A new chapter in M&A accounting
BL The new company law prohibits the creation of treasury shares in a merger and acquisition scheme.
The new company law prohibits the creation of treasury shares in a merger and acquisition scheme.
Many companies use merger-and-acquisition schemes to restructure business for reasons ranging from unlocking valuation, rationalising operations and tax benefits to splitting the family wealth. Historically, companies have also used them to clean up balance sheets.
Some companies, for example, have used them to write off expenses or impairment loss directly against the securities premium or other reserves, instead of charging them to profit and loss. This helped present a better P&L and EPS (earnings per share).
To address these anomalies and ensure compliance with accounting standards, listed companies since April 2010 are required to submit an auditor's certificate stating that the treatment in an M&A scheme complies with accounting standards.
For non-listed companies, the responsibility to ensure compliance rested with the Regional Directors/ Registrar of Companies. Under the new Companies Act, the National Company Law Tribunal will not sanction any M&A scheme unless the company's auditor certifies compliance with accounting standards.
Hence, all companies, including non-listed, should comply. This will significantly reduce the opportunities for balance sheet clean-up available to non-listed companies.
However, some opportunities may still be available. For example, no standard prohibits adjustment of debit balance in P&L against the securities premium, if the adjustment is directly through balance sheet transfer.
Certain schemes, previously sanctioned by courts, allow departures from accounting standards not only at the appointed date, but also going forward. For example, a court scheme may have permitted write-off of goodwill impairment/ amortisation for the next 10 years directly against reserves rather than through P&L. It may be argued that the new Act applies only to new schemes approved after its enactment and not earlier.
Another area where the new Act may significantly impact M&A accounting is treasury shares. Under the old Act, companies have used M&A schemes to invest in own shares (treasury shares).
Some companies with treasury shares recognise the dividend income and gain/ loss arising on sale of these shares in P&L. The new Act prohibits the creation of treasury shares in an M&A scheme and, hence, these practices will cease. As the new Act is silent on treasury shares previously held by companies, the restriction will seemingly apply only to new treasury shares.
Currently, no notified accounting standard deals with demerger accounting. The draft rules uploaded online by the Ministry of Corporate Affairs on September 20, 2013, contain specific guidance on such accounting.
The draft rules propose that accounting will follow the conditions stipulated in section 2(19AA) of the Income-tax Act. The demerged company will transfer assets and liabilities at book value. It will recognise the difference between the value of assets and liabilities as capital reserve/ goodwill. The resulting company will recognise assets and liabilities at book value. Shares issued will be credited to share capital account. The excess or deficit will be recognised as capital reserve/ goodwill.
While one appreciates the concern arising from the absence of specific guidance on demerger accounting, it is incorrect to prescribe accounting based on the Income-tax Act requirements.
Accounting treatment should be governed by accounting standards. Also, the draft rules assume a very simple example of demerger to prescribe accounting. In practice, it may involve complex structures. Moreover, the accounting proposed is restrictive and limited.
To illustrate, for a demerged company, treating the difference as goodwill/ capital reserve is one option.
Other possibilities not discussed include treating it as investment in the resulting company or as substance distribution to shareholders. Similarly, for the resulting company, it may be possible to use AS-14 analogy and apply the pooling of interest method. This results in adjustment of surplus or deficit to reserves. The Corporate Affairs Ministry should revisit the matter.
(The author is a senior professional in a member firm of Ernst & Young Global)
(This article was published on September 29, 2013)
A fine balance
The notified GAAR strikes a fine balance between the need for foreign investment flows and the legitimate demands of the Indian exchequer.
The Government has taken the right step in postponing the enforcement of the General Anti Avoidance Rules to 2015-16. Foreign investment flows are critical at this juncture given the precarious state of the country's external account. India's current account deficit of $21.8 billion in the June quarter was partially bridged with the help of increased foreign direct investment inflows. The currency too slid to record lows as sentiment towards the entire emerging market equity and debt assets is dampened by fears that reduced liquidity — when the Federal Reserve begins tapering its quantitative easing program — will erode the value of assets. Against this backdrop, this is hardly the time to stir the hornet's nest by implementing the anti-avoidance rules.
That said, the rules notified do not sacrifice the interest of the Indian exchequer. The fine print reveals that the days when foreign investors were allowed to get away without paying any tax on profits made in India are over. Despite GAAR taking effect only from April 2015, all tax benefits earned after August 2010 will come under scrutiny. As a result, so will foreign institutional investors who are already routing their investments in Indian equity through off-shore tax havens. The government has also not back-tracked from its stance on tax residency certificates being 'essential but not sufficient'. Brass-plate firms will now have to provide evidence regarding the ultimate owner of the funds. FIIs using tax havens will now have to find an alternate (read: legitimate) investment route to Indian assets.
