Companies Act 2013
Accounting and financial reporting
- Uniform financial year
What the Companies Act 2013 states:
The definition of term “financial year” is applicable from 1 April 2014. It requires a company to adopt a uniform accounting year ending 31 March. Companies which are currently following a different financial year need to align with the new requirement within two years. A proviso to the definition states that a company may apply to the NCLT for adoption of different financial year, if it satisfies the following two criteria:
- Company is a holding or subsidiary of a company incorporated outside India, and
- Company is required to follow a different financial year for consolidation of its financial statement outside India.
The Central Government has still not notified the NCLT and many provisions relating thereto are not currently notified. Under section 434 of the 2013 Act, certain matters pending with the High Court, District Courts or the CLB, as the case may be, which will be within the jurisdiction of the NCLT, would be transferred to the NCLT from a notified date. Till such time, the courts and the CLB will continue to function. In the absence of NCLT, a company may contact the MCA to seek guidance with regard to which of these authorities they should file an application for adoption of a financial year other than one ending on 31 March.
In accordance with AS 21, AS 23 and AS 27, a parent company can use financial statements of subsidiaries, associates and joint ventures drawn up to a different reporting date to prepare CFS if it is impractical to have their financial statements prepared up to the same reporting date as the parent. How is the impracticality provision of AS 21, AS 23 and AS 27 impacted by the requirement to have a uniform financial year?
Section 129(4) of the 2013 Act states that “the provisions of this Act applicable to the preparation, adoption and audit of the financial statements of a holding company will, mutatis mutandis, apply to the CFS.” Hence, the requirement concerning uniform financial year applies to both separate financial statements of the parent company as well as CFS of the group.
A parent company has unilateral control over all its subsidiaries. Hence, it should normally be able to obtain their financial statements for the same reporting date as the parent and use them in the preparation of CFS. However, this may not be practical for all the associates/joint ventures. For example, an associate/joint venture incorporated outside India may have non 31 March year-end, either due to requirement of local regulations or requirement prescribed by other significant shareholder. Since the parent company does not have unilateral control over these associates/joint ventures, it may not be in a position to require them to prepare an additional set of financial statements for 31 March year-end for use in its consolidation. Similarly, in case of Indian associates/joint ventures, it is possible that these companies have 31 March year-end for their own statutory reporting. However, their systems may not be geared-up to provide timely information for use in the parent’s CFS. For example, due to requirements of listing agreement, a listed parent needs to finalize its CFS within 60 days of the year-end. However, its non-listed associates/joint ventures need much more time to finalize their financial statements. In such cases, maximum six months gap between the reporting dates of the parent company and its associates or jointly controlled entities may be permitted, provided that companies meet criteria prescribed in accounting standards for use of different period financial statements.
- National Financial Reporting Authority
What the Companies Act 2013 states:
Under the 2013 Act, the NFRA will replace the NACAS. NFRA will be a quasi-judicial body and will have responsibility to ensure overall quality of financial reporting. In addition to advising the Central Government on formulation of accounting standards for adoption by companies/class of companies, the NFRA will:
- Make recommendations to the Central Government on formulation and laying down of auditing policies and standards for adoption by auditors
- Monitor and enforce compliance with accounting and auditing standards in the manner as may be prescribed
- Oversee the quality of service of professionals associated with ensuring compliance with standards, and suggest measures required for improvement in quality and such other related matters as may be prescribed, and
- Perform other prescribed functions.
The Central Government has not yet constituted the NFRA. Also, the final rules relating to NFRA are not yet notified. The transitional provisions in the Accounts Rules state that accounting standards prescribed under the 1956 Act will continue to be accounting standards under the 2013 Act, until accounting standards are specified by the Central Government under the 2013 Act. The transitional provisions also state that until NFRA is constituted, the NACAS will continue advising the Central Government on formulation of accounting standards. Though not mentioned specifically, it appears that for the time being, the ICAI will continue to perform its existing functions, e.g., those relating to formulation of auditing standards and monitoring/ enforcing compliance both with the accounting and auditing standards.
- Board report
What the Companies Act 2013 states:
The 2013 Act read with the Accounts Rules require several disclosures about performance, risks, etc. Key disclosures include:
- Extract of the annual return, which covers matters such as indebtedness, shareholding pattern, details of promoters, directors and KMP and changes therein, details of board meetings and attendance, remuneration of directors and KMPs and penalty or punishment imposed on the company, its directors/officers
- Financial summary or highlights
- Change in the nature of business, if any
- Details of directors or KMP who were appointed or have resigned during the year
- Names of companies which have become or ceased to be its subsidiaries, joint ventures or associate companies during the year
- Details of significant and material orders passed by the regulators or courts or tribunals impacting the going concern status and company’s operations in future
- Statement indicating development and implementation of risk management policy for the company including identification therein of elements of risk, if any, which, in the opinion of the Board, may threaten the existence of the company
On the lines of pre-revised Clause 49, RC49 requires that as part of the directors’ report or as an addition thereto, a MD&A report should form part of the Annual Report to the shareholders. This MD&A should include discussion on the following matters within the limits set by the company’s competitive position:
- Industry structure and developments
- Opportunities and threats
- Segment–wise or product-wise performance
- Risks and concerns
- Internal control systems and their adequacy
- Discussion on financial performance with respect to operational performance
- Material developments in Human Resources/Industrial Relations front, including number of people employed
Preparation of board report
The Accounts Rules require that the board report will be prepared based on the SFS of a company. This report must contain a separate section wherein a report on the performance and financial position of each subsidiary, associate and joint venture company included in the CFS is presented.
Disclosure regarding median remuneration
Section 197 of the 2013 Act requires every listed company to disclose in the board’s report the ratio of the remuneration of each director to the median employee’s remuneration and such other details as may be prescribed. The Managerial Personnel Rules clarify how median remuneration is measured. They also require several additional disclosures, examples include: (i) % increase in remuneration of each director, CEO, CFO, Company Secretary or Manager, if any, in the financial year, (ii) % increase in the median remuneration of employees in the financial year, (iii) explanation on the relationship between average increase in remuneration and company performance, (iv) comparison of the remuneration of the KMP against the company’s performance, (v) key parameters for any variable component of remuneration availed by directors, and (vi) ratio of the remuneration of the highest paid director to that of the employees who are not directors but receive remuneration in excess of the highest paid director during the year.
Disclosures required under RC49 are similar to those under the pre-revised 49. However, companies need to ensure proper synchronization of these disclosures with the new disclosures under the 2013 Act.
In the case of a listed company, the board needs to disclose information under the three heads, viz., board report, Directors’ Responsibility Statement and MD&A. A listed company may present MD&A either separately in the annual report or as part of the board report itself. Though information requirements of the board report and MD&A are worded differently; from practical perspective, the presentation of such information is likely to significantly overlap with each other. A listed company may need to structure its board report and MD&A carefully so that meaningful information is presented to users without duplication, while ensuring compliance with both the requirements.
In many cases, this disclosure for each subsidiary, associate and joint venture may become very cumbersome for companies. Also, investors and analysts typically look at performance and financial position of the consolidated group, as against each individual entity. Therefore, groups will have to provide stand-alone performance of each company for complying with the 2013 Act and consolidated performance for the benefit of investors and other stakeholders.
These disclosures are in many respects consistent with the disclosures required globally. For example, the Dodd Frank Actin the US and recent changes in the Company Law in UK require similar disclosures. It is believed that these disclosures will bring about greater accountability amongst companies. Also, disclosure regarding remuneration of the employees, who are not directors but receive remuneration in excess of the highest paid director, during the year, may bring to focus the real decision makers.
The Managerial Personnel Rules clarify that median means the numerical value separating the higher half of a population from the lower half and the median of a finite list of numbers maybe found by arranging all the observations from lowest value to highest value and picking the middle one. Assuming a company has three categories of employees, i.e., 1150 workers, 550 officers and 299 middle and senior management. The median remuneration would be what employee number 1,000 would be earning, if they were arranged in an ascending or descending order based on their remuneration. In this case, that happens to be a worker. The comparison of a worker’s remuneration with the CEO will reflect a significant disparity and may not give any meaningful information to the users.
Similar disparity may arise in the case of a company which has many branches in countries where remuneration is high. In such cases, inclusion of foreign salaries with Indian workers to determine the median may reflect a distorted comparison.
To give more meaningful information to users, some companies may voluntarily disclose category-wise comparison in addition to the disclosures required as per the Managerial Personnel Rules. In the above example, comparison of median remuneration of middle and senior management with CEO’s salary may provide more meaningful information.
Disclosure of KMP remuneration and its linkage to company performance can make the board more accountable and reassure investors that the board is negotiating with executives at “arm’s length.” Disclosure of remuneration packages also provides information to investors about the incentives being set for executives. This could assist them to assess the company’s prospects and risk profile, such that the share price more accurately signals the market’s assessment of the stream of expected profits. Thus, through improving investor confidence and providing relevant information about company prospects, disclosures may enhance efficiency in equity markets. However, unlimited disclosure would be unlikely to deliver net benefits; for instance, detailed revelation of a company’s strategy may undermine its competitive advantage and long-term performance. In other words, the benefits of transparency need to be balanced against compliance costs and possible adverse consequences for a company’s commercial position.
In the 2013 Act, the board report includes many matters, which hitherto were not required in the 1956 Act. These matters to be reported may be very onerous and time consuming to prepare. Hence, the applicability date is important. Section 134 of the 2013 Act dealing with board report is applicable from 1April 2014. The MCA has clarified that the rules will also apply from 1 April 2014. However, neither the 2013 Act nor the rules clarify as to how this requirement should be applied. The following three views were possible:
- The new requirement applies to all board reports for periods beginning on or after 1 April 2014.
