Accounting for Direct Assignment under Indian Accounting Standards (Ind AS) - (One-Time Gains: NBFCs seek change in accounting policy.)

The Ministry of Corporate Affairs (MCA) had notified the Companies (Indian Accounting Standards) Rules, 2015 on 16 February 2015. Through its press release dated 18 January 2016, MCA outlined the road map for implementation of Indian Accounting Standards (Ind AS) by banks, non-banking financial companies, select all India term lending and refinancing institutions and insurers/insurance companies, making Ind AS applicable to the entities from 1 April 2018.

Phase 1 Non-banking financial companies (NBFCs) including housing finance companies (HFCs) made a mammoth journey in transitioning to the International Financial Reporting Standards (IFRS) convergent Indian Accounting Standards (Ind AS) for the year ended 31 March 2019. Also, the Ministry of Corporate Affairs (MCA) notified Division III to Schedule III of the Companies Act 2013 on 11 October 2018, which stated that every NBFC to which Ind AS applies, shall prepare its financial statements in accordance with the prescribed schedule or with such modification as may be required under certain circumstances. These NBFCs have published their financial results for the year ended 31 March 2019. The results provided useful insights on how the adoption of Ind AS impacted NBFCs and proved to be a testament to their readiness to adopt a significant change in financial reporting.

Introduction: Direct Assignment

Direct assignment (DA) is a very popular way of achieving liquidity needs of an entity. With the motives of achieving off- balance sheet treatment accompanied by low cost of raising funds, financial sector entities enter into securitisation and direct assignment transactions involving sale of their loan portfolios. DA in the context of Indian securitisation practices involves sale of loan portfolios without the involvement of a special purpose vehicle, unlike securitisation, where setting up of an SPV is an imperative.

The term DA is unique to India, that is, only in Indian context we use the term DA for assignment of loan or lease portfolios to another entity like bank. Whereas, on a global level, a similar arrangements are known by various other names like loan sale, whole-loan sales or loan portfolio sale.

In India, the regulatory framework governing DAs and securitisation transactions are laid down by the Reserve Bank of India (RBI). The guidelines for governing securitisation structures, often referred to as pass-through certificates route (PTCs) were issued for the first time in 2006, where the focus of the Guidelines was restricted to securitisation transactions only and direct assignments were nowhere in the picture. The RBI Guidelines were revised in 2012 to include provisions relating to direct assignment transactions.

Until the introduction of Indian Accounting Standards (Ind AS), there was no specific guidance regarding the accounting of direct assignment transactions, therefore, a large part of the accounting was done is accordance with the RBI Guidelines. The introduction of Ind AS have opened up several new challenges for the financial entities.

Following issues are relevant:

·      Whether DA would lead to de-recognition?

·      Whether there will be a gain on sale upon such de-recognition?

·      Whether DA should be treated as a partial transfer of asset or transfer of the whole asset?

·      Continuing valuation of retained interest?

Computation of Gain on Sale

It is a general notion that a sale results in a gain or loss, be it arbitrary or anticipated, the same is required to be accounted for. In case of a direct assignment, there is a sale of the loan portfolios, however, the same completely depends upon whether the assigned loan portfolio is getting derecognised from the books of the assignor or not. If it is not derecognised from the books of the assignor, then the question of recognising a gain or loss on sale does not arise. However, if the sale qualifies for de-recognition, then the seller must book gain or loss on sale in the year of sale.

Upon reading of Ind AS 109 and application guidance in para B3.2.17, the way of computing the same can be derived as follows:

Gain on sale = Sale consideration – Carrying value of asset * Fair value of transferred portion / (Fair value of transferred portion + Fair value of retained portion)

Ind AS 109 prescribes that the gain on sale or de recognition be recorded upfront in the profit and loss statement.

For reference, para 3.2.12 states that:

“3.2.12 On derecognition of a financial asset in its entirety, the difference between:

(a) the carrying amount (measured at the date of derecognition) and

(b) the consideration received (including any new asset obtained less any new liability assumed) shall be recognised in profit or loss.”