Leaving a large swathe of foreign investors outside the ambit of GAAR will avoid undue turbulence when the rules are enforced. Transactions where the tax benefit is less than Rs 3 crore in an assessment year are beyond the purview of the law. Again, foreign investors not availing themselves of tax benefits under double tax treaties and foreign residents investing in India through registered FIIs will not be subject to this scrutiny. The Government has also done well to leave investments through participatory notes outside the radar of GAAR since flows through this route have whittled down in recent years. All in all, the amended rules strike a fine balance between the need for foreign investment flows and the legitimate demands of the Indian exchequer.
(This article was published on October 1, 2013)
When auditors keep bad company
SEBI can act as an agent of change
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Lessons from NSEL, Satyam — managements should not appoint their own auditors.
October 1, 2013:
When scams break out in the private sector, auditors, too, end up on the firing line, and rightly so. This was evident in the Enron scam in 2001, the Satyam scam in 2009 and the NSEL episode now.
The massive Enron scam in the US, where future sales were booked as current, predictably took its toll on its auditor, Arthur Andersen.
In the case of Satyam, the management booked fictitious sales in order to project financial and profit muscle that it did not possess. Its auditor, Price Waterhouse Coopers, got away with a rap on its knuckles.
Now, Financial Tech, the holding company of NSEL that has defaulted on paying a whopping Rs 5,500 crore to its investors is in the news --- its auditor Deloitte has withdrawn its report pending revision. Withdrawing an audit report smacks of abdication of responsibility.
These are high profile cases, and have therefore come to light. There are many cases of auditors' negligence or complicity that do not hit headlines because the companies are not listed or are low profile.
CAG, AN EXCEPTION
In this depressing scenario of gloom and doom, one set of auditors stands tall, though its detractors are shrugging away its reports as exaggerated ----the Comptroller and Auditor General of India (CAG) and its nominees. The 2G and coal scams are examples. What sets apart the CAG and its private nominees who audit the accounts of public sector companies from auditors of private sector companies is their independence.
The CAG is a constitutional office enjoying considerable freedom. He or she can be removed only through the arduous process of impeachment. And private auditors nominated by the CAG do not have to fear anybody; they are not at the tender mercies of the managements of the companies concerned. They get some audit assignment or the other on a rotational basis, that eschews development of cosy relationship with the management.
The new Companies Act, 2012, has done quite a bit to restore the credibility of auditors in the eyes of the company stakeholders. Rotation of auditors, heavy penalties for mistakes, and assignment of the whistleblower role are commendable initiatives in reviving public confidence. But they fall short of the deep surgery the doctor has ordered.
AUDITORS' INDEPENDENCE
Nothing short of insulating the auditor from the management would bring about the desired results. Even under the proposed regime of auditor rotation, it would effectively be the management at the helm that would choose the auditor and make the appointment, as well as fix the fees.
This arrangement has lowered the dignity of the office of the auditor the world over and fostered the perception that he is the handmaiden of the management; he simply cannot be counted upon to give a fearless and frank report. The only way to end this justified cynicism is to delink his appointment from the management.
Research papers, articles or theses are blind referenced to ensure freedom from bias. But accounts cannot be blind referenced to auditors, as the identity of the client would be known in the course of auditing. Yet, a device must be found that insulates the auditor from the management of the auditee --- while an accused can be seen hobnobbing with his lawyer and a patient can choose his own doctor, there is no way an auditee can be seen hobnobbing with the auditor. Auditing is the only profession that casts the professional in an adversarial role vis-à-vis his client.
LEAVE IT TO sebi
In the event, there is no escape from the CAG-like regime in place for public sector audit. An independent body should be mandated to appoint an auditor every five years for a listed company. That body should not be the ICAI because there would be a lingering suspicion that a powerful member wangled a plum audit. It must necessarily be the market watchdog, SEBI. If SEBI were to conduct the allotment of audit as a transparent exercise once in five years, in full public view, like the allotment of flats by the Delhi Development Authority, it would restore some credibility to the auditing profession.
This could be done by a draw of lots, with the names of the companies in one container and names of auditors meeting the qualifying norms in another. The two can be dipped into at random and displayed in full public view.
Appointment by an independent agency is only the first step in restoring the credibility of the profession. Internal audit has turned out to be at best audit of the efficacy of the system, including internal controls, and at worst, spying of divisional heads and profit centre heads. It would be futile for a statutory auditor to repose faith in and take shelter behind an internal auditor's work.
A meaningful system of peer review, even if it has the effect of pitting one professional against another, must be put in place, if the system of dual audit --- simultaneous audit of the same accounts by two firms of auditors --- is found to be an expensive duplication.
(The author is a Delhi-based chartered accountant.)
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