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Cos Act Ep#7: Accounts

Published on Mon, Jun 09,2014 | 16:48, Updated at Thu, Jun 12 at 17:35Source : CNBC-TV18 |   Watch Video :

Auditors - they will now be rotated. Accounts will now have to be consolidated; even for unlisted companies and in the case of fraud, the liability may lie not just on the offending Partner but also the audit firm.

This week on Companies, Act! we begin our analysis of Chapter 9: Accounts and Chapter 10: Audit & Auditors with Seshagiri Rao, Joint MD & Group CFO, JSW Steel, Santhana Krishnan, Partner – PKF and an ICAI veteran, PR Ramesh, Chairman, Deloitte India and Jamil Khatri, Global Head of Accounting Advisory Services at KPMG.

Let’s begin with the battle of differing definitions. Accounting standards define an ‘Associate’ as one over which the reporting party has significant influence but which is neither a subsidiary nor a joint venture. The Companies Act 2013 goes two steps further to define significant influence as control of at least 20 percent of total share capital or of business decisions and it includes joint ventures among associates.

ASSOCIATE’ DEFINITION
Accounting Standards
10.5 An Associate - an enterprise in which an investing reporting party has significant influence and which is neither a subsidiary nor a joint venture of that party.

‘ASSOCIATE’ DEFINITION
Companies Act, 2013
Section 2(6)
a company in which another company has a significant influence, but which is not a subsidiary company of the company having such influence and includes a joint venture company.
Explanation:  “significant influence” means control of at least 20% of total share capital, or of business decisions under an agreement.

Now to the subsidiary confusion - accounting standards define a subsidiary as one in which the holding company owns more than 50 percent of equity share capital or controls the composition of the Board. The Companies Act 2013 definition looks the same but is very different because the Companies Act definition refers not to equity share capital but to total share capital and total share capital includes convertible preference shares as well. 

‘SUBSIDIARY’ DEFINITION
Accounting Standards
10.11 Subsidiary - a company:
(a) in which the holding company holds directly or indirectly more than one-half in nominal value of its equity share capital; or
(b) of which the holding company controls, directly or indirectly, the composition of its board of directors.

‘SUBSIDIARY’ DEFINITION
Companies Act, 2013
Section 2(87)
a company in which the holding company -
(i) controls the composition of the Board of Directors; or
(ii) exercises or controls more than one-half of the total share capital

Total Share Capital = Paid-up Equity Share Capital + Convertible Preference Share Capital

Ramesh: There is a serious implication because when you are preparing financial statements, you can only prepare them in accordance with accounting standards. They do concede that the Rules provide that they shall be consolidated in accordance with accounting standards. Look at the definition of subsidiary and so effectively you are consolidating a set of entities which are not necessarily subsidiaries under the Companies Act or the reverse- you are not consolidating certain entities which are subsidiaries under the Companies Act’s definition. It further compounds the problem because Directors’ report discusses subsidiaries. So if you have a situation where you have added together five entities and prepared consolidated financial statements and you have to discuss the results. If the Director’s report is to cover subsidiaries under the Companies Act, you maybe discussing seven entities instead of five or three entities instead of five. So, for regulating entities it maybe important to determine what are subsidiaries but it should just stop there. For all other purposes the definition should be in line with accounting standards because accounting standards are dynamic and the definitions are changing as the international definition changes.

Khatri: The key point is to layout that the definition of subsidiary under the Companies Act is relevant for the purposes of compliance with the provisions of the Companies Act other than preparation of financial statements.

Krishnan: I may not agree because the accounts will be prepared in accordance with the Act and the Act says in accordance with the accounting standard. There is a regulatory requirement that subsidiary definition for regulatory purposes is different from the accounting standard. Thus regulatory accounts will have to be filed in accordance with the audit report and also to the regulator. Therefore, the financial statements will have to come only in accordance with the Act. If there is a difference between the Act and the standard, I think the Act should override the standard - that is what we have also spelt out.

‘SUBSIDIARY’ DEFINITION
Accounting Standards
Holds > 50% of Equity Share Capital
Controls composition of its Board of Directors

Companies Act, 2013
Controls >50% of Total Share Capital*
Controls composition of its Board of Directors
*Total Share Capital = Paid-up Equity Share Capital + Convertible Preference Share Capital

Doshi: So in simple English if a subsidiary is a subsidiary under the Act but not a subsidiary under accounting standards, it will still have to be considered a subsidiary when preparing accounts and consolidating them etc under the Act. Is that the simplest way to understand that?

Krishnan: Yes under the Act it has to be consolidated.

