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Companies Act Diary: Part 2

Published on Thu, Nov 14,2013 | 13:52, Updated at Thu, Nov 14 at 13:52Source : 

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

The Companies Act, 2013 – Enhanced & Better Financial Reporting

In my inaugural note, I highlighted the six key themes arising out of the Companies Act. In this note, I would like to discuss the details around the first theme – ‘Enhanced and better financial reporting’.  The Act makes several changes with a view to enhance financial reporting by companies. Several of these changes align the financial reporting requirements in India with international practices.  However, some of the changes may also result in undue efforts without any significant benefits.  These key changes are discussed below:

Consolidated Financial Statements

The Act mandates preparation of consolidated financial statements (CFS) by all companies, including unlisted companies, that have one or more subsidiaries, joint ventures or associates. Previously, SEBI required only listed companies to prepare CFS. The CFS would be in addition to the standalone financial statements and are required to be prepared in the same form and manner as the standalone financial statements.  The decision to legally mandate CFS is a step in the right direction as it would compel all stakeholders to increase their focus on CFS, which present a more accurate reflection of the financial position and financial results of an entity.  However, the decision to mandate CFS for unlisted entities in which there is no public interest, may result in undue efforts for such companies with limited corresponding benefit.  Even under IFRS, intermediate holding companies are exempt from preparing CFS, if the ultimate parent company prepares CFS that are publicly available.  Given that there is no similar exemption under the Act, groups with multi-layered structures (for example, many real estate groups) would be required to prepare CFS at multiple levels.

By requiring all companies that have one or more subsidiaries, joint ventures or associates to prepare CFS, the Act addresses an interesting loophole that existed in previous reporting standards.  This relates to preparation of CFS by listed companies that have joint ventures or associates, but do not have a subsidiary.  Several such companies had taken a view that since they do not have a subsidiary, they are exempt from preparation of CFS even for reporting to the stock exchanges and investors.  The Act would now change this position. 

Interestingly, the definition of a subsidiary under the Act is different from the definition under the accounting standards.  The Act defines a subsidiary as an entity where the parent owns more than one-half of the total share capital, which may be different than the voting share capital considered under the accounting standards.  For example, an entity where the investor holds a majority of the voting share capital (equity shares), but does not hold a majority of the total share capital (due to non-voting preference shares held by other investors), would be accounted for as a subsidiary in the CFS, but not treated as a subsidiary the purposes of the other provisions of the Act, including for determining whether CFS are required to be presented. 

Lastly, the Act does not provide any transitional relief for companies that are preparing CFS for the first time.  Such entities would be required to apply the principles of consolidation retrospectively, which may pose a significant operational challenge for subsidiaries acquired in the past at different points in time.


The Act permits a prescribed class of companies (yet to be defined) to depreciate assets over their useful lives.  Accordingly, such companies now have the flexibility to determine the useful lives for assets based on actual planned usage without being constrained by a regulatory-prescribed maximum life.  For example, several companies that were depreciating their plant & machinery based on the current Schedule XIV maximum lives, may see a reduction in the depreciation charge due to change in the useful lives.  Even for ‘non-prescribed’ companies that are required to follow useful lives laid out in a new schedule to the Act, the useful lives are generally more realistic as compared to the previous Schedule XIV.

The Act also requires that useful life and depreciation for significant components of an asset should be determined separately.  This is likely to have a significant impact for several companies that previously capitalized the total cost of an asset without distinguishing individual parts that may have a shorter useful life.  While the component approach may result in accelerated depreciation in the first instance, it would also permit companies to capitalize the cost of major replacements/overhauls, which may currently be charged as period costs when incurred.

These changes are a step in the right direction and align the reporting requirements to IFRS.  However, companies would be required to update their systems and processes to comply with the revised requirements.  Significant one-time efforts may also be required based on the nature of assets at the date of transition.

The transition provisions of the Act in this area could result in other unanticipated challenges.  For example, consider a 15 year old asset being currently depreciated over 20 years.  If the useful life of this asset is determined to be 16 years, the entire value of the asset on the date of the implementation of the Act would be charged-off over 1 year.  On the other hand, if the useful life is determined as 15 years,  the entire value would be charged against the reserves with no charge to the profits.

The changes in the Act may have an adverse impact on companies that have revalued assets and are off-setting the higher depreciation charge by transferring amounts to the profit & loss from the revaluation reserve.  Such a treatment may no longer be permitted under the Act.  Further, companies with road projects built on a BOOT basis, which are currently depreciating such assets based on the pattern of revenue generation (toll collection) may no longer be permitted to continue with this practice, which was specifically endorsed under Schedule XIV and which has not been carried forward under the Act.

Adjustments To Reserves

Currently, companies are permitted to adjust certain costs and charges directly against reserves either using specific clauses under the The Companies Act, 1956 (for example, section 100 on capital reduction or section 78 on utilization of share premium balance) or under court approved schemes of mergers & amalgamations (for example, sections 391-394).  Many companies were using these provisions to write-off unrecoverable assets, charge-off ‘one-time’ costs or to adjust costs associated with redemption of debt instruments.  These direct adjustments to reserves often result in an inaccurate reflection of profits & losses and affect comparability between companies (as also comparison with global peers). 
The Act now prohibits most such adjustments and this would reflect in a more uniform and accurate representation of financial results.  However, it is currently uncertain on whether the restrictions imposed by the Act would also cover ‘special reserves’ existing at the time of the transition to the Act, which were previously set-up by companies with the specific objective of adjusting future costs & write-offs.

Restatement Of Financial Statements

Currently, companies are generally not permitted to revise or restate previously approved financial statements. Material misstatements in the accounts related to previous years, whether due to occurrence of fraud or error are reported as a ‘prior period adjustment’ in the financial statements of the period in which such misstatements are discovered. The Act introduces provisions on restatement of financial statements in the following circumstances:

-A statutory / regulatory authority (example, Central Government, SEBI, income tax authorities,) can apply to the prescribed authority or a court of law when the accounts of the company were prepared in a fraudulent manner or the affairs of the company were mismanaged thereby casting a doubt on reliability of the financial statements. There is no time restriction to revision initiated by a statutory regulatory authority.

-Voluntary restatement on application by the Board of Directors if in their opinion the financial statement report do not comply with the requirements of the Act (example, non-compliance with accounting standards subsequently discovered).  Voluntary restatement is permitted after obtaining approval of the prescribed authority in respect of three preceding financial years.

These provisions seek to align the requirements in this area to the international standards and will enable all stakeholders to understand the impact of material errors and frauds on the numbers previously reported for each individual year in the past.  These provisions also seek to operationalize the previous decision by SEBI to require listed companies to restate financial information for audit qualifications.

The new requirements are likely to result in implementation challenges in incidental areas such as determination of taxable profits and Minimum Alternate Tax liabilities for the previous periods, which are subsequently restated. 

Uniform Financial Year

The Act requires all companies to adopt a uniform financial year of 1 April to 31 March with limited exceptions for a company that is a holding company or subsidiary of a company incorporated outside India, which may be required to follow a different financial year for consolidation outside India.  In the event that a company seeks to avail of such an exemption (for example, an Indian subsidiary of a multinational that wants to follow a 31 December year-end), it would need to seek approval from a prescribed authority.  The benefits of this requirement are unclear and may result in undue hardship on impacted companies.

On an overall basis, the changes in this area seem to be ‘net’ positive and would generally result in enhanced & better financial reporting within corporate India.  Like all significant changes, implementation challenges are likely to arise in the initial period of the implementation.


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