1. Applicability of IAS 20 “Accounting for Government Grants and Disclosure of Government Assistance” for loans obtained from the provincial Government at lower interest rate
Enquiry:
A public listed Gas Company (the Company) is engaged in providing essential services of transmission and distribution of natural gas in the provinces of Sindh and Baluchistan. Being the only transmission and distribution company in both provinces, the Company takes various projects for laying of pipelines including those ones which are initiated based on instructions received from the Government of Sindh (GoS) which provide financing facility to the Company at the interest rate which is lower than market interest rate, due to which requirements of paragraphs 12 of lAS 20 “Accounting for Government Grant and Disclosure for Government Assistance” are triggered with regard to recognition of government grant and its amortization. In ensuing paragraphs, we have provided background facts and described three possible options for accounting of such government grant and request your guidance as to which of these options are appropriate in terms lAS 20.
Regulatory Regime of the company
The Company is regulated by the Oil and Gas Regulatory Authority (OGRA) which is statutory body created under the Oil and Gas Regulatory Authority Ordinance, 2002 (the Ordinance) with a mandate to regulate licensees engaged in the transmission, distribution and sale of natural gas. Under the provision of license given by OGRA, the Company is provided a minimum annual return (ROA) of 17% per annum of the net operating fixed assets (net of deferred credit) for the year excluding financial and other non-operating income and taxation. The determination of annual required return is reviewed by OGRA under the terms of License for transmission, distribution and sale of natural gas, along with the targets and parameters set by OGRA. Income earned in excess I short of the above guaranteed return is payable to I recoverable from the Government of Pakistan (GOP) and is adjusted from I to the Gas Development Surcharge (GDS) balance payable to I receivable from GOP.
Details of loans obtained from the Government of Sindh (GOS) at lower interest rate, and the related accounting requirements in light of the approved accounting standards as applicable in Pakistan.
The Government of Sindh (GOS) has provided unsecured loans to the Company at interest rate of 2-4% per annum, against a market rate (9% to 13.5%), for period of 12 years under the agreement for supply of gas to the areas in the Sindh province only subject to prior approval from the competent authority of the province.
In the previous years, the Company did not recognize difference between interest rate charged by GoS and prevailing market interest rate, as government grant, as impact of amounts was not considered material and no new loan was obtained since 2013. However, the Company is currently expecting more loans in future and management now considers that cumulative impact owing to changes in financial position may become significant.
Management has evaluated the accounting treatment in the light of accounting standards and prevalent industry practice, and has identified three possible options for accounting the government grant arising from GOS Loans explained below:
1 – Amortization of Grant over the Useful Life of the Asset
If the requirements of lAS 20 are followed as per the agreements, the Company would have to incorporate the following impacts in its books of accounts:
- GoS loans will be discounted at market rate and any difference between the loan amount received and the discounted loan amount will be recognized as a government grant (credit).
- GoS loans will be recognized at present value i.e. discounted loan amounts.
- Interest expenses on the discounted loans will be recognized at market rate, resulting in increase in financial charges every year, except in case of initial years wherein interest expenses will be capitalized to asset for which the loan has been provided by GOS.
- Government grant (deferred credit) will be amortized over the period of useful life of asset, which is considered 20 years, as income in profit and loss account.
The issue with this treatment is that actually there is no cost to the Company, as the assets also get financed through revenue requirements under cost plus formula of 17% return on operating fixed assets except for those assets which may be disallowed by OGRA due to the reason that such projects are not meeting per customer cost criteria being not feasible. In the past, OGRA has been allowing ROA on all such projects, and only in the FY 2013, 14, 15 and 16, OGRA has disallowed certain projects on the basis that such projects were not feasible:
2- Government Grant be amortized over the repayment period of loan
Loans are discounted at market rate and any difference between the loan amount received and the discounted loan amount is recognized as a government grant which is amortized over the repayment period of the loan instead of useful life of the asset.
3- Matching the Government Grant with related cost
As per paragraph 12 of IAS 20 “Accounting for Government Grants and Disclosure of Government Assistance”:
“Government grants shall be recognized in profit or loss on a systematic basis over the periods in which the entity recognizes as expenses the related costs for which the grants are intended to compensate” (emphasis is ours)
Since there are no “related costs” as all costs of assets acquired or constructed by Company are recovered through cost plus return of 17% on operating fixed assets as revenue of the Company through OGRA except for those assets which are disallowed by OGRA from time to time due to the reason that such projects are considered unviable. It can be argued that such government grant is provided to compensate the Company for any unviable projects which are disallowed by OGRA. Therefore, a case can be made to recognize the government grant in profit and loss account at time of recognizing the impairment loss related to unviable projects (if needed) and any remaining unamortized grant in excess of expected impairment to be transferred to profit and loss account immediately.
Seeking appropriate opinion from ICAP for lAS 20
We request ICAP to kindly advise us as to which of the three options described above reflect right accounting treatment in accordance with the approved accounting standards as applicable in Pakistan.