- It is applicable to all board reports for periods ending on or after 1 April 2014.
- It is applicable to all board reports issued on or after 1 April 2014.
General Circular no 8/2014 issued on 4 April 2014 has addressed this issue. It clarifies that the Board’s report in respect of financial years, which commenced earlier than 1April 2014, will be governed by the relevant provisions of the1956 Act (View (i)). A company having 31 March year-end applies the requirements of the 2013 Act for board reports issued with respect to year ended 31 March 2015. A company having any other year-end will apply the requirements from the next financial year onwards. For example, a company having 31 December year-end will apply the requirements of the 2013Act for boards reports issued with respect to year ended 31 December 2015. Till such date, the requirements of the 1956 Act will continue to apply.
- Internal financial controls
What the Companies Act 2013 states:
Section 134(5)(e) of the 2013 Act requires that in case of listed companies, Directors’ Responsibility Statement should, among other matters, state that directors had laid down internal financial controls and such controls are adequate and were operating effectively. An explanation given to clause (e) of section 134(5) states as below:
- “For the purposes of this clause, the term ‘internal financial controls’ means the policies and procedures adopted by the company for ensuring the orderly and efficient conduct of its business, including adherence to company’s policies, the safeguarding of its assets, the prevention and detection of frauds and errors, the accuracy and completeness of the accounting records, and the timely preparation of reliable financial information.”
Hence, the 2013 Act lays down very wide responsibility regarding internal financial control reporting on the directors. It includes policies and procedures for ensuring orderly and efficient conduct of business — thereby covering not just financial reporting aspects, but also the strategic and operational aspects of the business and the efficiency with which those operations are carried out. For the purpose of this publication, internal financial controls related to financial reporting aspects are referred as “financial reporting controls” and those related to strategic and operational aspects of the business are referred to as “business controls.”
Section 134(3) (p) of the 2013 Act states that in case of a listed company and every other public company having such paid-up share capital as may be prescribed, the board report will include a statement indicating the manner in which formal annual evaluation has been made by the board of its own performance and that of its committees and individual directors. Section134 (3) (q) of the 2013 Act enables the Central Government to prescribe additional matters for inclusion in the board report.
With regard to section 134(3)(p), sub-rule 8(4) of the Accounts Rules states as below:
- “Every listed company and every other public company having a paid up share capital of twenty five crore rupees or more calculated at the end of the preceding financial year shall include, in the report by its Board of directors, a statement indicating the manner in which formal annual evaluation has been made by the Board of its own performance and that of its committees and individual directors.”
With regard to section 134(3)(q), sub-rule 8(5) of the above rules states as below:
- “In addition to the information and details specified in sub- rule (4), the report of the Board shall also contain: …”
One of the disclosures contained in the sub-rule 8(5) is “the details in respect of adequacy of internal financial controls with reference to the financial statements.”
RC49 requires that discussion on “internal control systems and their adequacy” is included in the MD&A report. Also, the board has to ensure the integrity of the company’s accounting and financial reporting systems, including the independent audit, and that appropriate systems of control are in place, in particular, systems for risk management, financial and operational control, and compliance with the law and relevant standards.
Section 143(3) of the 2013 Act states that the auditor’s report, among other matters, will state “whether the company has adequate internal financial controls system in place and the operating effectiveness of such controls.” This requirement is applicable to all companies, including non-listed public and private companies. Neither the 2013 Act nor the Audit Rules define the term “internal financial controls” for this purpose.
The 2013 Act has already prescribed the directors’ responsibility with respect to internal financial controls. It requires that in case of listed companies, Directors’ Responsibility Statement should state that directors had laid down internal financial controls and such controls are adequate and were operating effectively. For this purpose, “internal financial controls” include both financial reporting controls and business controls. In addition, rule 8(5) under the Accounts Rules requires that the board report should contain details for adequacy of financial reporting controls. The rules do not refer to adequacy of business controls.
Given the specific requirement in the 2013 Act, what is the relevance of requirement on similar matter prescribed in the Accounts Rules? How do these two requirements interact with each other?
One view is that the 2013 Act requires directors’ reporting on internal financial control only in case of listed companies. In contrast, auditors are required to report on the existence and operating effectiveness of internal financial controls in all companies. To bridge this gap, the Accounts Rules require directors of even non-listed companies to comment on the matter. Under this argument, the requirement regarding directors’ responsibility will apply as below in table
Place to include directors’ reporting
Directors’ Responsibility Statement
Adequacy/ existence and operating effectiveness of internal financial controls using wider definition in the Act
Adequacy of internal financial controls pertaining to financial statements
In this view, there is no conflict between the requirements of the 2013 Act and the Accounts Rules. Also, the directors’ responsibility with regard to reporting on internal financial controls will be in sync with the auditors’ responsibility. In the case of listed companies, the directors’ responsibility will be based on the wider definition of internal financial controls (i.e., both financial reporting controls and business controls); whereas in the case of non-listed companies, the definition of internal financial controls is narrowed to financial reporting controls.
The second view is that the MCA has included this provision in the Accounts Rules to address significant concerns that were being raised about the definition of internal financial controls and to bring the same in line with the global practices. Hence, the intention of the MCA is to restrict internal financial control reporting in case of listed companies to financial reporting controls only; it does not intend to extend such reporting to non-listed companies. In this view, there are two fall outs. The first concern is that in trying to narrow the definition of internal financial controls, the Accounts Rules have inadvertently made the requirement applicable to non-listed companies. The second concern is that of the Accounts Rules overriding the 2013 Act.
The third view is that the directors of both listed and non-listed companies are required to report on internal financial controls pertaining to financial statements, i.e., financial reporting controls only. Under this view, the Accounts Rules have the effect of (i) extending the internal financial control reporting requirement to non-listed companies, and (ii) narrowing the definition of “internal financial control” to financial reporting controls. In this view, the Accounts Rules are overriding the2013 Act.
It may be appropriate for the MCA/ ICAI to address this issue. Until such guidance or clarification is provided, our preferred view is that the 2013 Act and the Accounts Rules should be read harmoniously so that there is no conflict. Hence, our preferred approach is to apply the first view.
Reference is drawn to sub-rules 8(4) and 8(5) of the Accounts Rules as reproduced above. Sub-rule 8(4) deals with annual evaluation of the board, and is applicable to listed and specified class of public companies. Sub-rule 8(5) prescribes other matters, including comment on internal financial controls, to be included in the board report. Sub-rule 8(5) starts by stating that “in addition to matters prescribed under sub-rule 8(4).” Does it mean that the requirements under sub- rule 8(5) apply only to companies prescribed in the sub-rule8 (4)?
Sub-rule 8(5) of the Accounts Rules is worded in a confusing manner. One view is that by drawing reference, its applicability is restricted only to companies mentioned in the sub-rule 8(4), i.e., listed companies and public companies having paid-up share capital of `25 crore or more at the end of the preceding financial year. The second view is that sub-rule 8(4) and 8(5) are independent and have been issued in the context of two different sections, i.e., section 134(3) (p) and section 134(3) (q), of the 2013 Act, respectively. Whilst the first section refers to “class of companies”; there is no such reference in the latter. Also, the sub-rule 8(5) does not state that its applicability is restricted only to companies mentioned in the sub-rule 8(4). Hence, the requirements covered under the sub-rule 8(5) apply to all companies, including private companies.
We expect that the MCA/ICAI may provide guidance on various issues regarding internal financial control reporting. Until any guidance or clarification is provided, our understanding is that sub-rule 8(4) and 8(5) are independent. Hence, our preferred approach is to apply the second view on this issue, i.e., requirements covered under sub-rule 8(5) apply to all companies.
The term “internal financial controls” is not explained in the context of auditors’ reporting responsibility. What is the scope of auditors’ responsibility for reporting on internal financial controls?
In the 2013 Act, the meaning of the term “internal financial controls” is given only in the explanation to section 134(5) clause (e). The explanation begins with the use of words “for the purposes of this clause” and assigns a wider meaning to the term.
One view is that in the absence of any other definition/ explanation, the explanation to clause (e) in section 134(5) is relevant for deciding the auditors’ reporting responsibility as well. This implies that an auditor needs to report on internal financial controls relating not only to the financial statements, but also other matters such as policies and procedures for ensuring orderly and efficient conduct of business and safeguarding of assets, i.e., auditors’ reporting includes both financial reporting controls and business controls.
The second view is that before using the explanation given for the purposes of a particular section for interpreting another section, one needs to look at the context. The directors of a company are responsible for overseeing all aspects relating to functioning of a company. Hence, wider meaning of the term ‘internal financial controls’ in the context of their responsibility may be somewhat justified. However, the auditors’ responsibility is only with regard to reporting on financial statements and matters connected therewith. An auditor is typically not expected to look into or comment on strategic and operational business decisions, including whether management is running business efficiently. In many cases, an auditor may not have sufficient knowledge/expertise to do so. Basis this, the proponents of this view suggest that the auditor is required to comment only about adequacy/existence and operating effectiveness of internal financial controls pertaining to financial statements, i.e., financial reporting controls only.
We understand that the ICAI is developing guidance on various issues arising from the 2013 Act, including the framework on auditors’ responsibility to report on internal financial controls. Until such guidance or clarification is provided by the ICAI, our preferred approach is to apply the second view. We expect that the ICAI may clarify the same in due course.
