Dr. J.J.Irani's Report On Company Law
J.J.Irani committee has taken a very pragmatic approach towards the ground realities, emerging economic scenario and the increasingly important role of Indian corporate in global arena. The report contains 13 chapters. Though changes suggested by the committee in each of 13 chapters is important, due to space constrain, I will discuss chapter number 9 only i.e "Accounts and Audit".
ACCOUNTS AND AUDIT
œ Accounting Standards should be notified under the Companies Act early.
œ Consolidation of financial statements should be made mandatory. Requirement of attaching financial statements of subsidiary company(ies) with the holding company to be done away with.
œ Format of financial statements should be prescribed in the Act/Rules. Cash Flow Statement to be made part of mandatory financial statements. Financial year should be aligned to uniformly end on 31 st March. Option to maintain books in electronic form should be given to companies. Books of accounts should be preserved by a company for a period of seven years.
œ Companies should have the option to keep records outside the country also along with safeguards providing for access and production of such records if needed.
œ Small Companies should be given exemptions/relaxations in respect of disclosures relating to financial statements.
œ The financial statements should be signed by MD/CEO/CFO/Company Secretary, wherever applicable, even if they were not present in the meeting which approved the financial statements. All directors present in relevant meeting to sign financial statements. Dissenting director also to sign with dissent note.
œ Listed companies should put full financial statements on their websites. Companies should be allowed to use electronic means for circulation of financial statements. Revision of financial statements should be allowed only in extreme situation such as those dictated by change in law.
œ The Companies (Transfer of Profits to Reserves) Rules, 1975 and The Companies (Declaration of Dividend out of Reserves) Rules, 1975 may be done away with. Provisions relating to payment of Interest out of capital [existing section 208] may be deleted.
œ When Central Govt approves any basis of depreciation, there need not be any restriction of writing off of 95% of cost of the asset over a specified period. The Act should provide flexibility in respect of rates of depreciation for infrastructure or similar projects.
œ Rotation of auditors not be mandated in Law. Auditor to be prohibited from performing certain non-audit functions/services to be specified in Law/rules. Disqualification of auditors to be suitably mentioned in the Law/rules. Basic duties and liability of auditors should be in the Act itself. Quantification of penalty for auditors to be prescribed.
œ Investors to be educated to understand financial statements. Shareholders associations to be enabled to take part actively in this regard.
œ Enabling provisions for empowering Central Government to order Cost audit in certain cases should be retained. Government approval for appointment of Cost Auditor for carrying out such audit is not necessary. Special Audit need not be continued.
BACKGROUND OF RECOMMENDATIONS
1. Proper and accurate compilation of financial information of a corporate and its disclosure, in a manner that is standardized and understood by stakeholders, is central to the credibility of the corporates and soundness of investment decisions by the investors. The preparation of financial information and its audit, therefore, needs to be regulated through law with stringent penalties for non-observance. It would however, not be feasible for the law to prescribe all the details guiding the treatment of this subject. This is a technical matter which needs to be gone into by experts keeping in view the requirements of proper disclosures of financial information in the interests of healthy corporate governance. However, once developed, use of such principles should be mandated through law. Accounting Standards serve a vital function in this respect. These should be developed keeping in view international best practices and provided statutory backing. There should be integration of Accounting Standards with substantive law.
Institutional mechanism for developing Accounting Standards
2. The present statute provides for a mechanism for development of Accounting Standards. We understand that Accounting Standards for the use of Indian corporate sector, taking into account International Accounting Standards, are being developed through the instrumentality of the National Advisory Committee on Accounting Standards (NACAS). This is animportant aspect that needs to be pursued. In the meantime, the Institute of Chartered Accountants of India (ICAI) has done useful work in prescribing operational standards of accounting to fill the gap till Accounting Standards could be notified. We expect that the process of notification of Accounting Standards, incorporating international best practices, would be completed shortly.
3. The Committee took note of the contribution made by the ICAI and the NACAS in development of proposals for Accounting Standards and took the view that the existing institutional mechanism for formulating and notifying Accounting Standards under the Companies Act, 1956 may be retained.
