1. Foreign Currency Interest Free Sponsor’s Loan
Enquiry:
Pursuant to TR-32, the sponsors’ interest free loans repayable at the discretion of Borrower Company are required to be classified as part of the ‘equity’ instead of a liability. One such loan from sponsors’ received in foreign currency was disclosed as a liability and accordingly translated at year-end exchange rate every year. After change of its status as mentioned above, please let us know:
1. Whether the translation at the year-end exchange rates will still be required? and
2. What should be the accounting treatment of net cumulative amount of translation differences included in carrying value of loan?
Please note that sponsor is a foreign parent company.
Opinion:
The Committee considered your queries and its views are as follows:
1. According to paragraph 2.17 of the Technical Release (TR) – 32 ‘Director’s Loan’, a loan from a parent to a subsidiary in its capacity as shareholder, is in substance an additional contribution by the parent. Further, a loan from a parent to an entity which is agreed to be paid at the discretion of the entity does not pass the test of liability and shall be recorded as equity at face value and this is not subsequently re-measured.
In relation to the query, the interest free loan received from the parent and repayable at the discretion of the subsidiary under the initial agreed loan terms, shall be recorded at the exchange rate when loan was received, thereafter; translation of this amount is not required.
2. In the above scenario, the net cumulative amount of translation differences included in the carrying value of loan is required to be eliminated; consequently, related comparative amounts shall be restated.
TR-32 is applicable for preparation of financial statements for the period beginning on or after 1 January 2016. As required under paragraph 4.2 of TR – 32, the change in accounting policy resulting from the initial application of TR – 32 shall be accounted for retrospectively in accordance with IAS 8 ‘Accounting Policies, Changes in Accounting Estimates and Errors’.
(March 15, 2017)
2. Break-Up value computation in case of Life Insurance Companies
Enquiry:
We would like to draw attention to the ICAP’s Technical Release (TR) – 22 which provides professional guidance for the computation of book value per share of a company. As per the TR – 22, shareholders’ equity is used as a basis to compute the book value per share and the components of shareholder’s equity are stated to include the following:
• Paid up capital
• Revenue reserves and retained earnings (less accumulated losses if any).
• Capital reserves
• Surplus created as a result of revaluation of fixed assets.
In a peculiar situation of Life Insurance Companies operating in Pakistan, the insurer is also required by law (the Insurance Ordinance 2000 and SECP Insurance Rules, 2002) to maintain separate Statutory Funds in respect of assets, liabilities, equity and profit or loss attributable to the life insurance business. The statutory funds so maintained are presented separately in the financial statements from the shareholder’s fund.
In order to comply with the solvency requirements under the applicable life insurance regulations, the life insurance companies are required to maintain required amount of equity balance (including capital contribution and retained earnings) in the statutory funds at all times. However, as the equity balance in the statutory fund is arrived at after deducting all liabilities including those pertaining to the policyholders, this equity by its nature and substance represents shareholder’s interests in the statutory fund which is held to meet the solvency requirements. Therefore, for the purposes of determining the book value or breakup value per share of a life insurance company, the equity balance in the statutory fund should be taken into account as otherwise the book value or the breakup value will not be reflective of the total shareholder’s interest in the entity.
The requirements to maintain capital for regulatory, solvency and risk management purposes is not only limited to insurance companies but also is common with other entities operating in the financial services sector such as banks. The capital retained and held by banks, for instance, to comply with the capital adequacy requirements set by the State Bank of Pakistan or to maintain statutory reserves, is always taken as part of the shareholder’s equity for all purposes.
It would be pertinent to mention that this conceptual position regarding the equity balance of statutory funds is also recognized under the draft insurance regulations issued by the SECP with the recommendation of ICAP. As per the draft regulations the equity of statutory funds and shareholder’s funds is combined to state a single equity position in the balance sheet which is also in line with the IFRSs and Practices.
In view of the above, we request the Committee to confirm our understanding that the equity balance appearing in the statutory fund should be included for breakup value calculation.
Opinion:
The life insurance companies are required to maintain statutory fund/(s) in accordance with the provisions of the Insurance Ordinance, 2000 and the related rules.
