Enquiry:

ICAP is requested to please provide clarification on the treatment of unrealized mark-up on advance on the following matter as per applicable accounting standards.

Some of the banks/ DFIs have given advances to XYZ Company, which defaulted on the payments, so the mark-up was suspended in the books of the banks. However, XYZ Company was later acquired by ABC Company and in turn; these advances (liabilities of XYZ Company) were transferred to ABC Company.

It may be noted that the banks had a total exposure of Rs. xx billion (Outstanding Rs. xxx million as of 30-09-2016) on XYZ Company. The suspended mark-up as of 30-09-2016 stood at Rs. xxx million.

After the acquisition, one of the leading banks approached the SBP to allow it to take the unrealized mark-up to the income account due to improved risk profile of the borrower (new ABC Company). SBP advise the banks to recognize the suspended mark-up only when realized in cash.

Nonetheless, the bank claims that both amount (principal and mark-up) are today expected to be fully recoverable based on the credit standing and performance of the ABC Company. Previously, there was a concern that the amount due would not be recoverable from the XYZ company, however after the acquisition, the market standing of the ABC company has further strengthened and the amount are expected to be fully recovered. The bank has requested to take the suspended mark-up to the income by saying that the previously suspended markup now satisfies the conditions of recognizing the revenue as per IAS 18; stated below.

International Accounting Standard 18 ‘Revenue’ requires that revenue shall be recognized when following criteria are met:

• Reliable measurement of consideration
• Probability that the economic benefits associated with the transaction will flow to the entity.

The revenue is measurable and the probability of it flowing to the bank is no different from the probability of the principal flowing to the Bank, which is recognized at full amount. In order to recognize these claims, the recognition of the principal will simply require a change in obligor in the books of the bank (i.e. from XYZ to ABC Co). However, there is no receivable outstanding in the books against the suspended markup as the receivable was reversed from the books when the markup was suspended. Therefore, as a first step, the claim in respect of the suspended markup will have to be recognized as a receivable, with a corresponding credit to income.
Further, the bank sated that in order to not recognize the previously suspended markup as income (until received in cash), while still maintaining the claim against this amount, it would have to debit the income and take a provision against this claim. Since this is now a claim against ABC Co, it would be tantamount to questioning the recoverability of a claim against ABC. It could also cause negative repercussions for ABC as any reversal of markup would imply that there are questions about either the ability or the willingness of ABC to settle this claim. Since there is no doubt of the recoverability of all other claims on ABC which are significantly larger than this amount, it could be maintained that there is also no need to doubt the recoverability of the claim against the previously suspended markup.

During this issue, SBP highlighted the fact that mark-up payment is due to be received at a future date i.e. in 2024. In this regard the bank states that the criteria for recognition of an asset should be dependent on the probability of the recoverability of the asset rather than the timing of the recoverability of the asset. While the first installment of the previously suspended markup will now be due for payment in Jan 2024, the last principal installment of the loan is due in December 2023. Hence, if the much larger principal that is due in future is considered good and fully recoverable, then it would not be unreasonable to also consider the markup, which is due only one month later, good, and fully recoverable.

Opinion:

The Banks/DFIs prepare their financial statements in accordance with the approved accounting standards as applicable in Pakistan, which comprise of:

• International Financial Reporting Standards (IFRSs) and Islamic Financial Accounting Standards (IFASs) as notified under the Companies Ordinance, 1984;
• provisions and directives issued under the Companies Ordinance, 1984;
• provisions and directives issued under the Banking Companies Ordinance, 1962; and
• the directives issued by the Securities Exchange Commission of Pakistan (SECP) and the State Bank of Pakistan (SBP).

However, in case requirements of provisions and directives issued under the Banking Companies Ordinance, 1962, Companies Ordinance, 1984 and the directives issued by SBP and SECP differ from requirements of IFRSs and IFASs, the provisions of and directives issued under the Banking Companies Ordinance, 1962, the Companies Ordinance, 1984 and the directives issued by SBP and SECP shall prevail.

In the enquired scenario, i.e. the recognition of un-realized mark-up on classified loans/advances by banks/DFIs, the requirements of IAS 18 ‘Revenue’ are not relevant, and the financial instrument recognition criteria, outlined in IAS 39 ‘Financial Instruments: Recognition and Measurement’ has to be considered and fulfilled. However, the SBP has deferred the applicability of IAS 39 for the banks/DFIs, and has issued directives, prescribing the recognition and measurement criteria of the financial instruments. Accordingly, the banks/DFIs recognize and measure financial instruments related transactions in accordance with the SBP issued directives. The SBP has issued Prudential Regulations for Corporate/Commercial Banking (the Regulation), advising the Banks/DFIs to ensure compliance of the Regulation in the letter and spirit.

The Regulation-8, “Classification and Provisioning for Assets”, explains the criteria and provides detailed guidance for the classification and provisioning of assets, including the treatment of suspended/un-realized mark-up of classified advances. The Regulation-8 is reproduced below for reference purposes:

“1. Loans/Advances:

a) Banks/DFIs shall observe the prudential guidelines given in Annexure-V in the matter of classification of their asset portfolio and provisioning there against on the time based criteria.”

The Annexure-V of the Regulation provides guidelines to the Regulation-8, including the treatment of income related to the classified loans/advances. In accordance with the guidelines of Annexure-V, the suspended/un-realized mark-up on a classified loans/advance is recognized on the receipt basis. The relevant part of the Annexure-V of the Regulation is reproduced below for reference purposes:

“Unrealized mark-up/ interest to be kept in memorandum account and not to be credited to income account except when realized in cash. Unrealized mark-up/interest already taken to income account to be reversed and kept in the memorandum account.”

The Committee during its deliberations and conclusion has assumed that the loan was transferred from XYZ company to ABC company on the original agreed terms (as agreed between XYZ company and the bank), and the loan was not restructured/ re-scheduled, subsequent to its transfer to ABC company. However, for reference purposes the Committee would like to refer paragraph 3 of Regulation-8, which explains the basis for the recognition of suspended mark-up of the rescheduled/restructured loans/advances.

In the light of above, the Committee is of the view that suspended/un-realized mark-up of classified loans/advances should be recognized in accordance with the provisions of the Regulation, as issued by the SBP.

(February 01, 2017)