Holding-Subsidiary Accounts and Consolidation
4. The Committee took the view that consolidation of financial statements of subsidiaries with those of holding companies should be mandatory. The Committee discussed the question of the manner of maintenance of accounts of entities other than companies but controlled by companies registered under the Act. With the proposed consolidation of accounts by holding companies, the Committee felt the need for prescribing maintenance of proper records by a non-corporate entity which is controlled by a company to which the provisions of the Act apply. This is because companies are now increasingly controlling entities such as partnership firms, special purpose vehicles, associations, etc. which are non-corporate bodies. Further, the responsibility for proper maintenance of records in such cases should be that of the holding company.
5. With consolidation of financial statements by holding companies on mandatory basis, the provisions requiring attaching the accounts of subsidiary companies with those of holding companies, for circulation to shareholders in accordance with the provisions of the present Companies Act should be done away with. In case the financial statements of a foreign subsidiary are required to be furnished to the shareholders of the holding company, these should be accepted in the same format and currency in which these were prepared as per laws of the relevant country. With implementation of e-governance project, it should be possible to view the records of the companies filed with Registrars through electronic media. Notwithstanding this, both holding and subsidiary companies should be encouraged to make greater use of electronic media to make their published financial accounts available for viewing.
6. Further, the Committee took the view that the holding companies should be required to maintain records relating to consolidation of financial statements for specified periods. Presentation of consolidated financial statements by the holding company should be in addition to the mandatory presentation of individual financial statements of that holding company.
Preservation of Records by the Companies
7. At present, Section 209 (4A) of the Act requires companies to preserve the books of accounts, together with the vouchers relevant to any entry in such books of account, in good order, relating to a period of not less than 8 years immediately preceding the current year. The Committee felt that the rules may provide for preservation of books of account and records of the company for a period of 7 years to bring it in harmony with Income Tax Act.
Form Of Accounting Records And Accounting Standard
8. In order to bring about more transparency and uniformity in the maintenance of accounts, the Committee felt that the companies should continue to be mandated to maintain their books of accounts on accrual basis and double entry method of book keeping. The question arose before the Committee as to whether the form and content of the financial statements needs to be specified separately in the Act or should be left to the Accounting Standards prescribed by the Central Government in consultation with NACAS. After considerable deliberations, it was decided that the form and content of the financial statements and the disclosures required therein need to be provided for under the Act/Rules. Any changes made in the Accounting Standards could be factored in the Act/Rules from time to time. It was also decided that the companies should be given the option to maintain the records in electronic form capable of conversion into hard copy.
Maintenance of Records Outside the Country
9. The companies should have an option to keep records outside the country provided financial information in compliance with the Companies Act is available within the country and written notice is given to the Registrar of the place where the records are kept. However, such a Company should be obligated to produce the records that are kept outside the country, if and when required to do so as specified in the Rules.
Cash Flow Statement To Be Made Mandatory
10. World over, the importance of Cash Flow Statement is being specifically recognized. At present, the listed companies are mandated to include a Cash Flow Statement in the Annual Report and the Standards of Accounting prescribed by ICAI also requires in specified cases a Cash Flow Statement to be submitted along with the Balance Sheet and Profit & Loss Account with a view to make Cash Flow Statement mandatory. The Committee felt that there was a need to include the definition of the term Financial Statement in the Act, to include Profit & Loss Account, Balance Sheet, Cash Flow Statement and Notes on Accounts.
Relaxation/Exemption To Small Companies
11. The Committee was of the view that Small Companies need not be subject to the costs of a regime suited to large companies with a wide stakeholder base. Relaxations to small companies with regard to the format of accounts to be prescribed in the Act/Rules may also be considered. If necessary, a separate format for small companies may be devised. Exemptions from certain disclosures may also be considered and relaxations, if any required, in respect of compliance with Accounting Standards may be provided for while notifying the Accounting Standards. If necessary, a separate Accounting Standard may be framed for small companies.