In accordance with section 129(4) of the 2013 Act, the requirement concerning preparation, adoption and audit of the financial statements of a holding company, mutatis mutandis, apply to the CFS. Does it mean that directors as well as auditor of a parent company are also required to comment regarding existence and operating effectiveness of internal financial controls in the entire group?
Neither section 129(4) nor any other section of the 2013 Act requires the provisions concerning preparation of the board report of a parent company to be applied, mutatis mutandis, to the consolidated board report. In fact, there is no concept of a “consolidated board report” under the 2013 Act. Rather, sub- rule 8 in the Accounts Rules is clear that board report needs to be prepared based on the standalone financial statements of a company. Considering this, directors of a parent company are not required to comment regarding adequacy/ existence and operating effectiveness of internal financial controls for the group as a whole.
With regard to auditors’ reporting responsibilities, two views seem possible. The first view is that section 129(4) of the2013 Act deals with issuance of audit opinion on the CFS, i.e., whether CFS present true and fair view in accordance with the applicable accounting standards. Reporting on internal financial control is not the same as issuing audit opinion on the CFS. Hence, auditors’ reporting on internal financial control does not apply to the CFS.
According to the supporters of the second view, section 143(3) requires reporting on “internal financial control” to be part of the auditors’ report. Hence, section 129(4) read with section143 (3) indicates that the requirements concerning auditors’ reporting on internal financial control are likely to apply to the CFS as well.
From our perspective, the second view appears to be a more logical reading of the relevant sections of the 2013Act. However, the final decision rests with the MCA/ ICAI. In providing guidance, the ICAI may consider providing exemptions/ relaxations for immaterial subsidiaries and newly acquired subsidiaries included in the CFS, on the lines of exemption available under the SOX Act. The ICAI may also consider providing guidance on how to deal with associates and jointly controlled entities accounted for using the equity method and proportionate consolidation, respectively, in the CFS, where the parent may not have the right/ authority to evaluate the internal financial controls and/or may lack the access necessary to make such an evaluation.
The auditor of a parent company and the CFS may not be the auditor of all the subsidiaries, associates and joint ventures that are included in the CFS. In such cases, the parent company and its auditor will have to put a system in place whereby the auditor of each of the component includes in their audit report, the reporting on internal financial controls. The parent company’s auditor can use these audit reports to finalize the reporting on internal financial controls on a consolidated basis. This is an approach similar to what is currently being followed for issuing audit report on the CFS.
The Guidance Note on Audit of Consolidated Financial Statements allows the parent company auditor to rely upon the work performed by the auditors of subsidiaries, associates and joint ventures, while issuing audit opinion on the CFS. In such cases, the auditors’ report on CFS may draw attention to the fact that part of the audit of the group was carried out by other auditor(s). To avoid any potential issue, it is suggested that the ICAI issues similar guidance for reporting by auditors on matters relating to internal financial controls also.
Other key perspectives
The director’s and auditor are reporting concerning internal financial controls will be with respect to periods commencing from 1 April 2015 or after. For a company, whose financial year begins on 1 April 2015, this implies that the system of internal financial controls should be in place and be operating effectively from 1 April 2015. It may be noted that sections containing requirements concerning internal financial controls were notified on 26 March 2014 and the final rules were issued on 27 March/31 March 2014.
- Definition of the term “subsidiary”
What the Companies Act 2013 states:
Definition of the term “subsidiary”
In accordance with the 2013 Act, “’Subsidiary company’ or ‘subsidiary,’ in relation to any other company (that is to say the holding company), means a company in which the holding company:
- Controls the composition of the board of directors, or
- Exercises or controls more than one-half of the total share capital either on its own or together with one or more of its subsidiary companies.”
The draft rules stated that for the above purpose, total share capital includes both paid-up equity share capital and preference share capital. This resulted in a very unique situation whereby a lender providing finance to a company in the form of redeemable preference shares would treat the borrower as its subsidiary, if the preference shares worked out to be more than 50% of the total share capital.
In the Definition Rules, the definition of total share capital is changed. The Definition Rules state that for the purposes of definition of subsidiary and associate company, “total share capital” comprises paid-up equity share capital and convertible preference share capital. In our view, a convertible preference share includes both optionally as well as compulsorily convertible preference shares. However, preference shares with no option of conversion into equity capital will not be considered for determining if a company is a subsidiary/ associate company. Also, instruments, such as, convertible warrants or options and convertible debentures, are not considered for determining if a company is a subsidiary/ associate company.
Undoubtedly, the Definition Rules represent an improvement vis-à-vis the draft rules. However, it leaves scope for significant structuring. Consider the following two examples:
- For regulatory and other purposes, company A does not want to present a loss making entity (company B) as its subsidiary. Company B may issue convertible debentures to company A. The convertible debentures give it tremendous powers, but unlike preference shares are not considered for determination of subsidiary.
Though company A is completely funding and possibly in control of company B, it would not be treating company B, as its subsidiary.
- Consider another scenario, company C desires to present a hugely profit making company D as its subsidiary, though it may not have any board control. Company D plans to get significant equity investment from an investor J whereby J will own the entire equity capital of D, and also control the board of D. Company D issues new equity shares to J and J also acquires the existing equity capital of D from the market. Also, D issues to C, optionally convertible redeemable preference shares (exceeding the 50% threshold), where conversion right is non-substantive, deeply out of the money and in practical terms may never get exercised. In this case, J in substance controls D. However, based on the definition, it may be possible to argue that both J and C control D. Whilst AS 21 recognizes that a subsidiary may have two parent companies; however, it is may not reflect true economic substance of the arrangement.
Is the definition of the term “subsidiary company” under the2013 Act in sync with the definition under AS 21? If this is not the case, which definition should be used for preparing CFS?
AS 21 read with AS 23 is clear that potential equity shares of the investee are not considered for determining voting power. Also, control under AS 21 is based on voting power, as against total share capital ownership under the 2013 Act. Hence, the definition of the term “subsidiary company” under the 2013Act is different from that under AS 21.
- One view is that the Accounts Rules, among other matters, state that consolidation of financial statements will be made in accordance with the applicable accounting standards. Thus, for preparing CFS, definition given under AS 21 is relevant. For legal and regulatory purposes, definition of subsidiary as per the 2013 Act should be used.
However, there are others who do not appear to be convinced with the view expressed in the previous paragraph. They point out that it is a well settled position in India that in case of conflicting requirements between the statute and accounting standards, the law will prevail. They further argue that the final rule requires the use of accounting standards (AS 21) for preparing CFS but is not relevant for identifying the subsidiaries that will be included in the CFS. For identifying the subsidiaries, definition under the 2013 Act should be used.
This is an area where MCA/ICAI needs to provide guidance. Until such guidance or clarification is provided or AS 21 is revised, our preferred view is that identification of subsidiaries for consolidation should be based on the economic substance; rather than, mere legal form. If definition given in the 2013Act is used to identify subsidiaries for CFS, one may end-up consolidating companies where the reporting company has provided loan in the form of convertible preference shares that do not have any voting power. Hence, our preference is to apply the first view. Under this view, a company applies AS 21 definition to identify subsidiaries to be consolidated. For legal and regulatory purposes, definition of subsidiary as per the2013 Act should be used.
- Consolidated financial statements
What the Companies Act 2013 states:
Section 129(3) of the 2013 Act requires that a company having one or more subsidiaries will, in addition to separate financial statements, prepare CFS. Hence, the 2013 Act requires all companies, including non-listed and private companies, having subsidiaries to prepare CFS.
The 2013 Act also provides the below:
- CFS will be prepared in the same form and manner as SFS of the parent company.
- The Central Government may provide for the consolidation of accounts of companies in such manner as may be prescribed.
- The requirements concerning preparation, adoption and audit of financial statements will, mutatis mutandis, apply to CFS.
- An explanation to section dealing with preparation of CFS states that “for the purposes of this sub-section, the word subsidiary includes associate company and joint venture.”
While there is no change in section 129(3), rule 6 under the Companies (Accounts) Rules 2014 deals with the “Manner of consolidation of accounts.” It states that the consolidation of financial statements of a company will be done in accordance with the provisions of Schedule III to the Act and the applicable accounting standards. The proviso to this rule states as below:
- “Provided that in case of a company covered under sub-section (3) of section 129 which is not required to prepare consolidated financial statements under the Accounting Standards, it shall be sufficient if the company complies with provisions on consolidated financial statements provided in Schedule III of the Act.”
Given below is an overview of key requirements under the Schedule III concerning CFS:
- Where a company is required to prepare CFS, it will mutatis mutandis follow the requirements of this Schedule as applicable to a company in the preparation of balance sheet and statement of profit and loss.
- In CFS, the following will be disclosed by way of additional information:
- In respect of each subsidiary, associate and joint venture, % of net assets as % of consolidated net assets.
- In respect of each subsidiary, associate and joint venture, % shares in profit or loss as % of consolidated profit or loss. Disclosures at (i) and (ii) are further sub-categorized into Indian and foreign subsidiaries, associates and joint ventures.
- For minority interest in all subsidiaries, % of net assets and % share as in profit or loss as % of consolidated net assets and consolidated profit or loss, separately.
- All subsidiaries, associates and joint ventures (both Indian or foreign) will be covered under CFS.
- A company will disclose list of subsidiaries, associates or joint ventures which have not been consolidated along with the reasons of non-consolidation.
