Just catch-up or an opportunity for true change?
As with all good things, corporate India had to wait a long time for a reporting framework that's current and, with some work, could even be considered visionary
Comply or explain
Introduction of the 'comply or explain' principle in the case of corporate social responsibility, instead of a mandatory rule, is one such example. A mandatory rule to spend on social responsibility wouldn't be different from a tax; it would only encourage those with no intentions to comply to find ways to comply in form but not in substance.
In any case, our regulators do not have the bandwidth to monitor whether hundreds of thousands of companies have spent money to the 'appropriate' end-use on something as ambiguous as social responsibility. (A PRIMER: All you wanted to know about the new companies law)
The UK regulatory framework has long used this 'comply or explain' approach and while every system has its weaknesses, this principles-based approach is one of the many reasons why the UK is number seven on the ease-of-doing-business index, while we stand at 132 out of 185 countries. I hope we enhance the use of principles and the 'comply or explain' approach in our regulatory framework, as opposed to rules and consequences, as a balancer between best practices and something critical.
National financial reporting authority (NFRA)
Globally, the issue of enhancing auditor independence has been high on the regulatory agenda through the last decade. The basic principle of independence is being seen as independent by a third party, not whether one considers oneself independent. Globally, the audit profession started as a self-regulated one by the so-called audit profession-led institutes - the American Institute of Certified Public Accountants in the US, the Institute of Chartered Accountants in England and Wales in the UK, the Institute of Chartered Accountants of India (ICAI) in India.
India was once at the forefront in this space, as a founder member of the International Federation of Accountants, where all such institutes came together to help improve global standards. Over the last decade, about 30 countries have seen regulatory powers shift from these self-regulated institutes to independent regulators such as the Public Company Accounting Oversight Board in the US and the Financial Reporting Council in the UK. Emerging markets such as South Africa and relatively smaller economies such as Liechtenstein have also preferred to adopt independent regulation of the profession, so that the profession is seen as truly independent and the answer to the question of "who audits the auditor?" can be "an independent regulator", not "another auditor!"
Before investing in a company, would you prefer to rely on audited financial statements in a jurisdiction where the auditors' work is subject to review by an independent agency or where the their work is checked by someone from their own fraternity? Obviously, the NFRA, the proposed independent regulator, would see opposition from ICAI, just like its counterparts did in developed and developing markets.
However, there is no doubt the formation of the NFRA is a step towards where the rest of the world has already moved.
| EASE OF BUSINESS |
|
Mandatory audit firm rotation (MFR)
Now, an audit firm is supposed to rotate off an audit if it has completed 10 years. The intent of the Bill is through the next three years, any audit firm that completes 10 years with a client is expected to be replaced by a new one.
Globally, MFR has been actively discussed as a potential solution to break the so-called auditor-client nexus and the threat posed by the long-term association between firms and clients. Every step that provides the perception of enhancing auditor independence should be tried. To this extent, I welcome the leadership shown by India in becoming the first major economy to legislate MFR.
At the same time, the ability to monitor its implementation in spirit is what we need to focus on while framing the phases in which MFR should be extended. A one-size-fits-all approach, through which all listed companies would have to rotate auditors over a three-year period in a country with about 7,000 listed companies and about 1,000 firms that serve such companies, has the potential to create hurdles for companies in finding a suitable new audit firm.
Also, the regulators would find it difficult to monitor compliance in substance and many audit firms would find it difficult to remain commercially viable.
Therefore, a phased implementation of MFR, using a publicly-available list (possibly based on the size of public interest involved), is something that should be encouraged by all stakeholders. The regulators should review the results from MFR and to what extent it served its purpose, before extending it to the next phase of large and listed companies.
Class-action law suits
Generally, penalties in India have been found to be inadequate in serving as deterrents, let alone the slow pace of enforcement. The Bill has corrected this by providing shareholders the opportunity to challenge companies and auditors with class action law suits. A class action suit, by definition, is one brought by a person/small group, as representative of a larger class, to file for claims against erring parties.
This would effectively enable small investors to pursue legal routes against companies, directors and auditors for wrongful acts. This cannot be anything but good in a place where penalties need to be enhanced multi-fold across almost all laws. At the same time, while we adopt Western-style laws, we need to boost the capacity of our legal system to fairly and reasonably implement such laws.
In summary, the Bill provides an opportunity to catch up and make our corporate regulatory framework a model for other economies with similar characteristics to emulate. We all have a part to play in enabling this change. I hope the significant initiative taken by the minister and the Ministry of Corporate Affairs is supported without self-interest, so that we can achieve both the objectives in the wider public interest. That is an obligation on every regulator, citizen, shareholder, financial investor, promoter, manager and, yes, auditor, if we are to fully achieve the immense potential our entrepreneurs have.