12. The Companies Act at present does not contain any provision relating to the minimum period of a Financial Year. The Concept Paper has defined the Financial Year with the minimum period of six months. The Committee dwelt on the subject and came to the conclusion that the first financial year should begin from the date of incorporation and end on the immediately succeeding 31 st March and the subsequent Financial Years should also end on 31 st March every year. The definition of Financial Year may be modified to indicate that the duration of the first Financial Year should be minimum three months instead of the six months proposed in the Concept Paper (2004). It was also suggested that the present provisions regarding laying down of the accounts before the shareholders within six months of the end of the Financial Year should continue.
Authentication, Circulation and Revision Of Financial Statements
13. The Committee discussed at length the existing provisions of the Act regarding approval and authentication of accounts, circulation of accounts and filing of accounts with the Regulatory body. The Committee was of the view that the concept of appointment of CFO should be recognized under the Act who should be made responsible for preparation and submission of financial statements to the Board. The financial statements should also be signed by Managing Director, CEO, CFO, and the Company Secretary wherever such functionaries are mandated, whether or not they are present at the Board meeting at which the accounts are adopted. All the Directors who were present in the meeting which approved the accounts should also be mandated to sign the accounts. If a Director dissents, he should also sign the financial statement with the dissent note.
14. It was brought to the notice of the Committee that provisions should be made in law for revision of accounts after its adoption/approval by the shareholders subject to conditions laid down under the law. This should however be possible only in cases where changes in law necessitate restatement with retrospective effect or for rectifying the errors apparent from the records.
15. The provisions under the Companies Act relating to circulation of financial statements should continue. However, the Committee recommended that the financial statements should be permitted to be sent by electronic means instead of hard copy. In the case of listed Companies. Where abridged financial statements are circulated amongst members, the full financial statements should be made available on the web-site and the hard copy thereof should also be made available on request.
Director's Responsibility Statement
16. The Committee noted that the Companies Act was amended by inserting section 217 (2AA) by the Companies (Amendment) Act, 2000, which has brought about inclusion of Directors" Responsibility Statement in the report of the Board of Directors. The Committee was of the view that in addition to the existing requirements, the Responsibility Statement should include that the related party transactions and have been entered into at arm"s length, and if not, the relationships of the directors in such transactions along with the amounts involved have been disclosed as a part of the Director's Report along with management justification thereof. The existing requirement in Section 217 (2AA) requiring a Director R esponsibility statement indicating that the Directors have taken proper and sufficient care for the maintenance of adequate accounting records in accordance with the provisions of the Act and that the books of accounts comply with the accounting standards and policies should continue .
17. The Committee discussed other miscellaneous matters in relation to definition of certain terms such as "derivative", "employees stock option","net worth" etc. the need for rules relating to "Transfer of Profit to Reserves" and "Declaration of Dividend out of Reserves" and related matters. The Committee took the view that the definition of term "derivative" could be omitted from the Companies Act. However, definitions of the terms "Employee Stock Option" and "Networth" may be retained with appropriate modifications to reflect their meaning as per generally accepted terminology. After a detailed debate relating to declaration of dividend only out of the profits of the Company arrived at after complying with the Accounting Standards, the Committee endorse this principle for declaration of dividend.
18. The Committee also took the view that the two sets of existing rules relating to declaration of dividend out of reserves and transfer of profit to reserve were irrelevant in the present environment and may be deleted.
19. The relevance of Section 205(2)(c) of the Act requiring companies to write off at least 95% of the original cost of the asset to the Company was discussed at length. The Committee agreed that there need not be any restriction of writing off 95% of the original cost to the company of the asset over a specified period, on the Central Government in approving the basis of providing depreciation.
20. The measure of depreciation is based on three important parameters viz. depreciable amount, estimated useful life and estimated scrap value. The policy of liberalization of the economy has brought about a public-private co-operation especially in infrastructure projects. Such projects are taken up under BOOT or BOT structure. The general tenure of the agreement in such structures is that the Special Purpose Company (SPC) would be required to ensure construction of the facility and maintenance of the facility to ensure the required quality of service during the concession period. The asset is handed over by the SPC to the Government or its agencies in a physical condition which is similar to the condition at the start of the project. It is therefore necessary that the method of providing for depreciation by the SPC should be administered in a different manner.