AS 21 does not mandate a company to present CFS. Rather, it merely states that if a company presents CFS for complying with the requirements of any statute or otherwise, it should prepare and present CFS in accordance with AS 21. Keeping this in view and proviso to the rule 6, can a company having subsidiary take a view that it need not prepare CFS?
This question is not relevant to listed companies, since the listing agreement requires listed companies with subsidiaries to prepare CFS. This question is therefore relevant from the perspective of a non-listed company.
Some argue that because neither AS 21 nor Schedule III mandates preparation of CFS, the Accounts Rules have the effect of not requiring a CFS. Instead, a company should present statement containing information, such as share in profit/loss and net assets of each subsidiary, associate and joint ventures, as additional information in the Annual Report. In this view, the Accounts Rules would override the 2013 Act. If it was indeed the intention not to require CFS, then it appears inconsistent with the requirement to present a statement containing information such as share in profit/loss and net assets of each of the component in the group.
Others argue that the requirement to prepare CFS is arising from the 2013 Act and the Accounts Rules/ accounting standards cannot override/ change that requirement. To support this view, it is also being argued that the Accounts Rules refer to AS 21 for the requirement concerning preparation of CFS and AS 21, in turn, refers to the governing law which happens to be the 2013 Act. Hence, the Accounts Rules/ AS 21 also mandate preparation of CFS. According to the supporters of this view, the proviso given in the Accounts Rules deals with specific exemptions in AS 21 from consolidating certain subsidiaries which operate under severe long-term restrictions or are acquired and held exclusively with a view to its subsequent disposal in the near future. If this was indeed the intention, then the proviso appears to be poorly drafted, because the exemption should not have been for preparing CFS, but for excluding certain subsidiaries in the CFS.
In our view, this is an area where the MCA/ ICAI need to provide guidance/ clarification. Until such guidance/ clarifications are provided, our preferred approach is to read the “proviso” mentioned above in a manner that the Accounts Rules do not override the 2013 Act. Hence, our preference is to apply the second view, i.e., all companies (listed and non-listed) having one or more subsidiary need to prepare CFS.
IFRS exempts non-listed intermediate holding companies from preparing CFS if certain conditions are fulfilled. Is there any such exemption under the 2013 Act read with the Accounts Rules?
Attention is invited to discussion on the previous issue regarding need to prepare CFS. As mentioned earlier, our preferred view is that all companies having one or more subsidiary need to prepare CFS. Under this view, there is no exemption for non-listed intermediate holding companies from preparing CFS. Hence, all companies having one or more subsidiaries need to prepare CFS.
Currently, the listing agreement permits companies to prepare and submit consolidated financial results/financial statements in compliance with IFRS as issued by the IASB. For a company taking this option, there is no requirement to prepare CFS under Indian GAAP. Will this position continue under the 2013 Act?
Attention is invited to discussion on the earlier issue regarding the requirement to prepare CFS. As mentioned earlier, our preferred view is that CFS is required for all companies having one or more subsidiary. The Accounts Rules are clear that consolidation of financial statements will be done in accordance with the provisions of Schedule III to the 2013 Act and the applicable accounting standards. Hence, companies will have to mandatorily prepare Indian GAAP CFS, and may choose either to continue preparing IFRS CFS as additional information or discontinue preparing them.
In the presentation of the Union Budget 2014–15, the Honourable Minister for Finance, Corporate Affairs and Information and Broadcasting proposed the adoption of Ind AS. In accordance with the Budget statement, the MCA has notified Company (Indian Accounting Standard) Rules 2015 vide its G.S.R dated 16 February 2015.
Salient features of the roadmap
Phase I applicable from 1 April 2016 onward to:
- Listed or unlisted companies whose net worth is >= Rs 5,000m
- Holding, subsidiaries, joint ventures or associates of these companies
- Listed companies whose net worth is < Rs 5,000m
- Unlisted companies whose net worth is >= Rs 2,500m but < Rs 5,000m
- Holding, subsidiaries, joint ventures or associates of these companies
Early adoption permitted from 1 April 2015, with one year comparatives.
Once adopted, cannot be revoked.
Companies not covered by the roadmap to continue to apply existing standards under Companies (Accounting Standards) Rules, 2006 Indian GAAP.
An explanation to section 129(3) of the 2013 Act states that “for the purpose of this sub-section, the word subsidiary includes associate company and joint venture.” The meaning of this explanation is not clear. Does it mean that a company will need to prepare CFS even if it does not have any subsidiary but has an associate or joint venture?
The following two views seem possible on this matter:
- One view is that under the notified AS, the application of equity method/proportionate consolidation to associate/ joint ventures is required only when a company has subsidiaries and prepares CFS. Moreover, the Accounts Rules clarify that CFS need to be prepared as per applicable accounting standards. Hence, the proponents of this view argue that that a company is not required to prepare CFS if it does not have a subsidiary but has an associate or a joint venture.
- The second view is that the above explanation requires associates/joint ventures to be treated at par with subsidiary for deciding whether CFS needs to be prepared. Moreover, the 2013 Act decides the need to prepare CFS and the Accounts Rules are relevant only for the manner of consolidating entities identified as subsidiaries, associates and joint ventures. Hence, CFS is prepared when the company has an associate or joint venture, even though it does not have any subsidiary. The associate and joint venture are accounted for using the equity/proportionate consolidation method in the CFS.
We understand that the MCA/ICAI may provide an appropriate guidance on this issue in the due course. Until such guidance is provided, from our perspective, the second view appears to be more logical reading of the explanation. Hence, our preference is to apply the second view.
Section 129(4) read with Schedule III to the 2013 Act suggests that disclosure requirements of Schedule III mutatis mutandis apply in the preparation of CFS. In contrast, explanation to paragraph 6 of AS 21 exempts disclosure of statutory information in the CFS. Will this exemption continue under the 2013 Act?
A company will need to give all disclosures required by Schedule III to the 2013 Act, including statutory information, in the CFS. To support this view, it may be argued that AS21 (explanation to paragraph 6) had given exemption from disclosure of statutory information because the 1956 Act did not require CFS. With the enactment of the 2013 Act, this position has changed. Also, the exemption in AS 21 is optional and therefore this should not be seen as a conflict between AS21 and Schedule III. In other words, the statutory information required by Schedule III for SFS will also apply to CFS.
The disclosures given in the CFS will include information for parent, all subsidiaries (including foreign subsidiaries) and proportionate share for joint ventures. For associates accounted for using equity method, disclosures will not apply. This ensures consistency with the manner in which investments in subsidiaries, joint ventures and associates are treated in CFS.
Some practical challenges are likely to arise in implementing the above requirement. For example,
- It is not clear as to how a company will give disclosures such as import, export, earnings and expenditure in foreign currency, for foreign subsidiaries and joint ventures. Let us assume that an Indian company has US subsidiary that buys and sells goods in USD. From CFS perspective, should the purchase/sale in US be treated as import/export of goods? Should such purchase/sale be presented as foreign currency earning/expenditure?
- How should a company deal with intra-group foreign currency denominated transactions which may get eliminated on consolidation? Let us assume that there are sale/purchase transactions between the Indian parent and its overseas subsidiaries, which get eliminated on consolidation. Will these transactions require disclosure as export/import in the CFS?
ICAI should provide appropriate guidance on such practical issues. Until such guidance is provided, differing views are possible. One view is that the MCA has mandated these disclosures to present information regarding imports/exports made and foreign currency earned/spent by Indian companies. To meet disclosure objective, CFS should contain disclosures such as import, export, earnings and expenditure in foreign currency for the parent plus Indian subsidiaries (100% share) and Indian joint ventures (proportionate share). These disclosures may be omitted for foreign subsidiaries and joint ventures. Since disclosures for foreign operations are not being given, there may not be any intra-group elimination.
The second view is that Schedule III has mandated specific disclosures and one should look at disclosures required and ensure compliance. Hence, for each subsidiary and joint venture, import, export, earnings and expenditure in foreign currency is identified based on its domicile country and reporting currency. To illustrate, for a US subsidiary having USD reporting currency, any sale and purchase outside US is treated as export and import, respectively. Similarly, any income/ expenditure in non-USD currency is foreign currency income/ expenditure. Under this view, intra-group transactions may either be eliminated or included in both import and export.
In the absence of specific guidance/clarification, we believe that first view is the preferred approach. To explain the approach adopted, we recommend that an appropriate note is given in the financial statements.
Assume that the 2013 Act requires even non-listed and private groups to prepare CFS. Under this assumption, the following two issues need to be considered:
- The date from which the requirement concerning preparation of CFS will apply. Particularly, is it mandatory for non-listed/private groups to prepare CFS for the year- ended 31 March 2014?
- Whether the comparative numbers need to be given in the first set of CFS presented by an existing group?
- Basis the General Circular no. 8/2014 dated 4 April2014, non-listed/private groups need to prepare CFS from financial years beginning on or after 1 April 2014.
- Regarding the second issue, Schedule III states that except for the first financial statements prepared by a company after incorporation, presentation of comparative amounts is mandatory. In contrast, transitional provisions to AS 21 exempt presentation of comparative numbers in the first set of CFS prepared even by an existing group.
- One may argue that there is no conflict between transitional provisions of AS 21 and Schedule III. Rather, AS 21 gives an exemption which is not allowed under the Schedule III. Hence, presentation of comparative numbers is mandatory in the first set of CFS prepared by an existing company.
