Effect of the EU's 8th directive - Interview in The Hindu Business Line on 3 Dec 2009

To a company, what can be worse than having a qualified audit report? Perhaps, the non-acceptance of the financial statements, despite an opinion from the accounting professional, as in a likely situation that is set to impact corporates with a European financial footprint.

“In just a few more months, these companies run the risk of their financial statements not being accepted by the European Union (EU) member-states where their instruments are listed,” says Aniruddh Sankaran, a senior professional in a member firm of Ernst & Young Global, during the course of a recent interaction with Business Line.

Sankaran cites as examples the Aditya Birla group, Tatas, GAIL, Axis Bank, HDFC Bank, Infosys, Reliance, UB, and Wipro, which have equity/debt listed on European stock exchanges. He explains that the risk of non-acceptance of financial statements emerges from recent changes to the EU's Company Law Directive (widely known as the 8th Directive), designed to restore investor confidence in European capital markets.

“These new changes, the focus of which seems to be the creation of a new and globally-recognisable commercial, regulatory and accountability framework, require that auditors of entities having equity or debt listed on any European stock exchange should, in effect, be ‘accredited' by the relevant member-state where that stock exchange is situated.”

Excerpts from the interview, carried out over the phone and through email:

First, what is the scale of the problem that we have on hand, in terms of the number of Indian companies that would be impacted by the Directive?

At present, of the 7,000-plus entities listed across various capital markets in the European Union (EU), nearly 300 are Indian issuers. This includes listing of debt and equity instruments. These issuers are audited by around 90 different Indian auditors and/or audit firms. By virtue of the amended Directive, auditors of these issuers will now need to be registered with the relevant member-state(s) of the EU.

Is there a history behind the 8th Directive? Are there similar such regulations in other countries that Indian corporates should be aware of?

The 8th Directive, or more formally, the EU's Company Law Directive, was initially adopted in April 1984. However, in its original form, it did not specifically address quality assurance by external regulators.

The recent amendments attempt to rectify that position and clarify matters such as duties, ethics, independence, etc, of auditors. The focus seems to be the creation of a new and globally-recognisable commercial, regulatory and accountability framework. There is also an attempt to improve coordination between regulators in the EU and those outside the EU, such as the Public Company Accounting Oversight Board (PCAOB) in the US.

At present, the UK, Germany, Ireland, the Netherlands, Norway and Denmark have registration requirements for auditors, under the 8th directive. Other jurisdictions within the EU are expected to join soon. The PCAOB in the US also has oversight requirements for its registrants and, in some cases, affiliates of such registrants as well.

What is the process for an Indian audit firm to be registered with EU member-states? Also, what are the costs?

The European Group of Auditors' Oversight Bodies (EGAOB) have worked together to develop model application forms and guidance material. There are two types of scenarios currently envisaged — full registration and transitional relief.
In general, full registration will require information that includes particulars of the audit firm or auditor, status of existing registrations, a list of relevant audit clients, Transparency Report, confirmation of good repute, to list a few, that need to be filed with the regulator.

For auditors and audit firms that are not able to comply with the requirements for full registration, a transitional relief is available. This provides the option to auditors to file minimal documentation, and yet continue to be registered. Transitional relief is not available to auditors of all countries, but only to those in a specified list of 36 countries.

Registration requirements vary by country. Also, registration is not “passportable,” so registration is required for each country. However, registration as such requires filing of these specified documents, and a lot of time is involved. Nevertheless, cash costs of registration itself are not expected to be significant.

India is one of the countries eligible for transitional relief. However, one must be aware that although there are some benefits of the relief, it is available only up to June 2010 (December 2010 in some cases). Also, in a couple of instances, the documentation to be filed for it is more than what is needed for full registration. Therefore, for obvious reasons, transitional relief may not be the best approach.

Can you describe the likely adverse effects of non-acceptance of audit reports in the EU states?