21. Law needs to recognize a modified approach for providing depreciation to the assets coming under the category of infrastructure assets. In fact, in some countries, law has recognized that there cannot be a statutory limit on the useful life of a capital asset. Expenditure incurred/to be incurred to maintain the operating capabilities of such eligible assets could be charged off towards permissible depreciation. The Company Law should provide a framework that recognizes rates of depreciation for infrastructure projects where such rates are prescribed by statutory regulator for concerned sector. In all other cases, rates of depreciation may be provided taking into account the special requirements of infrastructure sector, as applicable to a class of projects, under the Company Law.
Appointment of Auditors
22. The issue of appointment of First Auditor of the Company and his subsequent appointments were discussed at length. The relevant provisions as existing in Indian law vis-à-vis those prevalent in USA, UK, Australia and Canada were also discussed. The Committee acknowledged the role of the Audit Committee wherever such Committees were mandated, in recommending the appointment of the Auditors to the Board in general. The Committee recommended that the existing provisions relating to appointment of first Auditor to be made by the Board, failing which by the shareholders and the power of the Central Government to appoint the Auditors whenever the Board/shareholders fail to appoint them were necessary and should continue. The Company should also be required to send intimation to the Registrar of Companies regarding appointment of First Auditors, within 7 days of such appointment.
23. Subsequent to the appointment of First Auditors, the appointment of Auditors should be done on AGM to AGM basis with a power to the Board to fill any casual vacancy. There should not be any situation where the company is without duly appointed Auditors. Such appointment of Auditors should be made by the shareholders taking into account the recommendations of the Board, which, in turn should be arrived at after obtaining the recommendations of the Audit Committee, where such a Committee is mandated or is in existence. In case any of the shareholders wish to propose any other Auditor in place of retiring Auditors, this process should also necessarily seek the views of the Audit Committee. There should be an obligation to intimate appointment of Auditor to Registrar of Companies by the Company within 7 days.
Remuneration of Auditors
24. The Committee discussed the provisions relating to the payment of remuneration to the Auditors and felt that this should be subject to decision by shareholders and that the provisions in the existing law provided a suitable framework for the purpose. However, the Committee felt that the basic remuneration to be termed as "Audit Fee" should be distinguished from reimbursement of expenses. Reimbursement of expenses to Auditors should not form part of remuneration but should be disclosed separately in the Financial Statements along with the Auditor"s fees.
Rotation of Auditors
25. There was a detailed discussion on the need for rotation of Auditors. The view that rotation of Audit partner should take place every five years in the case of all listed Companies was also considered by the Committee. However, the Committee thought it fit that the matter of change of Auditors be left to the shareholders of the Company and the Auditors themselves rather than be provided under law.
Provision of Non-Audit Services
26. The Committee took note of the fact that rendering of non-audit services by Auditors of the Company was is a matter of general concern. The Committee was of the view that rendering of all services by the Auditors which were not related to audit, accounting records or financial statements, should not be prohibited from being rendered by the Auditors subject to a prescribed threshold of materiality. All non audit services may however be pre-approved by Audit Committee where such a committee is mandated or in existence.
An Audit firm should however be prohibited from rendering the following non audit services to its audit client and its subsidiaries:
- Accounting and book keeping services relating to accounting records.
- Internal Audit
- Design and implementation of financial information systems including services related IT systems for preparing financial or management accounts and information flows of a company.
- Actuarial services
- Investment Advisory or Investment banking services
- Rendering of outsourced financial services.
- Management function including provision of temporary staff to audit clients.