- Subsidiary financial statements
What the Companies Act 2013 states:
A proviso to section 136(1) of the 2013 Act requires every company having one or more subsidiaries to:
- Place separate audited accounts in respect of each of its subsidiary on its website, if any
- Provide a copy of separate audited financial statements in respect of each of its subsidiary, to a shareholder who asks for it.
The listing agreement requires all listed companies to maintain a functional website containing basic information about the company, including financial information. The 2013 Act does not mandate non-listed companies to have their website.
The 2013 Act requires a listed company to place its financial statements, including CFS, if any, and all other documents required to be attached thereto, on its website. Listed companies are also required to place financial statements of their subsidiaries on the website. For non-listed companies, the 2013 Act only requires financial statements of subsidiaries to be hosted on the website, if they have one. Interestingly, it does not mandate non-listed companies to place their own SFS or CFS on the website, even if they have one. However, many companies may choose to do so voluntarily.
The discussion below explains key issues relating to foreign subsidiary’s financial statements. Though these discussions refer to these financial statements for hosting on the website, they equally apply when they are not hosted on website. For example, in the case of a non-listed company, it may not have a website and hence would not be required to host the financial statements of foreign subsidiaries on the website. Nonetheless, the discussions below would still be relevant as these financial statements are required to be made available to shareholders on request.
Are financial statements of foreign subsidiaries, for placing on the website, needed to be prepared in accordance with Indian GAAP, i.e., notified accounting standards and Schedule III? Or will it be sufficient compliance if a company uses the financial statements prepared as per local GAAP for this purpose.
Neither the 2013 Act nor the final Accounts Rules provide any guidance on this matter. In the absence of guidance, one possible view is that it is acceptable to host foreign subsidiaries’ local GAAP financial statements on the website. The proponents of this view make the following arguments:
- Requirement to host subsidiaries’ financial statements on the website is given in a proviso to section 136(1). Section129, which deals with preparation of financial statements as per notified accounting standards and Schedule III, is not applicable to foreign companies.
- Section 2(40) of the 2013 Act defines the term “financial statements.” It prescribes minimum components of financial statements; however, it does not require whether these financial statements should be prepared as per Indian GAAP or any other GAAP.
The counter view is that financial statements of foreign subsidiaries to be hosted on the parent company’s website need to be prepared as per Indian GAAP. The proponents of this view make the following arguments:
- Attention is drawn to the fourth proviso to section 137(1).It requires financial statements of foreign subsidiaries to be filed with the RoC. This seems to suggest that these financial statements are subject to certain requirements of Indian regulation and, therefore, should be prepared in accordance with the requirements of the 2013 Act.
- Section 2(40) only defines the minimum components of financial statements. It does not prescribe as to how these financial statements should be prepared. Section129, which requires financial statements to be prepared in accordance with Indian GAAP, is relevant for preparing all financial statements required to be prepared under the2013 Act.
ICAI should provide guidance on this issue. Until such guidance is provided, our preferred view is that it is acceptable to host foreign subsidiaries’ local GAAP financial statements on the website.
Whether the financial statements of foreign subsidiaries need to be translated into English for hosting on its website/ giving them to shareholders? Let us assume that an Indian parent company has a Chinese subsidiary which has prepared its financial statements in the Chinese language. Would a Chinese version of the financial statements suffice for hosting on the website or the Indian parent will need to host an English version?
No specific guidance under the 2013 Act is available on this matter. There is nothing specific in the 2013 Act which prohibits a non-English version. However, a non-English version may not serve any useful purpose. Also, the financial statements of foreign subsidiaries need to be filed with the RoC. There are other provisions in the 2013 Act, e.g., section380 and 381, which require certified English translation before filing the documents with the RoC. One may argue that the same analogy would apply. Considering this and to meet the requirement in spirit, a company may have to translate financial statements in English before hosting them on its website. Currently also, companies are following similar practices.
Some foreign jurisdictions do not require an audit of financial statements. Is it compulsory to have financial statements of a foreign subsidiary audited under the 2013 Act?
The 2013 Act is clear. Companies with one or more subsidiaries need to place audited financial statements of each subsidiary on their website, if they have one. It also requires companies to provide a copy of audited financial statements of each subsidiary to shareholders on their request. The language used suggests that it is mandatory for a company to have financial statements of all its subsidiaries audited for this purpose, even if there is no other requirement to have a foreign subsidiary financial statements audited.
Are financial statements of foreign subsidiaries to be audited by an Indian auditor or foreign auditor?
Neither the 2013 Act nor the Accounts Rules nor Audit Rules contain an explicit requirement for audit of foreign subsidiaries by an Indian auditor. In the absence of any specific requirement, one may argue that it is acceptable if financial statements of foreign subsidiaries prepared in accordance with their local GAAP are audited by a foreign auditor. To support this view, it may also be argued that foreign auditor has comparatively better knowledge about local GAAP of foreign subsidiary and laws/regulations impacting financial statements in the respective jurisdiction. Hence, the foreign auditor will be better equipped to audit local GAAP financial statements of foreign subsidiaries.
However, the counter argument is that financial statements will be treated as “audited” only if the audit is carried out in accordance with the requirements of the 2013 Act. Hence, there is a requirement to get financial statements of each foreign subsidiary audited in accordance with the requirements of the 2013 Act.
ICAI should provide guidance on this issue. Until such guidance is provided, our preferred view is that it is acceptable if financial statements of foreign subsidiaries prepared in accordance with their local GAAP are audited by a foreign auditor.
In accordance with the first proviso to section 129(3), a company needs to attach along with its financial statements, a separate statement containing the salient features of the financial statements of its subsidiaries in such form as may be prescribed. In this context, Form AOC-1 requires companies to present the statement containing information, such as, share capital, reserves & surplus, total assets, total liabilities, investments, turnover, profit before taxation, provision for taxation and profit after taxation, for each subsidiary. For foreign subsidiaries, should this information be prepared in accordance with Indian GAAP or the local GAAP of the subsidiary?
Attention is invited to our earlier discussions on whether the financial statements of foreign subsidiaries need to be prepared in accordance with Indian GAAP. Similar arguments may apply here as well, except that this requirement is contained in section 129 and not section 136.
One view is that statement containing salient features should be prepared based on the local GAAP financial statements of all subsidiaries. Under this view, salient features of Indian subsidiaries are prepared using Indian GAAP financial statements and those of foreign subsidiaries are prepared using their local GAAP financial statements.
The second view is that most of the information required in Form AOC-1 is basic financial information. For foreign subsidiaries also, such information under Indian GAAP is readily available from their reporting packages used for consolidation purposes. Hence, the statement containing salient features for all subsidiaries (including foreign subsidiaries) should be prepared based on Indian GAAP numbers.
Our preferred approach is to apply the second view on this matter.
- Abridged financial statements
What the Companies Act 2013 states:
Like the 1956 Act, the 2013 Act also allows listed companies to circulate AFS. The Accounts Rules contain a format (Form AOC-3) for presentation of AFS, which is similar to the format prescribed under the 1956 Act. Additionally, the Accounts Rules contain the following clarification:
- “Where a company is required to prepare consolidated financial statements i.e. consolidated balance sheet and consolidated statement of profit and loss, the company shall mutatis mutandis follow the requirements of Schedule III of the Act, as applicable to a company in the preparation of balance sheet and statement of profit and loss. In addition, the consolidated financial statements shall disclose the information as per the requirements specified in the applicable Accounting Standards including the items specified at Serial numbers (1) and (2) under the heading ‘general instructions for the preparation of consolidated financial statements’ contained in the said Schedule.”
From the above, it appears that the preparation and circulation of abridged CFS is not allowed. Thus, AFS will be allowed only in the case of separate financial statements. This also ensures consistency with clause 32 of the listing agreement.
What the Companies Act 2013 states:
Amendments in Schedule II to the 2013 Act
Minimum vs. indicative rates
In Schedule II originally notified, all companies were divided into three classes.
- Class I basically included companies which may eventually apply Ind-AS. These companies were permitted to adopt a useful life or residual value, other than those prescribed under the schedule, for their assets, provided they disclose justification for the same.
- Class II covered companies or assets where useful lives or residual value are prescribed by a regulatory authority constituted under an act of the Parliament or by the Central Government. These companies will use depreciation rates/useful lives and residual values prescribed by the relevant authority.
- Class III covered all other companies. For these companies, the useful life of an asset will not be longer than the useful life and the residual value will not be higher than that prescribed in Schedule II.
Pursuant to a recent amendment to Schedule II, distinction between class (i) and class (iii) has been removed. Rather, the provision now reads as under:
- “(i) The useful life of an asset shall not be longer than the useful life specified in Part ‘C’ and the residual value of an asset shall not be more than five per cent of the original cost of the asset:
Provided that where a company uses a useful life or residual value of the asset which is different from the above limits, justification for the difference shall be disclosed in its financial statement.”
From the use of word “different”, it seems clear that both higher and lower useful life and residual value are allowed. However, a company needs to disclose justification for using higher/lower life and/or residual value. Such disclosure will form part of the financial statements.
Continuous process plant
Under Schedule II as originally notified, useful life of the CPP, for which there is no special depreciation rate otherwise prescribed, was 8 years. This was a major concern for certain companies using CPP as they would have been required to write-off their entire plant over 8 years. The amendment to Schedule II has resolved the issue as useful life of the CPP has now been increased to 25 years. Moreover, the impact of amendment as explained in the preceding paragraph is that a company can depreciate its CPP over a period shorter or longer than 25 years, with proper justification.