Further, the life insurance companies are also required to comply with the solvency requirements, and maintain an amount of the retained earnings in the above mentioned statutory fund/(s) at all times. Accordingly, the statutory fund/(s) of the insurance companies is an aggregation of the amount of the policyholder’s liabilities and amount of retained earnings locked-in the statutory fund/(s), pursuant to the solvency requirements applicable to the life insurance companies.
The currently applicable law to the insurance companies, i.e. Insurance Ordinance 2000, does not provide for the aggregation of equity balance of the statutory fund/(s) with the shareholder’s funds.
Presently, the life insurance companies are required to prepare their financial statements in accordance with the form/format prescribed by the SECP, in the SEC (Insurance) Rules 2002. In accordance with the above referred form/format of the financial statements, the statutory fund/(s) (containing the policyholder’s liabilities and amount of locked-in retained earnings) is presented separately after the net shareholder’s equity.
The Committee would also like to refer clause 14, ‘Shareholder interests in statutory funds’ contained in the Annexure II of the SEC (Insurance) Rules 2002, which states that:
(1) The shareholders’ fund shall not recognise as an asset any interest in, entitlement to the assets of or capital transfer provided to any statutory fund.
(2) A capital transfer provided to a statutory fund by the shareholders’ fund shall be recorded as a debit balance in shareholders’ equity, clearly identified as capital contributed to statutory fund, and changes in the amount of capital contributed to statutory funds shall not pass through the profit and loss account but shall be recorded in the financial statements of the shareholders’ fund as increases or decreases in that debit balance.
(3) No statutory fund shall recognise as a liability any amount due to the shareholder’s fund consisting of a capital transfer received from a shareholder’s fund, or retained profits attributable to shareholders, or any loan or advance, other than a current liability consisting of amounts due to the shareholder’s fund on account of expenses due to be reimbursed to the shareholder’s fund.
The Committee considers it pertinent to mention that the SECP has issued Insurance Rules 2017 and Insurance Accounting Regulations 2017 (Regulations 2017), on February 13, 2017. These rules and regulations supersede the SEC (Insurance) Rules 2002 and Insurance Rules, 2002. Further, the provision 6 of the Regulations 2017, applicable to the financial statements of life insurance companies, explain that the balances retained within the statutory funds over and above the insurance liabilities shall be treated as part of shareholder’s equity, and the balances in Ledger C and D shall be included as part of the Shareholder’s equity.
However, it is to be noted that the requirements of the Regulations 2017 are effective for the financial statements for the periods beginning on or after April 01, 2017. Consequently, the financial statements of the life insurance companies till the period ending March 31, 2017 should be prepared in accordance with the requirements of SEC (Insurance) Rules 2002.
In view of the above, the present applicable legal position makes it clear that shareholders’ fund/equity do not include any balance that is held in the statutory fund either on account of capital contribution or retained earnings.
The Conceptual Framework for Financial Reporting defines equity as the residual interest in the assets of the entity after deducting all its liabilities. Based on this, the above referred locked-in amount of the retained earnings in the statutory fund/s is ‘equity’; which will remain in the statutory fund/s to meet the solvency requirements and will not be available to the shareholders at the period end date.
However, it is to be noted that the provisions of the Companies Ordinance 1984, Insurance Ordinance, 2000 and SEC (Insurance) Rules 2002, regulations and directives will prevail over the IFRSs.
The Insurance Ordinance 2000, and related rules and guidelines do not provide the basis/mechanism for the computation of book/break-up value of life insurance companies. However, the Institute’s Accounting Technical Release (TR)-22 (Revised 2002), ‘Book Value per Share’, explains the basis for the computation of book/break-up value of shares. The relevant part of TR-22 is reproduced as under:
“Book value per share in the equity capital of the company is the amount each share is worth on the basis of carrying value per balance sheet, prepared in accordance with a framework of recognized accounting standards. Such standards provide that:-
(a) An asset is a resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise.
(b) A liability is a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits.”
The computation of the book value per share under TR-22 is dependent on the recognition of the asset and liability in accordance with the framework of recognised accounting standards that provide the stated definitions.