Disqualification of Auditors
27. The Committee deliberated on issues relating to disqualification of Auditors. The relevant provisions of the Companies Act in different countries including those existing in India as well as the views of the ICAI on the matter were discussed. The Committee was of the view that the Auditor's position and responsibilities involved access to sensitive market information particularly relating to the profits of the company. There was a possibility of misuse of such information. A view was expressed that the existing ban on an Auditor owning securities of the auditee company should be reviewed and that a concept of materiality be introduced. Considering the wide variation in the sizes of companies, a common prescription to be legislated under law would be difficult. The Committee, therefore, feels that at present there may not be any change in the existing framework. However, the matter may be examined further by the Government in context of the framework of ethical conduct and statutory requirements under the Chartered Accountants Act, 1949 in consultation with ICAI. The conclusions that emerged out of the discussions and deliberations are summed up as follows:
The amount of indebtedness/guarantee be increased beyond the present limit of Rs.1,000/- and such a limits could be prescribed under Rules.
The indebtedness/guarantee of the Auditors should also be extended to cover indebtedness/guarantee to the Directors and all entities whose financial statements are required to be consolidated under the Act.
The disqualification envisaged under the Act/Rules should be applicable not only to the Auditors but also to his relatives, (the term relatives being defined under the Companies Act) any of the associates of the auditor and any entity in which the Auditor has a substantial interest.
The Auditor should disclose holdings in the securities of the company, if any, at the time of appointment. However, the Committee feel that the Auditor would be privy to insight financial information of the company and there could be possibility of making wrongful gain by the Auditors by mis-utilizing such information. The work of the Auditor should be credible and free from conflict of interests. Therefore, the Committee are not in favour of relaxing the prohibition on holding of shares or securities of the subject company by the Auditor. The matter should be examined by the Government in consultation with the ICAI.
Appointment of Auditors other than Retiring Auditors
28. The Committee discussed and agreed that the existing provisions of the Companies Act relating to appointment of Auditors were well established and should continue. However, the retiring auditor should be appointed if in the Annual General Meeting, the accounts of the company for the immediately preceding financial year are not approved.
Duties and Liabilities of Auditors
29. Auditors have the general duty of discharging their statutory functions with care and diligence. Many stakeholders would rely on the auditor's reports for accessing the financial picture of the company. However, there cannot be any specific prescription of negligence keeping in view the expectations of all the stakeholders. However, auditors are required to carry out their work within the discipline of the legal provisions and the standards of accounting/Accounting Standards (where notified). There is a necessity that the work of the auditors should uphold the highest standards of excellence and independence. Non-compliance with such standards should invite stringent penalties. The Committee was of the view that the basic duties of the Auditors and their liability need to be laid down in the law itself instead of in the Rules. Quantification of penalty for Auditors may be prescribed in the Rules.
Powers of Auditor of a Holding Company
30. A view was expressed that the Auditor signing the consolidated financial statement should be empowered to access the books, records and documents of the entities whose accounts are consolidated. It was also felt that such right of the Auditor would be subject to the rules to be framed under the Act. In view of the legal position that a statutory auditor will not be able to access to all books and records of all entities whose accounts are consolidated, by virtue of the limitations of his appointment in the holding company, adequate records stating the basis for consolidation of accounts should be made available to him.
Certification of Internal Control by CEO/CFO
31. The Committee dwelt at length matters connected with Audit and the basic principles governing Audit. The Committee felt the need for a high quality of financial reporting, a strengthened corporate governance mechanism, an independent audit and fearless expression of opinion by the Auditors. The Committee feels that the internal controls in any organization constitute the pillar on which the entire edifice of Audit stands. For this purpose, it was felt that public listed companies be required to have a regime of internal financial controls for their own observance. Active interest of the shareholders’ association in improving the quality of financial reporting, investor education for better understanding of the financial statements combined with presence of internal controls would provide for effective financial reporting.
In sum :-
Internal controls as mandated by the company with the approval of the Audit Committee, if any, should be certified by the CEO and CFO of the Company and in the Directors report through a separate statement on the assessment.
The investors be educated and imparted with better understanding and appreciation of the financial statements. The law should also provide for an active role for the shareholders’ associations in ensuring high quality of financial reporting.