Rao: The Act overrides as far as accounting standards are concerned or any other regulations are concerned. So we have to follow the Act to comply with the requirement. 

Ramesh: It is easier said than done, if it becomes a subsidiary because of preference capital holding, preference capital is in substance debt. Even when you apply the accounting rules on consolidation, essentially you are coming up with the entire assets being part of…(Interrupted by Anchor)

Doshi: How do you resolve it; I get the problems but how do you resolve it?

Khatri: The way to resolve it and I don't necessarily agree with the view that the accounting standards in all cases are subordinate to the Companies Act because if the accounting standards are notified under the same Act which is what the plan is for AS 21 to be notified, they become as much a part of the Act as anything else and there is a fair argument to say that for the purpose of the financial statements the accounting standard definition will apply. Of course it will be in everybody's interest for the government to clarify this because there is no fun out of having these different definitions.

Krishnan: In fact this was discussed at the ministry level and at the rule making committee level. Very clearly, government wanted to define total capital. The reason for regulatory intervention here is there are several people who are keeping a huge preference capital and small equity capital. Therefore they were able to play around without consolidation. Now the law is supposed to bring in some kind of uniformity into people. When they don't follow a law they get stricter and define it. It was a clear definition discussion said it should be defined as total capital. But the total capital poses a lot of problem if we include preference. And when you calculate minority interest what do you do? It is a problem but then the problem can be solved only by amending the act.

‘SUBSIDIARY’ DEFINITION
Accounting Standards
Holds > 50% of Equity Share Capital
Controls composition of its Board of Directors

Companies Act, 2013
Controls >50% of Total Share Capital*
Controls composition of its Board of Directors
*Total Share Capital = Paid-up Equity Share Capital + Convertible Preference Share Capital

Doshi: What should companies do now according to you?

Krishnan: It has to go by the Companies Act definition because the auditors report is to say is it in accordance with the act and then only accounting standards. So the act will always override the standards and government has also written to the institute to say bring harmony between both. So it’s highly probable that the accounting standard may undergo a change. Wherever this standard has got a different definition from the act, the standard will say that the Act definition will prevail. There is a project that is going on in the ASB which we have commenced on bringing harmony between both.

Khatri: I think the problem gets compounded if you ask me because if the whole idea of this act was to move forward our reporting and governance towards international norms this is pushing us back two steps backwards because consolidating a subsidiary based on preference capital is not the right way to go. Santhana Krishnan rightly made a point on this was an anti abuse provision. Think about a private equity funding. You have a company where 100 percent of the equity is held by a sponsoring company. Rightfully should be consolidated, they get convertible preference capital into this company. Suddenly it is no long a subsidiary because the preference capital is many fold the value at which equity was put in. That cannot be the intension of any financial statements is the way I see it.

The Companies Act 2013 mandates every company to have a financial year ending March 31. Exceptions can be made for a holding company or subsidiary of a company incorporated outside India. The transition time provided for compliance is two years, starting April 1, 2014. The new law also requires for the first again that all companies, including unlisted and private companies with one or more subsidiary associate or joint venture (JV) company must prepare consolidated financial statements.

FINANCIAL YEAR
Section 2(41)
“Financial year” in relation to any company or body corporate, means the period ending on the 31st day of March every year…

Proviso: On an application made by a company/body corporate, which is a holding company or a subsidiary of a company incorporated outside India and is required to follow a different financial year for consolidation of its accounts outside India, the Tribunal may allow any period as its financial year

Transition Period: 2 years

CONSOLIDATED FINANCIALS
Section 129 (3)
All companies with one or more subsidiaries/associates/joint-ventures
To also prepare a Consolidated Financial Statement
To be laid before AGM

Rao: Industry point of view only one point which I have as far the March 31 date alignment is concerned, if a company is having a subsidiary overseas and that subsidiary as per the local law, it has to have a different accounting year, then there is a provision to get exemption by going to a tribunal. At the same time, if you have a joint venture then that joint venture there is no exemption provided, in case the local laws says, it has to be a different accounting year. So the exemption is not possible, so then it cannot be aligned as far as the accounting year of a joint venture which is outside India with the parent company, that is one problem which I am seeing there is no answer which I am seeing right now as per the act.