However, TR-22 also outlines the basis for the computation of break-up value of share for the surplus on revaluation of fixed assets, as it is not a part of the equity on the balance sheet but is also not a liability. In case of revaluation surplus, TR-22 allows for the computation of an additional book value per share, though referring to the comparability purposes. The relevant part of TR-22 is reproduced as under:
“If the balance sheet of an entity includes balance of surplus on revaluation, the book value per share should be computed separately both, including and excluding such surplus, to enable comparability with those entities where fixed assets have not been revalued”.
Conclusion: Based on the above, the Committee is of the view that the computation of break-up value per share of the life insurance company should be in accordance with the basis set out in TR-22. In view of the currently applicable financial reporting framework, in relation to the shareholders’ equity required to be maintained in the statutory funds, the life insurance company’s break-up value per share should be computed separately both, including and excluding such shareholders’ equity.
(February 15, 2017)
3. Obligation to follow IAS/IFRS by Government Institution
Enquiry:
A & Co. and B & Co are joint auditors of a government institution naming ‘Korangi Fisheries Harbour Authority’ (KoFHA) established under Ordinance No. XVI of 1982 as ‘Korangi Fisheries Harbour Authority Ordinance 1982’ (KoFHA Ordinance 1982). KoFHA is presently working under the administrative control of Federal Ministry for Ports & Shipping, GOP and is a Body Corporate like Port Qasim Authority. As such KoFHA, not being a company falls under the definition of sub clause (iii) of sub section 4 of section 2 of Companies Ordinance 1984. The creation of the Authority was notified in the Gazette of Pakistan dated July 12, 1982, copy of the Ordinance is attached.
As per KoFHA Ordinance 1982 related paragraphs of Audit and Accounts sections are as follows:
(1) The accounts of the Authority shall be maintained by the Authority in such forms as may be prescribed by the Auditor-General of Pakistan consistent with the requirements of this Ordinance.
(2) The accounts of the Authority shall be audited by not less than two auditors who are Chartered Accountants within the meaning of the Chartered Accountants Ordinance, 1961, appointed by the Federal Government in consultation with the Auditor-General of Pakistan, on such remuneration, to be paid by the Authority, as the Federal Government may fix.
(3) Every auditor appointed under sub-section (2) shall be given a copy of the annual balance sheet of the Authority, and shall examine it together with the accounts and vouchers relating thereto and shall have a list delivered to him of all books kept by the Authority; and shall at all reasonable times have access to the books, accounts and other documents of the Authority, and may in relation to such accounts examine any officer of the Authority.
(4) The auditors shall report to the Federal Government upon the annual balance sheet and accounts and in their report state whether in their opinion the balance sheet is a full and fair balance sheet containing all necessary particulars and properly drawn up so as to exhibit a true and correct view of the state of the Authority’s affairs, and, in case they have called for any explanation or information from the Board, whether it has been given and whether it is satisfactory.
The Authority is not in the list of Exempt entities contained in Schedule 2 of Manual of accounting principles (MAP) issued by AGPR.
Here we want to know that:
1. Either Authority is under obligation to follow International Accounting Standards as applicable in Pakistan?
2. What will be the format of Auditors Report for audit of such institutions?
3. Can auditors qualify the Auditors’ report on the basis of non-compliance with any IFRS/IAS, if answer to question 1 is yes?
4. What will be the course of action available to management and either of joint auditors if there is dispute on the opinion between joint auditors?
Opinion:
The Committee has examined your enquiry and its views on each of the questions raised are as follows:
1. The Committee would like to draw your attention to the following para of the ‘KoFHA Ordinance 1982’:
4(2) The Authority shall be a body corporate having perpetual succession and a common seal, with powers, subject to the provisions of this Ordinance, to acquire and hold property, both moveable and immovable, and shall by its name sue and be sued.