The Audit Committee
32. While considering issues relating to management and governance structures in a company (Chapter IV, para 17.1), this Committee has recommended a committee of the Board on accounting and financial matters to be termed as the Audit Committee.
33. All matters relating to appointment of auditors, examination of the auditor's report along with financial statements prior to consideration and approval by the Board, related party transactions, valuations and other matters involving conflicts of interest should also be referred to the Board only through the Audit Committee.
34. At present, the Companies Act contains provisions relating to maintenance of Cost Records under section 209 (1) (d) and Cost Audit under section 233B of the Companies Act in respect of specified industries. The Committee felt that Cost Records and Cost Audit were important instruments that would enable companies make their operations efficient and exist in a competitive environment.
35. The Committee noted that the present corporate scenario also included a sizeable component of Government owned enterprises or companies operating under administered price mechanism or a regime of subsidies. It would be relevant for the Government or the regulators concerned with non-competitive situations to seek costing data. The Committee, therefore, took the view that while the enabling provision may be retained in the law providing powers to the Government to cause Cost Audit, legislative guidance has to take into account the role of management in addressing cost management issues in context of the liberalized business and economic environment. Further, Government approval for appointment of Cost Auditor for carrying out such Cost Audit was also not considered necessary.
36. The Committee felt that the provisions in the present Act requiring Special Audit under certain circumstances were not relevant in view of the detailed investigation provisions recommended by the Committee. During the course of investigation, it is expected that the inspector would have access to the specialized expertise of various professionals as may be required. Further, such investigation may be carried out by private professionals operating individually or in teams. In this background, Special Audit taken in isolation would serve no useful purpose and may be dispensed with.
Audit of Government Companies
37. The Committee discussed the application of the corporate law framework to Government companies on many occasions and took the view that in general, there should not be any special dispensation for such companies. In respect of audit of Government companies however, Companies Act provide a special regime. Pursuant to Section 19(1) of Comptroller and Auditor-General’s Duties, Powers and Conditions of Service Act, 1971, audit of the accounts of Government companies is conducted by the Comptroller and Auditor General (C&AG) in accordance with the provisions of the Companies Act, 1956, the Auditor (Chartered Accountant) of a Government Company is appointed or re-appointed by the C&AG. It is further stipulated that C&AG shall have the power to (a) direct the auditor to conduct the audit in a specified manner, (b) give instructions on any matter relating to the performance of his functions, (c) conduct himself a supplementary or test audit of the company's accounts and (d) comment upon or supplement the audit report in such manner as he (C&AG) thinks fit. The comments of C&AG are to be placed before AGM along with Auditor's Report.
38. The Committee noted with concern the delays in finalization of the accounts of Government companies. In many cases, Government companies and their directors become liable for penal action but are provided selective exclusions from their liabilities only because they are Government companies. This is leading to an unhealthy situation which must be addressed.
39. While considering classifications of companies in Chapter III of this Report, the Committee discussed the manner in which company law should apply to Government companies (Chapter III, para 7.1-7.4). The law should clearly provide the definition of a Government company in context of ownership of the Central and/or State Government. Therefore, the extension of special exemptions and protections to various commercial ventures taken up by Government companies in the course of their commercial operations along with strategic partners or general public should be done away with so that such entities can operate in the market place on the same terms and conditions as other entities. In particular, reflection of financial information of such ventures by Government companies and their audit should be subject to the common legal regime applicable. The existing delays are enabling a large number of corporate entities to evade their responsibilities and liability for correct disclosure of true and fair financial information in a timely manner. In this context, the relevance of the present section 619B of the Act was considered appropriate for a review.
40. The Committee felt that since statutory audit is conducted by the statutory auditor appointed by the C&AG in the manner directed by him, the test/supplementary audit is superfluous since it would duplicate audit work already done by statutory auditor. Further, where any directions are given by the C&AG to the Statutory Auditor not in accordance with the Accounting Standards, the Statutory Auditor may be required to mention the same in the notes on accounts.