FINANCIAL YEAR
Section 2(41)
“Financial year” in relation to any company or body corporate, means the period ending on the 31st day of March every year…

Proviso: On an application made by a company/body corporate, which is a holding company or a subsidiary of a company incorporated outside India and is required to follow a different financial year for consolidation of its accounts outside India, the Tribunal may allow any period as its financial year

Transition Period: 2 years

CONSOLIDATED FINANCIALS
Section 129 (3)
All companies with one or more subsidiaries/associates/joint-ventures
To also prepare a Consolidated Financial Statement
To be laid before AGM

Rao: The second point as far as the consolidation of various subsidiaries and joint ventures are concerned. The major challenge is, one is consolidation at intermediate level that is one major challenge the industry is facing. Number two is disclosure of every subsidiary performance in the directors report that is also become very voluminous, particularly very small companies and comparative the parent company’s turnover and profitability not material or insignificant, even then every subsidiary’s performance has to be debated, discussed and given in the Directors Report, because their major compliance problem which the industry is facing.

BOARD REPORT
Section 134 (3)
Rules
The Board’s Report…shall contain a separate section wherein a report on the performance and financial position of each of the subsidiaries, associates and joint venture companies included in the consolidated financial statement is presented.

Doshi: Let’s take up both the points that Mr. Rao has raised, first the joint venture point can you throw some light on how you would interpret this at what you do with this?

Krishnan: It‘s an issue that we will have to get clarification from the ministry, may not be a clarification they may have to go for an amendment or there is a section which is called as removal of difficulties, they may have to invoke that difficulties section and exempt it, otherwise what Seshagiri Rao is saying is right and that problem will persist.

Ramesh: Essentially it means preparing two sets of financial statements on different dates and getting it audited, so it is an operational sure it is a cost versus benefit issue.

Doshi: Jamil, Consolidating that?

Khatri: I tend to agree because, even today there are many cases where your foreign subsidiaries have a different year end and company is either based on materiality or rather considerations take a view on how you need to incorporate their results. The accounting standards permit you to consolidate the results of an associate using a different year end and that’s the approach you will have to take out here.

Krishnan: The quicker remedy would be invoking the provision of 470

In yet another thrust the Companies Act 2013, provides for the re-opening of accounts, if an application is made by the government, the tax department, SEBI or any other regulator and a court or the National Company Law Tribunal (NCLT) find fraud or mismanagement. A company may voluntarily revise financial statements going back three financial years, if they are found to be non-compliant with sections 129 and 134, but it needs court approval to do so, all the rules accompanying these provisions are not yet final.

RE-OPENING ACCOUNTS
Section 130
On application by Government, Tax Department, SEBI…

If Court/NCLT finds
- earlier accounts prepared in fraudulent manner
-mismanagement casts doubt on financial statements


VOLUNTARY REVISION
Section 131
If Directors find that financial statement/Board Report do not comply with Sections 129 & 134
-They may prepare revised financial statements
-For any of the 3 preceding financial years
-After obtaining Court/NCLT approval
Detailed reasons to be disclosed in Board’s Report
Only one revision in a financial year

Krishnan: Hitherto, this has not been allowed, so typically for the first time we are coming in to revision of accounts and going retrospectively. This will certainly lead to… it just can’t be only because of change in law, it could be change in facts, change in perception anything could trigger a revision. If that revision is done then there are not going to be…if there is a board level change, there is an auditor change all this will pose an enormous problems and courts may not be able to come and adjudicate and say yes this revision is right, because there will be difference of opinion and people could misuse this provision for revision of accounts for various reasons, supposing an acquisition has taken place, they find they paid a huge price and they will have to put the blame on somebody and reduce the price considerations or take a view on the asset values. They may use this as a good legal method to revise the accounts. This will throw up lot of legal challenges.

Ramesh: It could have been on a proforma bases more than actually mandating, making of an adjustment as he rightly said.

Rao: No, voluntary revision of accounts are revision of accounts has been permitted in the act only to ensure that in case there is a fraud, that has been identified by any of the regulatory agency thereby they can direct to revise the account that is the purpose.

Ramesh: Actually one other difficulty which is a serious difficulty, is when you go back and re-open each of the past year accounts, it’s quite likely that the auditor in that year could have been different. You may be re-opening the account for a specific fraud or an accounting adjustment. This current auditor will not be able to express on opinion on those financial statements because he has not audited the entire financial statements. He only is familiar with this adjustment they could be much more there cut-off issues. So that is why I am saying, restatement on a proforma bases is easier,  whilst you can prepare a financial statements to give effect to this adjustments, getting an audit opinion is extremely difficult.

Krishnan: Another example is on the intangible assets. Somebody could have taken the view that intangible asset will come for 50 years. Suddenly three years later we may realize this particular intangible asset has lost its value, because of various reasons, you go back and adjust your depreciation for the past years it will be extremely difficult.

