income and expense items before and after the change in the current period, together with the corresponding amounts and classifications for the prior period. For example, an entity previously operated primarily as a manufacturer but subsequently expands its customer-financing operations to the extent that providing financing becomes a main business activity. If the assessment changes as a result, the entity applies the revised classification prospectively from the date of the change and does not retrospectively reclassify amounts reported before that date. It also provides the disclosures required by paragraph 51(c)(ii), unless doing so is impracticable. Thus, the assessment should be supported by evidence of the entity’s actual activities and performance evaluation practices. Relevant evidence may include internal management reports, performance measures communicated to investors, segment information and the nature of the investments or financing arrangements undertaken. The assessment should also distinguish between requirements that apply irrespective of the entity’s main business activity and those whose application depends on the outcome of the assessment.
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Insights on proposed Ind AS 118 Specified Main Business Activities under proposed Ind AS 118 and their impact on classification of Income and Expenses
4. Classification of income and expenses where investing in assets is a main business activity Paragraphs 53–58 of the Exposure Draft establish the classification requirements for income and expenses arising from investments. For entities whose main business activity is investing in assets, specified income and expenses that would ordinarily be classified under investing are classified under operating, subject to the exceptions prescribed by the Standard.
4.1
Income and expenses from investments in associates, joint ventures and unconsolidated subsidiaries
Paragraph 55 distinguishes between investments accounted for using the equity method and those not accounted for using that method. Where an entity invests in associates, joint ventures or unconsolidated subsidiaries as a main business activity: •
Investments accounted for using the equity method: The share of profit or loss and other income and expenses specified in paragraph 54 remain classified under the investing category.
•
Investments not accounted for using the equity method: The income and expenses specified in paragraph 54 are classified under the operating category.
The distinction is important because the main-business-activity assessment does not automatically transfer every return on an investment to the operating category.
4.2 Income and expenses from other investment assets Paragraph 53(c) covers assets that generate a return individually and largely independently of the entity’s other resources. Examples identified in the application guidance include debt and equity investments, investment properties and receivables for rent generated by those properties. Paragraph 54 identifies the relevant income and expenses, including income generated by the assets, gains and losses arising from their initial and subsequent measurement, and incremental expenses directly attributable to their acquisition or disposal. Where an entity invests in these assets as a main business activity, paragraph 58 requires the specified income and expenses to be classified under operating. For example, a company primarily earns rental income from investment properties and has determined, based on the evidence, that investing in such properties is its main business activity. During the year, it recognises the following amounts:
Insights on proposed Ind AS 118 Specified Main Business Activities under proposed Ind AS 118 and their impact on classification of Income and Expenses
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Particulars
Amount (₹ lakh)
Rental income
500
Depreciation on investment properties
120
Impairment loss
20
Fair value gain on other qualifying investment assets
40
Assuming these items fall within the specified requirements and no other classification rule overrides them, rental income, depreciation, impairment loss and the fair value gain are classified under the operating category. The illustration demonstrates that the classification follows the nature of the entity’s main business activity and the specific requirements of the Exposure Draft, rather than treating all investment-related income and expenses as investing items.
4.3 Income and expenses from cash and cash equivalents Paragraphs 56–57 address cash and cash equivalents separately. An entity need not assess whether investing in cash and cash equivalents is a main business activity. The general requirement is to classify the specified income and expenses from cash and cash equivalents under investing. However, exceptions apply where the entity invests in financial assets as a main business activity or provides financing to customers as a main business activity. Where an entity provides financing to customers as a main business activity, income and expenses from cash and cash equivalents that relate to providing such financing, for example, cash held to meet related regulatory requirements are classified under operating. For other cash and cash equivalents, the entity may have an accounting policy choice to classify the specified income and expenses under operating or investing. The choice must be consistent with the related accounting policy for income and expenses from liabilities that do not relate to providing financing to customers. If the entity cannot distinguish between the two types of cash and cash equivalents, paragraph 57 requires it to apply the accounting policy choice by classifying income and expenses from all cash and cash equivalents under operating.
5. Classification of income and expenses where providing financing to customers is a main business activity Paragraphs 59–66 distinguish between liabilities arising from transactions that involve only the raising of finance and liabilities arising from other transactions. This distinction is particularly important for banks, lending institutions, captive finance companies and other entities that provide financing to customers.
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Insights on proposed Ind AS 118 Specified Main Business Activities under proposed Ind AS 118 and their impact on classification of Income and Expenses
5.1
Liabilities arising from raising finance
Paragraph 65(a) requires an entity that provides financing to customers as a main business activity to classify income and expenses from liabilities arising from transactions that involve only the raising of finance as follows: a.
Liabilities related to providing financing to customers: The specified income and expenses are classified under operating.
b.