For further clarification your attention is drawn to the following paras of ISA 210 ‘Agreeing the Terms of Audit Engagements’:
3. The objective of the auditor is to accept or continue an audit engagement only when the basis upon which it is to be performed has been agreed, through:
(a) Establishing whether the preconditions for an audit are present; and
(b) Confirming that there is a common understanding between the auditor and management and, where appropriate, those charged with governance of the terms of the audit engagement
6. In order to establish whether the preconditions for an audit are present, the auditor shall:
(a) Determine whether the financial reporting framework to be applied in the preparation of the financial statements is acceptable; and (Ref: Para.A2–A10) ………………
A3. Without an acceptable financial reporting framework, management does not have an appropriate basis for the preparation of the financial statements and the auditor does not have suitable criteria for auditing the financial statements. In many cases the auditor may presume that the applicable financial reporting framework is acceptable, as described in paragraphs A8–A9.
A8. At present, there is no objective and authoritative basis that has been generally recognized globally for judging the acceptability of general purpose frameworks. In the absence of such a basis, financial reporting standards established by organizations that are authorized or recognized to promulgate standards to be used by certain types of entities are presumed to be acceptable for general purpose financial statements prepared by such entities, provided the organizations follow an established and transparent process involving deliberation and consideration of the views of a wide range of stakeholders. Examples of such financial reporting standards include:
• International Financial Reporting Standards (IFRSs) promulgated by the International Accounting Standards Board;
• International Public Sector Accounting Standards (IPSASs) promulgated by the International Public Sector Accounting Standards Board; and
• Accounting principles promulgated by an authorized or recognized standards setting organization in a particular jurisdiction, provided the organization follows an established and transparent process involving deliberation and consideration of the views of a wide range of stakeholders.
These financial reporting standards are often identified as the applicable financial reporting framework in law or regulation governing the preparation of general purpose financial statements.
A10. When an entity is registered or operating in a jurisdiction that does not have an authorized or recognized standards setting organization, or where use of the financial reporting framework is not prescribed by law or regulation, management identifies a financial reporting framework to be applied in the preparation of the financial statements. Appendix 2 contains guidance on determining the acceptability of financial reporting frameworks in such circumstances.
Based on the information provided to us, it is clear that the KoFHA is a body corporate established by the Federal Government and not formed under the sub clause (iii) of sub section 4 of section 2 of Companies Ordinance 1984.
Keeping in view of above paras of ISA 210, the Committee is of the view that there should be an accounting framework mutually agreed between the management and the auditor according to which financial statements should be prepared. As the KoFHA Ordinance 1982 is silent about the applicable financial reporting framework, therefore, apparently the KoFHA is under no obligation to follow IAS/IFRSs as applicable in Pakistan.
The Committee would also like to refer following para of TR-5: (underline is ours)
1.6 Furthermore, while expressing an opinion on financial statements of public utility entities or similar entities that provide an essential public service or regulatory agencies that do not fall under the regulatory jurisdiction of SECP, such entities shall ensure that accounting frameworks as prescribed in their relevant statutes are complied with. However, where the relevant statute is silent or does not prescribe any accounting and financial reporting framework or treatment, the Institute recommends that such entity shall comply with IASs/IFRSs as applicable.
Based on the requirements of TR-5 the Committee is also of the opinion that if the relevant statute is silent or does not prescribe any accounting and financial reporting framework and it is difficult to determine the applicable financial reporting framework, it is recommended to comply with applicable IASs/IFRSs.
2. The Committee is of the view that the report format will be in accordance with the requirement of ISA 700 ‘Forming an Opinion and Reporting on Financial Statements’:
However, in the opinion paragraph of the report, the requirements of subsection 18(5) of the ‘KoFHA Ordinance 1982’ could be used which is reproduced below:
18(5) the auditors shall report to the Federal Government upon the annual balance sheet and accounts and in their report state whether in their opinion the balance sheet is a full and fair balance sheet containing all necessary particulars and properly drawn up so as to exhibit a true and correct view of the state of the Authority’s affairs, and, in case they have called for any explanation or information from the Board, whether it has been given and whether it is satisfactory.
3. If the applicable financial reporting framework is other than IAS/IFRS then the auditor’s report cannot be qualified based on the non-compliance with any IFRSs/IASs and vice versa. (refer answer no. 1)
4. Joint auditors are jointly liable for the audit. Any dispute between the two should be resolved before the issuance of auditor’s report.