In accordance with amendment made to Schedule XIV to the1956 Act in April 2012, a company was allowed to use revenue based amortization for intangible assets (toll roads) created under BOT, BOOT or any other form of PPP route (collectively, referred to as “BOT assets”). Since Schedule II as originally notified did not contain a similar provision, an issue had arisen whether revenue based amortization will be allowed going forward.
The recent amendment to Schedule II has addressed this concern. In accordance with the amendment, a company may use revenue based amortization for BOT assets. For amortization of other intangible assets, AS 26 needs to be applied.
Double/ triple shift working
Under Schedule II, no separate rates/ lives are prescribed for extra shift working. Rather, it states that for the period of time, an asset is used in double shift depreciation will increase by50% and by 100% in case of triple shift working.
Let us assume that a company has purchased one plant and machinery three years prior to the commencement of the2013 Act. Under Schedule XIV, single, double and triple shift depreciation rates applicable to the asset are 4.75%, 7.42% and10.34%, respectively. Under Schedule II, its life is 15 years. For all three years, the company has used the asset on a triple shift basis and therefore, depreciated 31.02% of its cost over three years. For simplicity, residual value is ignored.
On transition to Schedule II, the asset has remaining Schedule II life of 12 years, i.e., 15 years – 3 years. The management has estimated that on single shift basis, remaining AS 6 life is also 12 years. The company will depreciate carrying amount of the asset over 12 years on a straight-line basis. If the company uses the asset on triple shift basis during any subsequent year, depreciation so computed will be increased by 100%. In case of double shift, depreciation will be increased by 50%.
With regard to the adjustment of impact arising on the first- time application, the transitional provisions to Schedule II state as below:
“From the date Schedule II comes into effect, the carrying amount of the asset as on that date:
- Will be depreciated over the remaining useful life of the asset as per this Schedule,
After retaining the residual value, will be recognised in the opening balance of retained earnings where the remaining useful life of an asset is nil.”
Proviso in the latest amendment to Schedule II states that if a company uses a useful life or residual value of the asset which is different from limit given in the Schedule II, justification for the difference is disclosed in its financial statements. How is this proviso applied if notified accounting standards, particularly, AS 6 is also to be complied with?
AS 6 states that depreciation rates prescribed under the statute are minimum. If management’s estimate of the useful life of an asset is shorter than that envisaged under the statute, depreciation is computed by applying the higher rate. The interaction of the above proviso and AS 6 is explained with simple examples:
- The management has estimated the useful life of an asset to be 10 years. The life envisaged under the Schedule II is 12 years. In this case, AS 6 requires the company to depreciate the asset using 10 year life only. In addition, Schedule II requires disclosure of justification for using the lower life. The company cannot use 12 year life for depreciation.
- The management has estimated the useful life of an asset to be 12 years. The life envisaged under the Schedule II is 10 years. In this case, the company has an option to depreciate the asset using either 10 year life prescribed in the Schedule II or the estimated useful life, i.e., 12 years. If the company depreciates the asset over the 12 years, it needs to disclose justification for using the higher life. The company should apply the option selected consistently.
- Similar position will apply for the residual value. The management has estimated that AS 6 life of an asset and life envisaged in the Schedule II is 10 years. The estimated AS 6 residual value of the asset is nil. The residual value envisaged under the Schedule II is 5%. In this case, AS 6 depreciation is the minimum threshold. The company cannot use 5% residual value. In addition, Schedule II requires disclosure of justification for using a lower residual value.
- Alternatively, let us assume that the management has estimated AS 6 residual value of the asset to be 10%of the original cost, as against 5% value envisaged in the Schedule II. In this case, the company has an option to depreciate the asset using either 5% residual value prescribed in the Schedule II or the estimated AS 6 residual value, i.e., 10% of the original cost. If the company depreciates the asset using 10% estimated residual value, it needs to disclose justification for using the higher residual value. The company should apply the option selected consistently.
Whether the amendment regarding BOT assets allows revenue based amortization only for toll roads? Or can a company apply revenue based amortization to other type of intangible assets created under the BOT model?
The amendment in Schedule II reads as follows “For intangible assets, the provisions of the accounting standards applicable for the time being in force shall apply except in case of intangible assets (Toll roads) created under BOT, BOOT or any other form of public private partnership route in case of road projects.” The amendment clearly suggests that revenue based amortization applies to toll roads. The same method cannot be used for other intangible assets even if they are created under PPP schemes, such as airport infrastructure.
Schedule II clarifies that the useful life is given for whole of the asset. If the cost of a part of the asset is significant to total cost of the asset and useful life of that part is different from the useful life of the remaining asset, useful life of that significant part will be determined separately. This implies that component accounting is mandatory under Schedule II. How does component accounting interact with AS 6 requirements and the amendment in the Schedule II, which allows higher or lower useful life, subject to appropriate justification being provided?
Component accounting requires a company to identify and depreciate significant components with different useful lives separately. The application of component accounting is likely to cause significant change in the measurement of depreciation and accounting for replacement costs. Currently, companies need to expense replacement costs in the year of incurrence. Under component accounting, companies will capitalize these costs as a separate component of the asset, with consequent expensing of net carrying value of the replaced part.
The application of component accounting, including its interaction with Schedule II rates and AS 6 requirements, is likely to vary depending on whether a company treats useful life given in the Schedule II as maximum life of the asset (including its components) or it is treated as indicative life only. Particular, attention is invited to earlier discussions regarding interaction between AS 6 and the proviso added through the recent amendment to Schedule II. Let us assume that the useful life of an asset as envisaged under the Schedule II is 10 years. The management has also estimated that the useful life of the principal asset is 10 years. If a component of the asset has useful life of 8 years, AS 6 requires the company to depreciate the component using 8 year life only. However, if the component has 12 year life, the company has an option to either depreciate the component using either 10 year life as prescribed in the Schedule II or over its estimated useful life of12 years, with appropriate justification. The company should apply the option selected consistently.
Is component accounting required to be done retrospectively or prospectively?
Component accounting is required to be done for the entire block of assets as at 1 April 1 2014. It cannot be restricted to only new assets acquired after 1 April 2014.
How do transitional provisions in Schedule II apply to component accounting?
AS 10 gives companies an option to follow the component accounting; it does not mandate the same. In contrast, component accounting is mandatory under the Schedule II. Considering this, we believe that the transitional provisions of Schedule II can be used to adjust the impact of component accounting. If a component has zero remaining useful life on the date of Schedule II becoming effective, i.e., 1 April 2014, its carrying amount, after retaining any residual value, will be charged to the opening balance of retained earnings. The carrying amount of other components, i.e., components whose remaining useful life is not nil on 1 April 2014, is depreciated over their remaining useful life. The transitional provisions relating to the principal asset minus the components are discussed elsewhere in this publication.
In case of revaluation of fixed assets, companies are currently allowed to transfer an amount equivalent to the additional depreciation on account of the upward revaluation of fixed assets from the revaluation reserve to P&L. Hence, any upward revaluation of fixed assets does not impact P&L. Will the same position continue under the 2013 Act also? If not, how can a company utilize revaluation reserve going forward?
Under the 1956 Act, depreciation was to be provided on the original cost of an asset. Considering this, the ICAI Guidance Note on Treatment of Reserve Created on Revaluation of Fixed Assets allowed an amount equivalent to the additional depreciation on account of the upward revaluation of fixed assets to be transferred from the revaluation reserve to the P&L.
In contrast, schedule II to the 2013 Act requires depreciation to be provided on historical cost or the amount substituted for the historical cost. In Schedule II as originally notified, this requirement was contained at two places, viz., Part A and notes in Part C. Pursuant to recent amendment in Schedule II, the concerned note from part C has been deleted. However, there is no change in Part A and it still requires depreciation to be provided on historical cost or the amount substituted for the historical cost. Therefore, in case of revaluation, a company needs to charge depreciation based on the revalued amount. Consequently, the ICAI Guidance Note, which allows an amount equivalent to the additional depreciation on account of upward revaluation to be recouped from the revaluation reserve, may not apply. Charging full depreciation based on the revalued amount is expected to have significant negative impact on the P&L.
AS 10 allows amount standing to the credit of revaluation reserve to be transferred directly to the general reserve on retirement or disposal of revalued asset. A company may transfer the whole of the reserve when the asset is sold or disposed of. Alternatively, it may transfer proportionate amount as the asset is depreciated.
Schedule II to the 2013 Act is applicable from 1 April 2014. Related rules, if any, also apply from the same date. It may be noted that the requirements of Schedule II are relevant not only for preparing financial statements, but also for purposes such as declaration of dividend. Given this background, is Schedule II applicable to financial years beginning on or after 1 April 2014 or it also needs to be applied to financial statements for earlier periods if they are authorized for issuance post 1 April 2014?
Schedule II is applicable from 1 April 2014. As already mentioned, Schedule II contains depreciation rates in the context of Section 123 dealing with “Declaration and payment of dividend” and companies use the same rate for the preparation of financial statements as well. Section 123, which is effective from 1 April 2014, among other matters, states that a company cannot declare dividend for any financial year except out of (i) profit for the year arrived at after providing for depreciation in accordance with Schedule II, or (ii) …
Considering the above, one view is that for declaring any dividend after 1 April 2014, a company needs to determine profit in accordance with Section 123. This is irrespective of the financial year-end of a company. Hence, a company uses Schedule II principles and rates for charging depreciation in all financial statements finalized on or after 1 April 2014, even if these financial statements relate to earlier periods.