Vishesh Chandiok
National managing partner, Grant Thornton India LLP
National managing partner, Grant Thornton India LLP
It looks like a new wine in a new bottle
Revision in depreciation rates would put considerable financial pressure on many companies
Every company having a net worth of Rs 500 crore or more or a turnover of Rs 1,000 crore or more, or a net profit of Rs 5 crore or Every company having a net worth of Rs 500 crore or more or a turnover of Rs 1,000 crore or more, or a net profit of Rs 5 crore ormore, will be required to spend each year at least two per cent of average net profit of the past three years in corporate social responsibility (CSR) activities. If a company does not spend the amount, the board would have to specify the reasons in its report. At this stage, it is not clear if a company will be forced to spend the amount or if it can get away by just making a disclosure. Hopefully, the rules, still being drafted, will provide clarity. Whether such CSR spend is tax-deductible also requires clarity. For many highly profitable companies, such as some technology companies, the two per cent threshold would mean a huge number, and will result in a significant cash outflow and dent in results. On the other hand, one may argue, the new law provides a structured framework through which such expenditure can be incurred by companies.
Globally, an independent director (ID) is expected to serve as a strategic advisor to management and as a watchdog to protect the interests of minority shareholders. In India, however, most IDs view their role principally as that of a strategic advisor to the promoters. Relatively, most IDs do not perceive their role to be that of a watchdog. The Code for Independent Directors under the Act requires an ID to safeguard the interests of all stakeholders; particularly the minority shareholders. Further, the whole board should act in good faith and in the best interest of the company, its employees, shareholders, the community, and for the protection of the environment. This, coupled with rotation of IDs, will usher in better discipline among independent directors. However, given that the responsibilities have become onerous, companies may find it extremely challenging to hire quality IDs.
Related party transactions (RPTs) that treat shareholders inequitably or oppress minority shareholders tend to damage capital market integrity. The new Act casts a duty on IDs to ensure adequate deliberations are held before approving RPTs and assure stakeholders these are in the interest of the company. Further, a special resolution of disinterested parties is required at the general body meeting when a RPT is not at arm's length. While this would protect minority interests, it could also result in oppression of the majority. Given that the attendance of minority shareholders at an annual general meeting is low, it is possible that a small group of rabble-rousers could block a special resolution and hold the company to ransom.
| PRESSURE ON FINANCIALS |
|
The stock exchange listing agreement mandates listed companies to prepare consolidated financial statements (CFS) annually. However, there was no requirement under any statute for private groups to prepare CFS. Under the new Companies Act, all companies, including private companies that have a subsidiary, will need to prepare CFS. An interesting debate is that in the absence of investors, why should private companies prepare CFS? Probably because of the recent scams and scandals. CFS for private groups will ensure that the regulators and tax authorities have better control over an organisation's activities. For private groups with multiple layers, it would increase compliance cost and bring in clarity.
The Act has revised depreciation rates. Overall, many companies might need to charge higher depreciation because of pruning of useful lives, as compared with the earlier specified rates. Useful life has decreased for general plant and machinery from 20 years to 15, general furniture from 15 to 10 years, continuous process plant from 18 years to eight, and so on. This would put considerable financial pressure on many companies. In some cases, the impact can also be a lower depreciation.
Companies that will have to follow International Financial Reporting Standards (IFRS) in future will not be allowed to utilise the securities premium for writing off preliminary expenses or premium payable on redemption of preference shares/debentures. Currently, the Securities and Exchange Board of India requires all listed companies to comply with accounting standards in a scheme of merger, amalgamation or restructuring.
Under the Act, even private companies will be required to comply with accounting standards during mergers and acquisitions. The accounting of treasury shares is often misused. Currently, companies recognise dividend income on treasury shares and gain or loss arising on sale of treasury shares in the statement of profit and loss. This is inappropriate, because any income cannot be derived by transacting in one's own shares. The Act prohibits companies from creating treasury shares under a high court scheme.
The above provisions in the Act are aligned to the requirements of IFRS and provide a framework for implementing IFRS in India. This will help India align itself with 100 countries that apply IFRS.
Besides, these provisions will bring about a more realistic accounting.
From a company's point of view, the above provisions could reduce tax planning opportunities and might also have a significant negative impact on their results.
Dolphy D'Souza
Partner in a member-firm of Ernst & Young Global
