The Firm

Show Timings:

Friday: 10.30 pm, Saturday: 11.30 am

Sunday: 9:30am & 11.00pm


Companies Act Diary: Part 1

Published on Tue, Oct 22,2013 | 18:10, Updated at Wed, Oct 23 at 13:12Source : 

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


The Companies Act, 2013 (Act) which replaces the Companies Act, 1956, is the culmination of several years of efforts to enact a new legislation governing companies in India.  The Act received the assent of the President of India on 29 August 2013 and will become applicable as and when individual sections are notified and made effective.  A vast majority of the sections in the Act are subject to rules, many of which have been issued in draft form for public comments.  98 sections of the Act that are not subject to rule making have already been made effective from 12 September 2013 and the balance sections are expected to be made effective in the coming months as comments on the draft rules are considered and the rules finalized.


While one can get lost in the 470 sections, many schedules and numerous rules under the Act, it may be useful to analyze the changes along the following six themes:


1.       Enhanced & better financial reporting – The Act makes changes to financial reporting in several areas.  All companies with subsidiaries, joint ventures or associates now need to prepare consolidated financial statements (CFS).  Previously only listed companies were required to prepare CFS under the listing agreement with the stock exchanges.  Inclusion of CFS within the purview of the Act would enhance the focus on these statements, which are a better reflection of the financial position and performance of a group.  The Act also moves away from minimum rates of depreciation for certain companies and permits such companies to depreciate assets over their useful lives.  Further, the Act permits restatement or revision of previously issued audited financial statements and prohibits certain costs & expenses from being directly adjusted against the reserves.  While overall many of these changes are investor friendly and consistent with international practices, certain provisions relating to preparation of CFS by unlisted companies and requiring companies to follow a uniform 31 March year-end may have limited benefits.

2.       Higher auditor accountability – The Act makes several changes in the area of auditor appointment and responsibilities.  The Act mandates auditor rotation after 10 years for most companies.  This is a bold step considering that very few countries currently mandate auditor rotation.  The US debated mandatory auditor rotation at the time of issuance of the Sarbanes-Oxley Act and concluded that this would not necessarily improve audit quality.  Further, auditor rotation is currently being hotly debated in Europe.  The few countries that require auditor rotation, generally restrict such requirements to listed companies and other public interest entities such as banks.  However, the Act seeks to extend auditor rotation requirements to almost all companies.  Auditor rotation for unlisted companies may result in undue burden with limited benefits.  The Act prohibits the auditor from providing certain prohibited non-audit services to their audit clients.  This is a step in the right direction and is consistent with the international requirements.  However, several implementation challenges will arise based on the manner in which the prohibited services have currently been defined.  The Act also requires the auditor to comment on matters such as adequacy and effectiveness of internal financial controls; financial transactions and matters with adverse effect; pending litigation; and adequacy of provision of foreseeable losses on long-term or derivative contracts.  Several of these requirements are fairly onerous and would significantly increase the audit efforts and costs.  Further, many of these matters are already covered by the reporting requirements of the accounting standards and hence the need for separate reporting in these areas is unclear.  Lastly, the Act requires the auditor to report frauds identified if these are material or occurring frequently.  This is very unusual since most international frameworks require reporting to the regulators only if the Board/Audit Committee has not investigated and addressed the fraud to the satisfaction of the auditors.  Even if reporting of frauds is deemed useful, there is limited merit in reporting immaterial but frequently occurring frauds to the regulators.

3.       Easing corporate restructuring – The Act eases corporate restructuring by permitting cross-border mergers; fast-track mergers; mergers of wholly owned subsidiaries; and ability to buy-out the minority in certain circumstances.  Several of these changes are corporate friendly. Further, a company cannot, unless otherwise prescribed, make investment through more than two layers of investment companies except to comply with law and in the case of acquisition of a foreign company.  While this change seeks to simplify corporate structures, this may have a significant impact on many large business groups.

4.       Increased responsibility of the Board – The Act requires many unlisted companies to have independent directors on their Board.  Requiring unlisted companies, including subsidiaries of listed companies, to have independent directors may pose significant challenges with limited benefits.  The Act prescribes a maximum term for independent directors and also changes the definition of an independent director.  These changes seek to ensure a higher level of governance in Board composition.  The Act enhances responsibilities of the Board & the Audit Committee in many areas and prescribes the process for annual Board performance evaluation.  The Act also prescribes significant penalties for non-compliance in the above areas.  While some of these changes may seem onerous and unnecessary, it would be interesting to see whether independent directors use this increased responsibility & authority as an opportunity to require companies to raise the overall level of governance, particularly in promoter-managed companies.

5.       Push on inclusive agenda – The Act obligates companies that meet certain thresholds to spend at least 2 percent of their average net profit for the last three years on CSR initiatives. The Board is required to explain the reason for any unspent amounts in their report to the shareholders.  The profitability thresholds of Rs 5 crores seem to be low when compared to the sales (Rs 1000 crores) and net worth (Rs 500 crores) thresholds.  Further, this requirement is likely to throw up several implementation challenges around what constitutes eligible CSR and fuels the debate on the appropriateness of requiring companies to mandatorily perform certain activities, which may not be fully aligned to their responsibilities to their shareholders.

6.      Emphasis on investor protection – The Act makes related party transactions a significant focus area.  All related party transactions that are not at an arms-length or not in the ordinary course of business require approval of the Board.  Further, most companies would need to get such transactions approved by their shareholders through a special resolution where ‘related party’ shareholders are ineligible to vote.  While requiring the Board and Audit Committee to approve related party transactions is a step in the right direction, this requirement is likely to throw up significant challenges to determine whether transactions are at an arms-length.  Further, the requirement to exclude all ‘related party’ shareholders from voting on the transactions may have unintended consequences since a particular related party may not be a party to the transaction and hence would like to exercise their corporate right to vote on such transactions.  The Act also significantly expands the scope and coverage of what constitutes a related party transaction.  Similarly, provisions around restriction on loans to directors or parties where the directors are interested have been enhanced.  Some of these restrictions, particularly those impacting loans to subsidiaries, may have unintended adverse consequences.  Lastly, the Act introduces provisions relating to class-action suits and whistle blower mechanisms, which seek to empower investors.

While the implementation of the Act is likely to pose significant challenges in certain cases, all stakeholders (management, Board, independent directors, auditors, regulators) need to use this as an opportunity to raise the level of governance within Corporate India.  Further, the regulators need to consider the genuine grievances that have been highlighted by various stakeholders in their comments on the draft rules and ensure that the Act, once finalized, is fair and does not result in undue hardship for genuine business transactions.




Copyright © Ltd. All rights reserved. Reproduction of news articles, photos, videos or any other content in whole or in part in any form or medium without express written permission of is prohibited.