(June 27, 2012)
4. Elucidation Required Regarding Accounting and Financial Reporting Standards for Medium Sized Entities (MSEs) Issued by ICAP
Enquiry:
With reference to the above mentioned subject, we need your professional advice regarding definition of Medium Sized Entities (MSE) clause (c) as compared with definition of Economically Significant Entities (ESE). Clause (c) specifies that:
“An entity shall not be classified as Medium sized entity if it holds assets in a Fiduciary capacity for a broad group of outsiders, such as a bank, insurance company, securities broker/dealer, pension fund, mutual fund or investment banking entity”
Further definition of Economically Significant Entity (ESE) is as follows:
“An entity is considered to be economically significant if it has:
• Turnover in excess of Rs.1 billion, excluding other income;
• Number of employees in excess of 750;
• Total borrowings (excluding trade creditors and accrued liabilities) in excess of Rs.500 million.
In order to be treated as economically significant any two of the criterion mentioned in 1, 2 and 3 above have to met. The criterion followed will be based on the previous year’s audited financial statements. Entities can be delisted from this category where they do not fall under the aforementioned criteria for two consecutive years.”
Professional advice required:
Comparing the preceding paragraphs, what is the appropriate classification of an entity if it falls under the clause (c) of “Medium Sized Entities” definition, and also does not fulfill the conditions for eligibility as an “Economically Significant Entity”.
Opinion:
Your attention is drawn to the following paragraphs of Technical Release 5 (Revised 2006) issued by ICAP:
2.5 The Institute further directs its members that while expressing an opinion on financial statements of entities that do not qualify to be treated as MSE or SSE as per the definition given in paragraphs 2.4.3 above (except for public utility entities or similar entities that provide an essential public service or regulatory agencies that do not fall under the jurisdiction of Securities and Exchange Commission of Pakistan (SECP), they shall ensure compliance with the International Accounting Standards (IASs)/ International Financial Reporting Standards (IFRSs) as adopted by the Council and notified by the SECP under section 234(3) of the Companies Ordinance, 1984.
In view of the above the entity will be required to comply with the requirements of IFRS while preparing their financial statements.
(June 5, 2009)
5. Impact of Withdrawal of TR-20
Enquiry:
One of our clients is facing problem in applying requirements of IAS -16 which have become effective due to withdrawal of TR-20. The client has not yet commenced its business activities and has not earned any income. All expenses incurred are classified as pre-commencement expenditure and shown as an asset in the financial statements. Prior to withdrawal of TR – 20, it was being understood that direct attributable expenses shall be allocated to the respective asset and indirect expenses shall be allocated to land and building proportionately according to their respective costs.
Now as a result of withdrawal of TR – 20, paragraph 19 of IAS 16, Property, Plant and Equipment becomes effective. This paragraph requires recognition of indirect pre-commencement expenses as expense in the period in which these are incurred rather than allocating these expenses to the cost of land and building.
Now the questions arise as follows:
a) Since the company has not commenced its operations and there is no income against which these indirect expenses will be matched. So whether preparing profit and loss account without income is necessary as a fundamental matching concept will not be complied with if we decide to prepare profit and loss account?
b) if profit and loss account is prepared, what will be its presentation since all expenses indirect expenses are in the nature of administrative expenses?
c) What would happen if the company has not commenced its business activities but is earning income through other sources e.g. interest income on deposit accounts? Can the indirect pre-commencement expenses be matched with the other income earned in a period?
d) Whether adopting para 19 of IAS – 16 and foregoing the application of TR – 20 constitutes a change in accounting policy.
Opinion:
First the Committee would like to apprise that the reason for withdrawing TR-20 by the Council of the Institute through Circular No. 07/2006 dated August 24, 2006 was the revision in IAS 16 since treatment of indirect costs referred to in the TR was not in compliance with the revised version of IAS 16.