Opinion:
In accordance with paragraph 10A of IAS 20, Accounting for Government Grants and Disclosure of Government Assistance, the benefit of the government loan at a below-market rate of interest is treated as a government grant, and requires the entity to measure and record the benefit of the below-market rate of interest in accordance with IAS 39, Financial Instruments: Recognition and Measurement. Consequently, the government grant is measured as the difference between total loan amount received and the fair value of the loan on initial recognition.
In addition, IAS 20 requires “the entity shall consider the conditions and obligations that have been, or must be, met when identifying the costs for which the benefit of loan is intended to compensate”. In the enquired scenario, the benefit available to the entity is reflected by the borrowing costs compensated through the loan at below-market rate of interest.
Further, the Committee understands that the borrowing costs (including the imputed interest originating on the below-market rate of interest loan) eligible for capitalization will be included in the cost of the qualifying asset, and subsequently, charged to the profit or loss through yearly depreciation charge. In the ensuing periods, the borrowing costs will be charged to the profit or loss, consequent to the completion of the qualifying asset.
IAS 20, paragraph 12 outlines, the principle for the recognition of grant in the profit or loss, reproduced as under:
“Government grants shall be recognised in profit or loss on a systematic basis over the periods in which the entity recognises as expenses the related costs for which grant was intended to compensate.” (Underline is ours)
IAS 20 also envisages that in most cases, the periods over which an entity recognises the costs or expenses related to the government grant are readily ascertainable and thus grant in recognition of specific expenses are recognised as income in the same period as the relevant expense. Furthermore, paragraph 19, clarifies that it may be appropriate to allocate part of the grant on one basis and part on another.
In the enquired scenario, the Committee is of the view that the recognition of government grant in the profit or loss shall be on the basis of pattern of recognition, as expenses, the costs the grant intends to compensate. As explained above, the borrowing costs related to the below-market interest loan shall be charged to the profit or loss through:
(a) Depreciation charge (represents the capitalized borrowing costs); and
(b) the finance costs.
Further, in accordance with IAS 20, the recognition of grant in the profit or loss shall represent an appropriate form of matching with the recognition of related expenses for which the grant intends to compensate.
Based on the above, the Committee is of the view that the accounting treatment of the government grant in the enquired scenario, shall be as follows:
- Government grant related to the borrowing costs capitalized as cost of the qualifying asset, amortized over the period of useful life of the asset, i.e. 20 years in the enquired scenario; and
- Government grant related to the borrowing costs charged to profit or loss as finance costs, amortized over the loan term, i.e. 10 years reduced by the years in which borrowing costs is capitalized, a) above, in the enquired scenario.
In this way, the benefit of the grant is recognized on a systematic basis because the entity recognises, as expenses, the costs the grant is intended to compensate.
(March 28, 2017)
2. Grant of Leasehold Land by the government and leasing out of such land to others
Enquiry:
Our client is a limited guarantee company who received land as grant from government which they have leased out to others. We are facing the following issues, which need to be resolved on an urgent basis. We also give below our understanding of the relevant sections of regulations governing the situation and need the Technical Advisory Committee’s recommendations thereon:
FACTS AND CIRCUMSTANCES
- Government has provided assistance in the form of a land to our client which is also a government owned entity having a status of a Limited Guarantee Company.
- Market value of land is not available and further special survey for valuation of land has not been carried out.
- This land has been leased out to others by our client.
- Land is given on lease for 99 years lease term with no bargain purchase option, subsequently renewable and cancelable at the option of lessor.
Issues:
1. Can land be treated as government grant?
2. Whether the grant should be treated as related to Income or Assets
3. At what amount land and related government grant be recorded?
4. What should be the classification of lease?
5. What are the presentation and disclosure requirements?
Our Opinion:
1) This land should be treated as a government grant (Refer Definitions Para 3 of IAS 20)
2) It should be taken as government grant related to asset (Ref: Definitions Para 3 and 23 of IAS 20)
3) It will be measured at nominal value i.e. fair value of land less government grant valued at the same amount. Only in case when fair market value is not available, fair value will be the present value of discounted cash flows expected from future intended use of the asset (present value of lease rentals and residual value for a period of 100 years discounted at time and risk adjusted discount rate). As in this case fair market value is not available, present value of lease rentals in the foreseeable future i.e. the lease term may be taken. (Ref: Para 23 of IAS 20)
4) As this lease does not indicate any of the conditions given in paragraph 10 or 11 of IAS 17 and risks and rewards incidental to ownership (fluctuation in the value of land) rest with the lessor therefore this lease may be classified as operating lease.
5) Further the land is an Investment Property as per IAS 40 and therefore its requirements should be met and it should be recognized by either using cost model or fair value model.
Further we need to bring your kind attention to Selected Opinion 1.8 Volume III “land lease for 99 years”, which deals with land obtained on lease for 99 years. This opinion requires disclosure of such land under fixed assets and prohibits the classification as operating lease. Keeping in view these provisions:-
- Should lessor classify 99 year lease of land as Finance Lease?
- What are accounting and reporting requirements for Lessor?
- If the lessor classifies it as Finance lease, should disclosure be made regarding the fact that IAS-17 has not been followed along with the reasons?