Further in case of de recognition of a part of financial asset, para 3.2.13 states that:

“3.2.13 If the transferred asset is part of a larger financial asset (eg when an entity transfers interest cash flows that are part of a debt instrument, see paragraph 3.2.2(a)) and the part transferred qualifies for derecognition in its entirety, the previous carrying amount of the larger financial asset shall be allocated between the part that continues to be recognised and the part that is derecognised, on the basis of the relative fair values of those parts on the date of the transfer. For this purpose, a retained servicing asset shall be treated as a part that continues to be recognised. The difference between:

(a) the carrying amount (measured at the date of derecognition) allocated to the part derecognised and

(b) the consideration received for the part derecognised (including any new asset obtained less any new liability assumed) shall be recognised in profit or loss.”

RBI Guidelines:

This approach is in stark contrast to what has been prescribed in the RBI Guidelines on Securitisation, which requires gain on sale to be amortised over the life of the transaction. As per the RBI Guidelines provide the following:

As per para 20.1 of RBI Guidelines on Securitisation of Standard Assets issued in 2006:

“In terms of these guidelines banks can sell assets to SPV only on cash basis and the sale consideration should be received not later than the transfer of the asset to the SPV. Hence, any loss arising on account of the sale should be accounted accordingly and reflected in the Profit & Loss account for the period during which the sale is effected and any profit/premium arising on account of sale should be amortised over the life of the securities issued or to be issued by the SPV.”

Also, as per para 1.4.1. of RBI Guidelines on Securitisation of Standard Assets issued in 2012:

“The amount of profit in cash on direct sale of loans may be held under an accounting head styled as “Cash Profit on Loan Transfer Transactions Pending Recognition” maintained on individual transaction basis and amortised over the life of the transaction.”

Impact on GST on the gain on sale

In the last couple of years, if there is anything that has bothered the financial entities in India, other than Ind AS, then it must be GST. Therefore, it becomes pertinent to look at whether GST will become applicable in any manner whatsoever.

Under GST regime, assignment of loans are treated as dealing in securities and are therefore exempted from GST.

One-Time Gains: NBFCs seek change in accounting policy.

(Dated 11th March 2021, Extract of Economic Times)

To reduce volatility in quarterly earnings, non-bank lenders have approached the Reserve Bank of India to allow amortisation of income from sale of loan pools over the tenure of the loan. Since Ind-AS accounting norms allow for one-time gain on loan pools, the mechanism leads to abnormality in income and false representation of a company’s performance, the non-banking finance companies have petitioned the RBI.

“We request you to consider the change in accounting policy because of implementation of Ind-AS, which has serious limitations. We request you to allow gain on direct assignment transactions to be amortised in the statement of profit and loss over the period of loans assigned instead of recognition of the gain in the statement of profit and loss immediately upon assignment of the loans,” the letter to RBI by NBFC industry body Finance Industry Development Council states.

The association has also requested that since the gain on loan pool sales so far got recognised as upfront profit, it inflated the companies’ net worth. These gains should be allowed as unearned income on assigned loans. The argument by the industry body is that such a classification would help project the liabilities at a fair value and depict the fair and transparent picture of the statement of profit and loss.

So far, non-bank lenders take a one-time gain on all loan sales to banks in direct assignment transactions. Prior to the implementation of Ind-AS accounting system, these gains were amortised over the life of the loan.

“RBI considers this income as abnormal and from a regulatory perspective in the past it has guided NBFCs not to consider such one-time gains, as it’s tantamount to false representation of company’s performance,” a CEO of a mid-sized NBFC stated.

Stable collections and sustained investor interest led to uptick in loan securitisation volumes, which crossed Rs 26,000 crore in the third quarter of this fiscal, according to a recent Crisil report. This was higher than the cumulative Rs 22,000 crore logged in the first half, as more originators entered the market.

Author's Insights:

Before the introduction of Indian Accounting Standards, RBI guidelines were followed for de recognizing the asset and recording the gain on sale after de recognition. There was no accounting guidance for financial instruments and their de recognition. In the absence of it, RBI guidelines were followed which talked about true sale. In case, the conditions of true sale were satisfied, then the asset was de recognized and the gain was regularised over the period by amortising the gain on derecognition.

While a well-documented piece of legislation is welcomed, however, every new thing has some shortcomings. In this case, the irregularities in the profit and loss and the complexities surrounding the de-recognition test comes as shortcomings. However, it is expected, with the passage of time, these shortcomings will also be settled.