With regard to your first concern on matching principle, the Committee would like to draw your attention to the following paragraph of the Framework of IFRS which is self explanatory:
95 Expenses are recognised in the income statement on the basis of a direct association between the costs incurred and the earning of specific items of income. This process, commonly referred to as the matching of costs with revenues, involves the simultaneous or combined recognition of revenues and expenses that result directly and jointly from the same transactions or other events; for example, the various components of expense making up the cost of goods sold are recognised at the same time as the income derived from the sale of the goods. However, the application of the matching concept under this Framework does not allow the recognition of items in the balance sheet which do not meet the definition of assets or liabilities. (underlining is ours)
With regard to your queries (b) and (c) the Committee wishes to draw your attention to the following paragraph of IAS 16:
21 Some operations occur in connection with the construction or development of an item of property, plant and equipment, but are not necessary to bring the item to the location and condition necessary for it to be capable of operating in the manner intended by management. These incidental operations may occur before or during the construction or development activities. For example, income may be earned through using a building site as a car park until construction starts. Because incidental operations are not necessary to bring an item to the location and condition necessary for it to be capable of operating in the manner intended by management, the income and related expenses of incidental operations are recognised in profit or loss and included in their respective classifications of income and expense.
In view of the above paragraphs the Committee is of the opinion that though there would not be any revenue or turnover until the commercial production is started or business is commenced, the profit and loss account would have to be prepared as IAS/IFRS do not exempt any entity from preparing profit and loss account. The income e.g. interest income and expenses which are not directly attributable to property plant and equipment should be recognised in the profit or loss account in their relevant heads.
However, while recognizing the interest income you are advised to take cognizance of the following paragraphs of IAS 23 ‘Borrowing Cost’:
15 To the extent that funds are borrowed specifically for the purpose of obtaining a qualifying asset, the amount of borrowing costs eligible for capitalisation on that asset shall be determined as the actual borrowing costs incurred on that borrowing during the period less any investment income on the temporary investment of those borrowings.
16 The financing arrangements for a qualifying asset may result in an entity obtaining borrowed funds and incurring associated borrowing costs before some or all of the funds are used for expenditures on the qualifying asset. In such circumstances, the funds are often temporarily invested pending their expenditure on the qualifying asset. In determining the amount of borrowing costs eligible for capitalisation during a period, any investment income earned on such funds is deducted from the borrowing costs incurred.
As previously TR-20 used to allow charging of indirect expenses to property, plant and equipment therefore the Committee is of the opinion that subsequent to withdrawal of TR-20 the change in the treatment of indirect expenses would be considered as change in accounting policies and dealt with as per IAS 8 ‘Accounting policies, Changes in Accounting Estimates and Errors’.
(January 5, 2007)
6. The Continuous Funding Systems
Enquiry:
With effect from August 22, 2005, the Karachi Stock Exchange (Guarantee) Limited has introduced “The Continuous Funding Systems (CFS) Regulations, 2005. The said Regulations have replaced the previously applicable “Carry Over Transactions (COT) Regulations, 1993”. The transaction mechanism under the new Regulations is the same as was under the previous COT Regulations.
In this regard we would like to have the ICAP’s opinion whether its ruling under TR-29 will continue to be applicable in case of CFS transactions i.e. whether CFS transactions should be treated as “Rev Repo Transactions” in our books of account. If yes, then whether it should be disclosed under the head “Lending to Financial and Other Institutions” or under the head “Advances”?
Opinion:
Preamble of Continuous Funding System provides that the system is introduced to improve market liquidity and would replace the existing Carry Over Regulations.
Review of the Rules reveals that though CFS Rules are different in form from the Carry Over Regulations, the essence of both the Regulations is to provide liquidity to the buyer of the shares by providing finance against shares following the mechanism given under the respective Regulations.
Paragraph 35 of the ‘Framework for the Preparation and Presentation of Financial Statements’ issued by IASB provides that transaction should be recorded on the basis of substance and not on form. As substance of both the Regulations is provision of liquidity through financing, therefore, the Committee is of the opinion that TR 29 should be followed in accounting transactions executed under CFS.
With regard to the disclosure, as the financing is done through Karachi Automated System, which can only be operated by the authorized members of the Stock Exchange who execute the transaction normally on behalf of their clients following the pooling of funds concept with subsequent allocation on required basis. As such, categorization of clients according to their operational status is not possible. In view of the above, it may be appropriate to generalize the disclosure and disclose the transaction as financing against shares.
(January 7, 2006)