The second view is that based on the General Circular 8/2014, depreciation rates and principles prescribed in Schedule II are relevant only for the financial years commencing on or after 1April 2014. The language used in the General Circular 8/2014, including reference to depreciation rates in its first paragraph, seems to suggest that second view should be applied. For financial years beginning prior to 1 April 2014, depreciation rates prescribed under the Schedule XIV to the 1956 Act will continue to be used.
In our view, second view is the preferred approach for charging depreciation in the financial statements. For dividend declaration related issues, reference is drawn to discussion under the section “Declaration and payment of dividend.”
How do the transitional provisions apply in different situations? In situation 1, earlier Schedule XIV and now Schedule II provide a useful life, which is much higher than AS 6 useful life. In situation 2, earlier Schedule XIV and now Schedule II provide a useful life, which is much shorter than AS 6 useful life.
In situation 1, the company follows AS 6 useful life under the1956 as well as the 2013 Act. In other words, status quo is maintained and there is no change in depreciation. Hence, the transitional provisions become irrelevant. In situation 2, when the company changes from Schedule XIV to Schedule II useful life, the transitional provisions would apply. For example, let’s assume the useful life of an asset under Schedule XIV, Schedule II and AS 6 is 12, 8 and 16 years respectively. The company changes the useful life from 12 to 8 years and the asset has already completed 8 years of useful life, i.e., its remaining useful life on the transition date is nil. In this case, the transitional provisions would apply and the company will adjust the carrying amount of the asset as on that date, after retaining residual value, in the opening balance of retained earnings. If, on the other hand, the company changes the useful life from12 years to 16 years, the company will depreciate the carrying amount of the asset as on 1 April 2014 prospectively over the remaining useful life of the asset. This treatment is required both under the transitional provisions to Schedule II and AS 6.
Let us assume that a company has adjusted WDV of an asset to retained earnings in accordance with the transitional provisions given in Schedule II? Should such adjustment be net of related tax benefit?
Attention is invited to the ICAI announcement titled, “Tax effect of expenses/income adjusted directly against the reserves and/ or Securities Premium Account.” The Announcement, among other matters, states as below:
- “… Any expense charged directly to reserves and/or Securities Premium Account should be net of tax benefits expected to arise from the admissibility of such expenses for tax purposes. Similarly, any income credited directly to a reserve account or a similar account should be net of its tax effect.”
Considering the above, it seems clear that amount adjusted to reserves should be net of tax benefit, if any.
- Declaration and payment of dividend
What the Companies Act 2013 states:
The 2013 Act states that a company will not declare/pay dividend for any financial year except:
- Out of profits of the company for that year after depreciation
- Out of accumulated profits for any previous financial year(s) arrived at after providing for depreciation
- Out of both
- Out of money provided by Central Government/state government for payment of dividend in pursuance of any guarantee given by them.
The 2013 Act contains the following provisions for interim dividend:
- Interim dividend may be declared during any financial year out of the surplus in the P&L and out of profits of the financial year in which interim dividend is sought to be declared.
- If a company has incurred loss during the current financial year up to the end of the quarter immediately preceding the date of declaration of interim dividend, such interim dividend will not be declared at a rate higher than the average dividends declared by the company during the immediately preceding three financial years.
Whilst the 2013 Act does not mandatorily require a specified percentage of profits to be transferred to reserves, it contains specific conditions for declaration of dividend out of reserves. The Dividend Rules state that “in the event of adequacy or absence of profits in any year, a company may declare dividend out of surplus subject to the fulfilment of the prescribed conditions” (emphasis added). The Dividend Rules prescribe the following conditions in this regard:
- Rate of dividend declared will not exceed the average of the rates at which dividend was declared by it in 3 years immediately preceding that year. However, this restriction does not apply to a company, which has not declared any dividend in each of the three preceding financial years.
- Total amount to be drawn from accumulated profits will not exceed an amount equal to 1/10th of the sum of its paid-up share capital and free reserves.
- The amount so drawn will first be utilized to set off losses incurred in the financial year before any dividend in respect of preference or equity shares is declared.
- The balance of reserves after such withdrawal will not fall below 15% of its paid up share capital.
- No company will declare dividend unless carried over previous losses and depreciation not provided in previous year are set off against profit of the company of the current year. The loss or depreciation, whichever is less, in previous years is set off against the profit of the company for the year for which dividend is declared or paid.
From the first condition, it appears that a company having history of dividend can declare maximum dividend upto past three years’ average. However, there is no limitation for companies not having dividend payout history.
Under the 1956 Act, the rules relating to dividend declaration out of reserves applied to declaring of dividends out of reserves but did not apply for declaring dividend out of accumulated past years’ profit lying in the P&L surplus. The Dividend Rules issued under the 2013 Act indicate that restrictions under the rules may apply even for declaring dividend out of opening P&L surplus. Does it mean that a company can no longer freely declare dividend from accumulated past year profits lying in the P&L surplus?
There seems to be some confusion on this matter. Whilst the2013 Act allows declaring both interim and final dividend out of previous years’ accumulated profit, the language used in the Dividend Rules indicate that such declaration will be subject to conditions laid down in the Dividend Rules.
One view is that the 2013 Act allows free distribution of dividend out of past year accumulated profits and the Dividend Rules cannot override this position. Hence, the restrictions prescribed in the Dividend Rules do not impact declaration of dividend out of accumulated P&L surplus balance.
The second view is that the 2013 Act and Dividend Rules should be read harmoniously. The Dividend Rules do not override/ change the provision of the 2013 Act; rather, they only prescribe top-up condition. Moreover, in the 2013 Act, the definition of the term “free reserves,” includes previous years’ accumulated profit. Hence, going forward, companies will need to comply with the Dividend Rules for declaring dividend from previous years’ accumulated profits.
We believe that the MCA did not intend to make requirements concerning declaration of dividend out of surplus stricter under the 2013 Act vis-à-vis those under the 1956 Act. The language used in section 123 suggests this. Hence, view 1 appears to be preferred approach. However, one may not rule out possibility of different view. To avoid any potential challenges, the MCA should provide clarification on this matter. Until such clarification is provided, we suggest that a company proposing to declare dividend out of P&L surplus balance consults the legal professionals.
Unlike the 1956 Act, the 2013 Act does not contain provision for adjustment of past losses before declaring dividend from the current year profit. Does it mean that a company may declare dividend from current year profit without adjusting past losses?
Whilst the 2013 Act does not contain provision requiring adjustment of past losses/depreciation before declaring dividend from the current year profit, similar provision is contained in the final Dividend Rules. The rule reads as below:
- “No company shall declare dividend unless carried over previous losses and depreciation not provided in previous year are set off against profit of the company of the current year. The loss or depreciation, whichever is less, in previous years is set off against the profit of the company for the year for which dividend is declared or paid.”
The above paragraph should be typically appearing as an independent rule. However, currently, it is mixed with the declaration of dividend out of reserve requirements.
How does the option given in the Schedule II to use higher useful life interact with the dividend related provisions of the 2013 Act? Assuming that an asset has AS 6 useful life which is much longer than the life prescribed in Schedule II. In accordance with the proviso recently added in the Schedule II, a company elects to depreciate the asset over its AS 6 useful life. For the purposes of calculating profit for declaration of dividend, is the company required to charge additional depreciation to comply with Schedule II life?
Section 123(1) and (2) of the 2013 Act require that for the purpose of declaring dividend, profit should be calculated in accordance with the provisions of Schedule II. Since the Schedule II itself allows the company to charge depreciation based on AS 6 useful life, we believe that there is no need to charge additional depreciation to comply with Schedule II life for the purpose of calculating profit for declaration of dividend.
Section 123 of the 2013 Act dealing with declaration of dividend is applicable from 1 April 2014. The Dividend Rules also apply from the same date. Does it mean that dividend declared on or after 1 April 2014 is governed by the requirements of the 2013 Act? Alternatively, can a company take a view that General Circular No 8/2014 applies and therefore the 2013 Act will apply for declaring dividend in respect of financial years beginning on or after 1 April 2014?
General Circular 8/2014 is relevant only for preparation of financial statements, board report and auditors’ report. Declaration of dividend does not fall under any of the three items. Hence, the General Circular is not relevant in this case.
Section 123 of the 2013 Act applies to dividends declared on or after 1 April 2014. Hence, it may be argued that any dividend declared by a company on or after 1 April 2014 is governed by the requirements of the 2013 Act. The acceptance of this view, among other matters, implies that a company declaring dividend on or after 1 April 2014 will not be required to transfer any profits to reserves.
Whilst the above view seems appropriate from dividend distribution perspective; there is confusion regarding its interaction with provision related to financial statements. Section 123 also requires that even profit for the concerned year should be determined as per the 2013 Act. However, this may not be permitted under General Circular 8/2014 which states that financial statements for financial year beginning earlier than 1 April 2014 are prepared as per the requirements of the 1956 Act. Please refer “Depreciation” section of the publication for discussion on the issue related to charging of depreciation in the financial statements for financial year beginning prior to 1 April 2014 and its interaction with dividend declaration requirements.
The MCA/ICAI should provide appropriate guidance on this matter. Until such guidance is provided, a company may need to consult its legal professionals on how to deal with this issue.
- Utilization of securities premium
What the Companies Act 2013 states:
Under the 2013 Act, companies covered under the prescribed class will not be allowed to use the securities premium for the following key purposes:
- Issue of fully paid preference shares as bonus shares
- Writing off preliminary expenses of the company
- Writing off debentures and preference share issue expenses
- Providing for premium payable on redemption of preference shares/debentures
It is understood that the Central Government introduced these restriction over the use of securities premium to align the accounting requirement with Ind-AS. Since Ind-AS are currently not notified, the rules do not define companies which will be covered under the prescribed class. This implies that currently, there will be no company covered under the prescribed class and the above restrictions will not apply.
