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Companies Act Diary: Part 4

Published on Thu, Apr 03,2014 | 16:00, Updated at Thu, Apr 03 at 16:00Source : Moneycontrol.com 

By: Jamil Khatri, Deputy Head of Audit & Global Head of Accounting Advisory Services, KPMG

 

Final Cos Act Rules: Many Concessions, Some Disappointments

After a significant amount of uncertainty and delay, the Companies Act 2013 (the Act) is finally a reality.  True to form, the substantive provisions of the Act and the Final Rules (Rules) to implement the Act have been notified only a few days prior to the date of the Act’s applicability.  Even though the regulators may argue that the Act and draft rules have been in public domain for several months, notification of the final law sufficiently in advance of the effective date is essential for a smooth transition.  In any case, the Act represents a major change in corporate law and would significantly impact the governance framework in the country. 

It is heartening that the Ministry of Corporate Affairs (MCA) held extensive consultation with a wide range of stakeholders prior to finalizing the Rules.  What is more heartening is that these consultations were done with an open mind, which is reflected in the several relaxations provided in the Rules as compared to the initial drafts.  However, there are some disappointments as well since the MCA has not incorporated certain legitimate changes suggested by stakeholders to address hardships in implementation.

Related party transactions

The Rules have rationalized the coverage of related parties to include only Directors and defined Key Managerial Personnel (example, CEO, CFO) of the company and its holding company, and not subsidiary and associate companies. Senior management personnel other than those defined as Key Managerial Personnel are no longer treated as related parties. Further, the Rules have reduced the list of relatives to cover only 8 relationships. Third generation relatives – grandparents and grandchildren have been excluded from the definition of relatives.  This rationalization will reduce the hardship in identifying related party transactions and getting them approved by the Audit Committee, Board or shareholders, as required.

Many stakeholders had highlighted that an individual may not have sufficient control over the decisions and actions of certain relatives such as independent parents or children; or siblings.  Recognizing this fact, several international jurisdictions include such relatives as ‘covered relatives’ only if they are financially dependent on the individual.  Accordingly, many had recommended that a similar concept should be introduced through the Rules.  The MCA has not incorporated this suggestion, which would result in hardship while implementing many provisions of the Act such as approval of related party transactions; independence of directors and auditor qualifications.

In the area of requiring shareholder approval for certain related party transactions, the Rules have correctly increased the monetary limits for determining cases where such approval is required.

Loans to subsidiaries

Section 185 of the Act could have been interpreted to prevent a company from advancing loans to subsidiaries or giving guarantees or security in connection with a loan taken by subsidiaries.  Many stakeholders highlighted that this would impact financing arrangements within the group, without any benefit to the shareholders of the group.  The Rules address this concern by exempting holding companies and their wholly owned subsidiaries from the requirements of Section 185. Further, guarantees given or security provided by a holding company to a bank or financial institution for the purpose of loan taken by any subsidiary is also exempt. These are fair change given that several corporate groups incubate and support their subsidiaries by lending or providing guarantees, particularly during the initial periods of formation.

Audit and auditors

The Act provides for mandatory audit firm rotation, which makes India one of the first few countries in the world to require this.  In addition to listed companies, the draft rules proposed mandatory rotation for almost all unlisted companies.  The Rules now establish a higher threshold based on the paid up capital (Rs 10 crores – Rs 20 crores) or level of borrowings (Rs 50 crores).  While this is a partial relaxation, requiring audit firm rotation for unlisted companies, which are closely held, is unique and inconsistent with global practices.  This is particularly likely to pose a hardship for Indian subsidiaries of multi-national companies, which may need to manage multiple auditors since the parent company auditors may not be covered by similar rotation requirements.

On the matter of auditor qualification and independence, the Act states that the auditor of the company would be disqualified if they have any business relationship with the client. The Rules have moved in the right direction by providing that if the auditor purchases goods or services such as telecommunication, hotel and airline services from a company in the normal course of business and on an arms-length basis, such a purchase would not constitute a prohibited business relationship that results in disqualification.  This aligns the requirement in India with global standards and would reduce undue hardship.