Khatri: For me this is fear of the unknown, this is not something which is unique, I mean globally restatement of accounts is very common, some of the issues that Santhana Krishnan mentioned again are real issues but all of them have been dealt with one way or the other. I find it very difficult from a true and fair view to take the entire… you mentioned Satyam as an example taking the entire effect in one year as a single period item, I always find it better to go back and show it in a particular manner. Does it throw up challenges around dividend distribution, Yes it does, does it throw up challenges around taxation, it does, challenges around who’s going to go back and audit it, and those are real challenges, but it is a fair presentation if you go back and adjust these kind of errors, fraud, differences whatever you may call it in the respective period. It is only going to reflect it in a better presentation of financial statements…

Rao: As per the Income Tax Act, revised return can be filed only for two years, so if you have to open the account more than two years, then there is a problem at Income tax.

VOLUNTARY REVISION
Section 131
If Directors find that financial statement/Board Report do not comply with Sections 129 & 134
-They may prepare revised financial statements
-For any of the 3 preceding financial years
-After obtaining Court/NCLT approval
Detailed reasons to be disclosed in Board’s Report
Only one revision in a financial year

Ramesh: What are you saying is that purpose is served by proforma preservation, after all you want to give what would the picture what look like if these were adjusted that’s all, without going into the next steps of getting an opinion on those and all of it which is a normal.

The Companies Act 2013 is big on disclosures and section 134 is a shining example. Compared to the 1956 act, the 2013 act requires many more disclosures in the board report such as appointment and remuneration policies, explanation on every adverse remark made in the audit and the secretarial audit, inter- corporate loans and investments, related party transactions, the risk management policy, CSR policy, board performance evaluation and a separate section with a report on the performance and financial position of each subsidiary associate and joint venture included in the consolidated financial statement. The director’s responsibility statement in the board report now requires directors of a listed company to state that they have laid down adequate internal financial controls that are operating effectively. Internal financial controls have been defined widely to include policies for ensuring orderly and efficient conduct of business, safeguarding of assets and prevention and detection of fraud. The rules attempt to narrow the scope of internal financial controls by linking them to financial statements but they are not limited to listed companies.

BOARD REPORT
Section 134 (3)
Report by Board of Directors to include

Extract of Annual Return
Directors’ Responsibility Statement
Policy on Directors’ Appointment & Remuneration
Explanations on every qualification/reservation/adverse remark in Audit & Secretarial Audit
Inter-corporate Loans & Investments
Related Party Transactions
Risk Management Policy
Corporate Social Responsibility Policy
Board Performance Evaluation


BOARD REPORT
Section 134 (3)
Rules
The Board’s Report…shall contain a separate section wherein a report on the performance and financial position of each of the subsidiaries, associates and joint venture companies included in the consolidated financial statement is presented.


INTERNAL FINANCIAL CONTROLS
Section 134 (5): Directors’ Responsibility Statement to include
-Directors of a listed company have laid down internal financial controls
-Such internal financial controls are adequate and operating effectively

‘internal financial controls’ means policies and procedures adopted by the company for ensuring orderly and efficient conduct of its business, including adherence to company’s policies, safeguarding of its assets, prevention and detection of frauds and errors, accuracy and completeness of the accounting records, and timely preparation of reliable financial information

INTERNAL FINANCIAL CONTROLS
Section 134 (5)
Rules: Matters To Be Included in Board’s Report
(5) (viii) the details in respect of adequacy of internal financial controls with reference to the Financial Statements

Rao: The Directors Responsibility Statement which now extends the scope where they have to take additional responsibilities particularly relating to internal financial controls. I think on that of course they have to rely on the audit committee to give the comfort that there are adequate internal financial controls in the system and in order to ensure further audit committee to do they can also now take the help of external agencies if required. Setting those systems and getting comfort every time there are enough controls are in place not only in ensuring that relating to finance; relating to operating effectiveness, there the challenges will be there as far disclosing that in the director's responsibility statement in my view.

INTERNAL FINANCIAL CONTROLS
Section 134 (5): Directors’ Responsibility Statement to include
-Directors of a listed company have laid down internal financial controls
-Such internal financial controls are adequate and operating effectively

‘internal financial controls’ means policies and procedures adopted by the company for ensuring orderly and efficient conduct of its business, including adherence to company’s policies, safeguarding of its assets, prevention and detection of frauds and errors, accuracy and completeness of the accounting records, and timely preparation of reliable financial information

Doshi: Added to the bit on all the subsidiary disclosures that are required which will make the directors statement a voluminous statement?

Rao: It will itself equal to annual accounts

Doshi: Internal financial controls; why is this such a sticky area?