It may be noted that the ICAI has recently proposed a new roadmap for implementation of Ind-AS in India and submitted it to the MCA for its consideration. The roadmap recommends preparation of Ind-AS accounts only at the CFS level. It seems that even companies, which are covered under the eligibility criteria for preparation of Ind-AS CFS, will continue preparing SFS in accordance with Indian GAAP. A perusal of the section indicates that for these companies, restrictions on utilization of securities may apply in both the Indian GAAP SFS and Ind- AS CFS. We believe that the MCA may further clarify while prescribing companies to whom Ind-AS and the restrictions on utilization of securities premium will apply.
- Free reserves
What the Companies Act 2013 states:
In accordance with the 2013 Act, the term “free reserves” means “such reserves which, as per the latest audited balance sheet of a company, are available for distribution as dividend:
- Any amount representing unrealized gains, notional gains or revaluation of assets, whether shown as a reserve or otherwise, or
- Any change in carrying amount of an asset or of a liability recognized in equity, including surplus in P&L on measurement of the asset or the liability at fair value,
Shall not be treated as free reserves.”
- The definition of the term “free reserves” appears to be based on the principle that a company should not include unrealized gains; but unrealized losses are included for computing free reserves.
One common example of reserve which may typically get excluded is revaluation reserve created on upward revaluation of fixed assets. Similarly, a company, which is applying hedge accounting principles of AS 30, will exclude hedging reserve from the “free reserves” if the hedging reserve has a positive (credit) balance. If the hedging reserve has a negative (debit) balance, it will be deducted from free reserves. An issue is likely to arise when the aggregate hedging reserve is positive, but it includes items with negative and positive balances. In this case, should the company exclude only net positive amount from the hedging reserve? Or should it include losses and exclude profits at each individual instrument level? No clear guidance is available on this issue. In the absence of clear guidance, it appears that a company may elect to follow either approach on this matter.
- The manner in which the term “free reserves” is defined, particularly its proviso (a), suggests that unrealized gains, whether shown as reserves or credited to P&L, are not free reserves. Thus, if a company has recognized foreign exchange gains on translation of receivable, payables or loans in accordance with AS-11 or recognized mark-to- market gains on derivative contracts in accordance with AS-30, such gains are not treated as free reserves. A company includes these amounts in free reserves upon realization, e.g., when receivable is realized or derivative is settled. Interestingly, any unrealized losses on the same will be treated as a reduction of the free reserves.
The application of this principle is likely to create some practical challenges. Tracking the unrealized gains and its subsequent realization on an individual item basis will be a very cumbersome exercise.
- It may be noted that the term ‘free reserves’ do not include securities premium. However the term ‘net worth’ will include securities premium. It is important to understand these fine nuances because these terms are frequently used in the 2013 Act; for example, with respect to limits on loans and investments.
- Debenture redemption reserve
What the Companies Act 2013 states:
Section 71(4) of the 2013 Act requires that where debentures are issued by a company under this section, the company will create a DRR account out of the profits of the company available for payment of dividend and the amount credited to such account will not be utilised by the company except for the redemption of debentures.
The SCD Rules contain the following provision regarding creation of DRR:
- DRR is created out of the profits of the company available for payment of dividend.
- The company needs to create DRR equivalent to atleast50% of the amount raised through the debenture issue before debenture redemption commences.
- Every company required to create DRR needs to invest/ deposit a sum, which will not be less than 15% of the amount of debentures maturing during the following year, in specified deposits/securities.
- In case of partly convertible debentures, DRR will be created in respect of non-convertible portion of debenture issue.
- The amount credited to DRR will not be utilised by the company other than for the purpose of redemption of debentures.
Under the 1956 Act, threshold for minimum DRR varied depending on the class of companies. These thresholds were lower than those prescribed under the 2013 Act. Table 2 describes minimum DRR required for debentures.
Class of company
All India Financial Institutions regulated by Reserve Bank of India and Banking Companies
NBFCs and other financial institutions
Other companies including manufacturing and infrastructure companies
Section 2(30) of the 2013 Act defines debenture as “debenture” includes “debenture stock, bonds or any other instrument of a company evidencing a debt, whether constituting a charge on the assets of the company or not” (emphasis added). Section 2(12) of the 1956 Act defined debenture as “debenture” includes “debenture stock, bonds and any other securities of a company, whether constituting a
charge on the assets of the company or not” (emphasis added).
There seems to be an argument that the word “instrument” used in the 2013 Act has a wider meaning than the word “security” used in the 1956 Act. Thus, the definition under the2013 Act may include several instruments, e.g., commercial paper and promissory note evidencing debt, as debenture, beyond our normal understanding of a debenture. This is particularly onerous, if one considers it together with the requirement to create a DRR on all such instruments.
The applicability of the 2013 Act requires higher DRR to be created vis-à-vis that required under the 1956 Act. How does it impact the creation of DRR for debentures issued prior to the commencement of the 2013 Act?
The language used in section 71(4) suggests that it deals only with creation of DRR for debentures issued under section71, i.e., any new debenture issued on or after 1 April 2014. For debentures issued before 1 April 2014, the requirements of the 1956 Act continues to apply. Let us assume that a manufacturing company has issued two tranches of non- convertible debentures. The first tranche was issued on28 March 2014 and the next tranche on 4 April 2014. The creation of DRR on the first tranche is governed by the 1956Act and the company needs to create a minimum DRR of 25%. The creation of DRR on the second tranche is governed by the2013 Act and the company needs to create minimum DRR of50% on the second tranche.
The SCD Rules state that in case of partly convertible debentures, DRR will be created in respect of non-convertible portion of debenture issue. However, there is no such clarity for FCDs. Does it mean that minimum 50% DRR needs to be created on the amounts raised through issuance of FCDs?
The logical answer is that no DRR is required to be created. However, in the absence of any exemption under the 2013Act/SCD from creation of DRR for FCDs, some argue that a minimum 50% DRR needs to be created on the entire amount of FCD. However, the acceptance of this argument may give outrageous results. Let us assume that a company has issued partly convertible debentures, where 99% of the debentures have conversion option. In this case, DRR needs to be created only for 1% non-convertible portion. However, if all the debentures were having conversion option, the company will need to create a minimum 50% DRR. This obviously cannot be the intention of the law. The MCA should provide clarification on this matter.
- Re-opening/revision of accounts
What the Companies Act 2013 states:
The 2013 Act contains separate provisions relating to:
- Re-opening of accounts on the court/tribunal’s order
- Voluntary revision of financial statements or board’s report
Re-opening of accounts on the court/tribunal’s order
On an application made by the Central Government, the Income-tax authorities, the SEBI, any other statutory/regulatory body or any person concerned, the tribunal/court may pass an order to the effect that:
- The relevant earlier accounts were prepared in a fraudulent manner, or
- The affairs of the company were mismanaged during the relevant period, casting a doubt on the reliability of financial statements
If the tribunal/court issues the above order, a company will need to re-open its books of account and recast its financial statements.
Voluntary revision of financial statements or board’s report
If it appears to directors that financial statements/board’s report do not comply with the relevant requirements of the2013 Act, the company may revise financial statements/board report in respect of any of the three preceding financial years. For revision, a company will need to obtain prior approval of the tribunal.
The Tribunal, before passing the order for revision, will give notice to the Central Government and the Income-tax authorities and consider their representations, if any.
Detailed reasons for revision of such financial statement/ board’s report will be disclosed in the board’s report for the relevant financial year in which such revision is being made.
The provisions of the 2013 Act concerning re-opening/revision of accounts are yet to be notified. The MCA has issued the draft rules concerning these provisions. However, the final rules on this subject are still awaited. The date from which the provisions of the 2013 Act concerning re-opening/revision of accounts apply is unknown.
Reopening of accounts whether voluntarily or mandatorily is not an easy process. The draft rules had prescribed several onerous steps which need to be completed for revision. Also, there are certain issues which are not clear. Given below is an overview of key aspects which may need to be considered:
- If the present auditor is different from the auditor who audited original financial statements, the current auditor is required to audit and report on the revised financial statements. However, before such revision, the views of the original auditor also need to be obtained and considered.
- Before the board approves any revision of financial statements or board report, the proposed revision is to be presented to the directors who authenticated the original financial statements/board report. Dissent and dissent vote, if any, at the board meeting, on such revision should be recorded with reasons in the minutes of the board meeting.
- If a company revises its financial statements for a period earlier than the immediately preceding financial year, it is mandatory to revise financial statements for all subsequent periods. However, it is not clear whether the revision of SFS will also trigger the revision of CFS.
- Many merger, amalgamation and reconstruction schemes approved by the court contain an appointed date which is earlier than the beginning of the current financial year. It is not clear whether a company will be required/allowed to revise its financial statements for earlier periods to give effect to the court scheme from the appointed date.
- In case of a voluntary change in accounting policy, error and reclassification, Ind-AS requires that comparative amount appearing in the current period financial statements should be restated. One may argue that this amounts to voluntary revision of financial statements for earlier periods. While the 2013 Act allows revision of previous period financial statements to correct an error, it is not clear whether a company is also allowed to revise financial statements in other cases, say, to apply change in accounting policy with retrospective effect.
We expect that the MCA may clarify these issues in the final rules.