The Act requires auditors to report on frauds, including suspected frauds to the MCA. The draft rules required all material frauds to be reported to the MCA without waiting for the remediation plan of the management & the Board. The Rules have now clarified that auditors will, in the first instance, report the fraud or suspected fraud to the management and thereafter report to the MCA within prescribed timelines. However, the Rules have dispensed with the concept of materiality thereby requiring all frauds to be reported in the manner prescribed. This requirement is likely to cause several hardships.  In the first instance, reporting suspected frauds that may be under investigation at the time of reporting may not serve a legitimate purpose if the investigation ultimately determines that no fraud was actually perpetrated.  Further, removing the materiality hurdle may result in reporting of small & inconsequential frauds. This requirement is also inconsistent with global practices, which generally require reporting to the regulators only if the auditor is not satisfied with the actions taken by the management & the Board.

Independent directors

The Act requires certain unlisted companies to have independent directors on their Board.  The threshold for unlisted companies that require such independent directors (paid up capital – Rs 10 crores; revenues – Rs 100 crores; or borrowings – Rs 50 crores) has been reduced as compared to the draft rules, which is contrary to the suggestions made by several stakeholders highlighting that requiring unlisted companies to have independent directors may have limited benefits.  Further, this may be quite burdensome since many subsidiaries within a group may need to have their own independent directors.  Many multinational companies with wholly-owned Indian subsidiaries would also be impacted by this requirement. 

Depreciation

The MCA has published an amendment to Schedule II of the Act whereby companies are provided with the option of depreciating assets over their useful lives, which could be different from the useful lives prescribed in the Schedule. Further, the determination of residual value could also deviate from the five percent stated in the Schedule. However, if a company chooses to use a useful life or residual value different from the limits indicated in the Schedule, it will be required to disclose a justification for the same in the financial statements. This is a positive development and aligns the depreciation accounting in India with international norms.  Companies could use this as a trigger to ensure that the depreciation charge reflects the useful life of the asset.  In many cases, companies have been artificially depressing the useful life of assets such as plant & machinery and buildings since the 1956 Act prescribed certain minimum depreciation rates.

In a concession for toll road operators, the notification provides for revenue-based amortization for intangible toll road assets.  This is consistent with current practice and would ensure that the Act does not result in a change in reporting for such companies.                                          

Subsidiaries and associates

In order to determine whether a company is a subsidiary or associate, the Act requires consideration of not just equity share capital but also preference share capital of the investee company. The definition of subsidiary and associate refers to investor’s holding in total share capital of the company. The Rules have now defined total share capital as including equity share capital and convertible preference shares. Excluding redeemable preference shares from the definition of total share capital is a positive development, especially since redeemable preference shares are more akin to debt than equity.  However, assessment of subsidiaries and associates after considering convertible preference shares is still inconsistent with accounting standards in India, which require that subsidiaries and associates be assessed based on currently outstanding voting rights.  Consensus is emerging that while the definition of a subsidiary/associate under the Act would be relevant for the purposes of the Act; the consolidated financial statements will be prepared using the definitions in the accounting standards.

Transition

One of the biggest challenges with the Act and the Rules is the limited guidance on transition in many cases.  For example, the Act and the Rules do not provide clear guidance on the how the new requirements and the old requirements will co-exist for audit reports and director’s reports issued after 1 April 2014 but which related to financial statements for the year ended 31 March 2014.  Intuitively, the old requirements should apply to such reports.  However, the repeal of the old Act and absence of clear transition provisions in the new Act has result in uncertainty.

In summary, while the MCA has addressed many legitimate suggestions, it needs to address some of the above matters to ensure a smooth and logical transition to the new law.

(You can find Part 1,2,3 of Jamil’s Diary here, here and here.)

 
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