Ramesh: Several reasons; one is what the law does not stipulate I am sure guidance will come from The Institute of Chartered Accountants of India (ICAI) is what should be the framework, should it be the Committee of Sponsoring Organizations (COSO) framework, should it be the Canadian Institutes guidance, should it be the England and Wales Institute guidance, there are multiple frameworks. Second is if the intent was controls over financial reporting but the way the law is defined it is internal financial controls and it talks of even, orderly and efficient conduct of business. That is too sweeping to expect both directors to be able to put that in place and the operating effectiveness and auditors to report thereon. So it is more to do with the definition and what is the importance of it. There is a third element which always one asks and this was also raised in the context of Sarbanes-Oxley is, is it commensurate with the benefit you are trying to derive from it. I think we should restrict it to internal control over financial reporting (ICFR) which is what is done internationally.

INTERNAL FINANCIAL CONTROLS
Section 134 (5): Directors’ Responsibility Statement to include
-Directors of a listed company have laid down internal financial controls
-Such internal financial controls are adequate and operating effectively

‘internal financial controls’ means policies and procedures adopted by the company for ensuring orderly and efficient conduct of its business, including adherence to company’s policies, safeguarding of its assets, prevention and detection of frauds and errors, accuracy and completeness of the accounting records, and timely preparation of reliable financial information

Krishnan: You have to segregate them into two; one the board report and the auditor's report. To the extent of the auditor's report you have dealt with in the rule to say that it is only with reference to the financial reporting. You will go through the rules we have specifically discussed and introduced it. To the extent of the board, things will settle down over a period of two years but are we saying that the directors were not responsible for this. I don't understand why people should be so worried about it. If directors were responsible for the conduct of the business, now all the directors are required to say is please state so in the director's responsibility statement. Now because it has come in the statement directors are saying why don't you document it. Is documenting an existing control is it such a serious thing that people should get worked up, I don't agree.

Ramesh: If you are applying the COSO framework and you get into documenting all of the controls in that way it is a huge exercise.

Krishnan: They have not set that in the rule, they have not it in the act or rules.

Ramesh: That is exactly the point I am making. What is the rigour and that needs clarity and one more dimension is does this also apply to consolidated financial statements including the auditor's report, that clarity is not there. So if you are extending that dimension across the world then including the auditor's reporting that is a completely different thing.

Khatri: I think the practical problem is if you have independent directors particularly directors who are not involved in the day to day operations of the company and they have to certify something in the board report then they would like a higher level of documentation and that is where the challenge comes from.

Doshi: Because where else are they going to get the comfort from.

Khatri: I agree and what the board of directors would insist on rightfully is to say not only do you in substance say that there is an internal financial control but how do you document it, how do you test it so that we have evidence of giving our assertion and that is where the build up of efforts kind of happens which results in cost and that is the question around cost versus benefit. So my own experience is that boards will insist on a lot more rigour, lot more documentation and testing before they include this in the board responsibility.

Krishnan: It leads to better governance.

Doshi: Better governance or more paperwork?

Rao: It is definitely better governance in my view because earlier it used to be a process which used to be robust enough to ensure that the internal controls are adequately in place. Today what is being expected to certify by way of a Directors Responsibility Statement every item which is coming in the P&L account and balance sheet and cash flow in order to enter into that statement all the processes, everything is perfect number one, efficiency of doing the business is also to be satisfied by Directors Responsibility Statement. So that is where the problem in my view lies, how you ensure that a business is done efficiently. There is always a subjective view on that. So for instance if we have to place an order with a supplier have we followed the entire process properly or not. Have we procured this item in the most efficient manner or not and we are running the planted machinery in the most efficient manner or not.

Ramesh: Most efficient would be e-auctions for all.

Krishnan: Is it not today a responsibility of the director; if the answer to that is yes, then we can't object to this. If the answer to that is no, saying no, it is not my responsibility, all that the people are saying is please put it as signature to a responsibility. If orderly and efficiently running a business was the board's responsibility, if it is not then who else. The whole idea is stakeholder should know who is responsible. I think for a while this can create problem or it will settle down over a period of one or two years, maybe we will dilute some of the procedures but I don't think this can be said, this is too much of paperwork don't do it.

Rao: The responsibility of the Board of Directors earlier was the same as that of today. We have introduced something else to certify and give a certificate to the shareholder.

Krishnan: They have only said put your signature.

Rao: So at the time whoever is now made to be known that this is additionally you have to do then he wants a comfort for which there is a compliance work. There is a cost.

Krishnan: I agree.

Rao: Today particularly the companies where there are larger operations have to incur more cost. Small companies cannot afford to do that.

Krishnan: So that is one of the reasons why they increased the sitting fee to Rs 1 lakh.

 
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