Liabilities not related to providing financing to customers: The entity may elect an accounting policy to classify the specified income and expenses under operating or financing. This choice must be consistent with the related policy for income and expenses from cash and cash equivalents under paragraph 56(b)(ii).
If the entity cannot distinguish between liabilities related and unrelated to providing financing to customers, paragraph 66 requires it to apply the accounting policy choice by classifying income and expenses from all such liabilities under operating.
5.2
Liabilities arising from transactions other than raising finance
Paragraph 65(b) addresses liabilities arising from transactions that do not involve only the raising of finance. Where the income and expenses are those specified in paragraph 61, such as qualifying interest income or expenses and income and expenses arising from changes in interest rates identified for the purpose of applying other Ind AS requirements, they are classified under financing. Income and expenses from such liabilities that are not specified in paragraph 61 are classified under operating. The classification therefore depends not only on whether the entity provides financing to customers as a main business activity, but also on the nature of the liability and the specific requirements applicable to the related income or expense. For example, a lending institution recognises the following amounts during the year: Particulars
Amount (₹ lakh)
Interest income from customer loans
1,200
Interest expense on borrowings used to fund customer loans
700
Interest expense on borrowings unrelated to customer financing
100
Assume that the institution has established that providing financing to customers is its main business activity and that the liabilities have been appropriately identified. Interest income from customer loans is classified under operating because it arises from the entity’s main business activity. The interest expense of ₹700 lakh on borrowings related to customer financing is also classified under operating under paragraph 65(a)(i). For the remaining interest expense of ₹100 lakh, the institution must determine whether the liability falls within paragraph 65(a)(ii) and apply its accounting policy choice consistently with the related policy for cash and cash equivalents. If that policy classifies
Insights on proposed Ind AS 118 Specified Main Business Activities under proposed Ind AS 118 and their impact on classification of Income and Expenses
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the relevant expense under operating, the amount is included in operating; if the policy classifies it under financing, the amount is included in financing. This example illustrates why the classification of interest expense cannot be determined solely by reference to the fact that the entity is a lending institution.
6. Disclosure and changes in assessment The Exposure Draft requires an entity to disclose whether investing in assets or providing financing to customers is a main business activity. Where the outcome of the assessment changes, it requires disclosure of the fact that the outcome has changed and the date of the change. Unless it is impracticable, the entity must also disclose the amount and classification of affected income and expenses before and after the change in the current period and the amounts and classification in the prior period for the items whose classification has changed because of the revised assessment. It clarifies that the assessment is based on the facts at the relevant time. A change in the assessment does not retrospectively alter the conclusion reached in previous periods. Accordingly, the revised classification is applied prospectively from the date of the change, and amounts presented before that date are not reclassified solely because the assessment has changed. Entities should therefore maintain appropriate documentation of the assessment, the supporting evidence, the date of any change and the resulting impact on the classification of income and expenses.
7. Implications for financial reporting and audit The proposed requirements may significantly affect how entities present operating profit or loss and communicate their financial performance. The implications extend beyond changing the labels of individual income and expense items. a.
Assessment of business activities: Management must establish whether investing in assets or providing financing to customers is a main business activity based on evidence, including internal performance measures, external communications and segment information where relevant.
b.
Classification of income and expenses: Finance teams must identify the assets and liabilities giving rise to the relevant income and expenses, distinguish the applicable categories and apply the specific exceptions and accounting policy choices consistently.
c.
Comparative information and disclosures: A change in the assessment requires prospective application and the disclosures specified in the exposure draft of the standard. Entities should evaluate whether their existing reporting systems can capture the amounts and classifications required.
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Insights on proposed Ind AS 118 Specified Main Business Activities under proposed Ind AS 118 and their impact on classification of Income and Expenses
d.
Audit considerations: Auditors should evaluate the reasonableness of management’s assessment, examine the supporting evidence, test the classification of material income and expenses and assess whether the required disclosures are complete and consistent with the financial statements.
8. Conclusion The specified-main-business-activity requirements under Ind AS 118 recognise that the classification of income and expenses depends on the nature of an entity’s business activities. For one entity, interest income may represent a return earned on surplus funds, whereas for another entity engaged in providing financing to customers, it may arise from its principal business activity. Similarly, income and expenses from investments may form part of operating performance for an entity whose main business activity is investing in those assets. However, an entity cannot classify investment or financing income and expenses under the operating category merely because management considers them to be operational in nature. The classification must comply with the specific requirements of Ind AS 118 and be supported by an appropriate assessment of the entity’s main business activities. For preparers and auditors, the key challenge is to establish a well-supported assessment of the entity’s main business activities and ensure that the assessment is consistently reflected in the classification, presentation and disclosure of income and expenses in the Statement of Profit and Loss.
Insights on proposed Ind AS 118 Specified Main Business Activities under proposed Ind AS 118 and their impact on classification of Income and Expenses
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