We seek you advice and the basis thereof regarding these matters.
Opinion:
The appropriate Committee of the Institute has examined the above issues and before reaching any conclusion would like to draw your attention towards the following paragraphs of IAS 20, Accounting for Government Grants and Disclosure of Government Assistance:-
Definitions
3. The following terms are used in this Standard with the meanings specified:
Government assistance is action by government designed to provide an economic benefit specific to an enterprise or range of enterprises qualifying under certain criteria. Government assistance for the purpose of this Standard does not include benefits provided only indirectly through action affecting general trading conditions, such as the provision of infrastructure in development areas or the imposition of trading constraints on competitors.
Government Grants are assistance by government in the form of transfers of resources to an enterprise in return for past or future compliance with certain conditions relating to the operating activities of the enterprise. They exclude those forms of government assistance which cannot reasonably have a value placed upon them and transactions with government which cannot be distinguished from the normal trading transactions of the enterprise.
18. Grants related to non-depreciable assets may also require the fulfillment of certain obligations and would then be recognized as income over the periods which bear the cost of meeting the obligations. As an example, a grant of land may be conditional upon the erection of a building on the site and it may be appropriate to recognize it as income over the life of the building.
23. A government grant may take the form of a transfer of a non-monetary asset, such as land or other resources, for the use of the entity. In these circumstances it is usual to assess the fair value of the non-monetary asset and to account for both grant and asset at that fair value. An alternative course that is sometimes followed is to record both asset and grant at a nominal amount.
In the light of the above paragraphs, the Committee is of the opinion that if there is no restriction on transfer of title of land to others, then the land may be considered as grant from the government as given in IAS 20.23 and it would be appropriate to record the land as income as required by paragraph 18 of IAS 20.
However, with regard to the value to be assigned to the land received as grant, the Committee is of the opinion that land should be recorded at its Fair value, as projected future cash flows in the case of land would not be appropriate or feasible as an alternate as these could substantially vary.
With regard to query relating to the classification of lease, the Committee would like to draw your attention towards the following paragraphs of IAS 17’ ‘Leases’:
14. Leases of land and of buildings are classified as operating or finance leases in the same way as leases of other assets. However, a characteristic of land is that it normally has an indefinite economic life and, if title is not expected to pass to the lessee by the end of the lease term, the lessee normally does not receive substantially all of the risks and rewards incidental to ownership, in which case the lease of land will be an operating lease. A payment made on entering into or acquiring a leasehold that is accounted for as an operating lease represents prepaid lease payments that are amortized over the lease term in accordance with the pattern of benefits provided.
15. The land and buildings elements of a lease of land and buildings are considered separately for the purposes of lease classification. If title to both elements is expected to pass to the lessee by the end of the lease term, both elements are classified as a finance lease, whether analyzed as one lease or as two leases, unless it is clear from other features that the lease does not transfer substantially all risks and rewards incidental to ownership of one or both elements. When the land has an indefinite economic life, the land element is normally classified as an operating lease unless title is expected to pass to the lease by the end of the lease term, in accordance with paragraph 14. The buildings element is classified as finance or operating lease is accordance with paragraphs 7–13.
Though the above paragraphs do not allow lessee to record the land in its books as an asset unless title is expected to pass to it by the end of the lease term, strictly speaking IAS 17 does not deal with those leasing arrangements where land is leased for a long term period. Like in many countries including Pakistan the lease period is 99 years. IASB itself in the following paragraphs of Basis for Conclusion of IAS 17 has acknowledged that:
BC4. Paragraph 14 of the Standard requires a lease of land with an indefinite economic life to be normally classified as an operating lease, unless title is expected to pass to the lessee by the end of the lease term. The previous version of IAS 17 was not explicit about how to classify a lease of land and buildings.
BC5. This is a matter of concern in countries where property rights are obtained under long-term leases and the substance of those leases differs little from buying a property. Therefore, the Board decided to deal with this matter in its Improvements project and not to defer its resolution until the more fundamental project on leases was completed.
Now the question arises as to what is the appropriate accounting treatment for such leasehold land in the books of lessee. The Committee after detailed deliberation reached a consensus that owing to the following reasons it appears to be appropriate for lessee to recognize the land in its books as an asset:-
a) Recording as operating leases the transactions involving long leasehold interests does not accord with the economic reality underlying such transactions. Cases involving purchases of such leasehold interests which typically contain a large component of land costs usually have the following characteristics:-
(i) the buyer (or lessee) has in fact acquired an asset with an upfront payment;
(ii) the lessee has acquired the right to do a variety of things with the leasehold interests just as if these leasehold interests were outright purchases, like freehold properties;
(iii) the lessee’s interest is for a reasonable long definite period of time;
(iv) the lessee can transfer his interest and obligations to others where on the other hand lessor can neither use the land nor it can sell it for a gain if price of such land goes up;
(vi) Further the legal structure governing the conveyancing of long leasehold interests in Pakistan effectively treats a sale and purchase of such interests as a complete transfer of risks and rewards incident to ownership of those interests which is the acid test for recognition of an asset.
(January 7, 2006)