The changes to the 8th Directive require that auditors of entities having equity or debt listed on any European stock exchange should, in effect, be “accredited” by the relevant member-state where that stock exchange is situated. Simply put, not meeting the registration requirements means that the reports of those auditors will not be valid in the relevant jurisdiction.

For Indian auditors, in the immediate short-term, this means that audit reports issued by Indian auditors will cease to be valid in the relevant EU member-state(s), unless they are registered. As mentioned earlier, there are some provisions for transitional relief up to 2010; however this does not solve the bigger problem.

Over the longer term, and contrary to the ICAI's vision of increased marketability and growth for Indian CAs, current and future issuers may have to move away from Indian audit firms, to firms abroad which are registered with the relevant member-state. Moreover, this will go against the fundamental grain of boosting investor confidence, to the extent this applies to auditors.

Do you see a conflict that Indian audit firms can run into within the country when complying with the EU Directive? (Owing to the ICAI's regulations.)

Full registration under the 8th Directive requires filing of a Transparency Report. This includes information relating to the internal quality control system and independence policies of the audit firm, quality assurance reviews performed on the firm, list of public interest companies for which audits were carried out.

The above interview appeared in the 3 December 2009 edition of The Hindu Business Line, a link to which is available here.

Rahul Roy (1963-2009)

Today, I have lost a great boss, colleague, mentor, counsellor and superior.  Rahul Roy was all of that to me.  But above all, he was a great friend.  Tomorrow’s newspapers will most likely carry memoirs about Rahul, the professional accountant.  But this is about Rahul the person.

In the last couple of years that I’ve worked and interacted closely with him, I’ve come to learn a lot, not just about work and technical aspects, but what it means to be “well read”.  His interests varied from accounting and auditing, to science fiction; from contemporary thriller fiction to poetry of the English Romantics; from debating to the latest Bollywood blockbuster movies; from linguistics and literature to diverse culinary and epicurean experiences.  And any conversation with this great man meant that one would hear no less than three of these topics mentioned.

A self-confessed slave to perfection, Rahul would never employ short-cuts; yet, he was the kind of man who used to write instant SMS poetry on his way to office.  His laconic, pithy one-line emails, almost always cynical yet comic, always stood out amidst the plethora of verbal diarrhoea one got to read otherwise.

In the last few months, he realised that he was behind in the digital age, and so activated a Facebook profile and two blogs – one professional (www.proandanti.blogspot.com) and one personal, which he meant to use as a forum to express his tangential streak but sadly, never ever got down to doing so.  As his “Boswell”, it wasn’t uncommon for me to receive requests to update his professional blog at strange times of the day.

In many ways, Rahul was an anachronism.  The right man caught in a wrong age.  If his thoughts and words seemed esoteric, it was only because the rest of the world was still too young to understand.  It was a privilege to learn just about anything from Rahul, that tremendous storehouse and font of all relevant and sometimes obscure knowledge!

I’m told that many years back, in response to a question on why he wanted to become President of the Institute of Chartered Accountants of India, he is said to have remarked in his typical fashion, “As the youngest president, the law of nature decrees that I would be the longest surviving past president”.  That, in a line, was Rahul Roy.

If only he could have read this tribute, I know exactly what he would have said: “We are not amused”.  Majestic plural in true Queen Victoria style!

R.I.P, Rahul.

Companies Bill 2008 – A closer look at norms for financial reporting

On reading the Companies Bill 2008, the term "The Curate's Egg" comes to mind immediately. It is excellent in parts! Overall, the Bill attempts to enable self-regulation, empower shareholders and reduce regulatory involvement in many areas. However, in the process, some deficiencies seem to have crept into the proposed law. A closer look at the key provisions of the Bill relating to financial reporting and areas that need more clarity, follows.

The new Bill proposes the preparation of consolidated financial statements (CFS) where a company has subsidiaries. Although CFS may be prepared voluntarily at present, only listed companies having subsidiaries are mandated by the SEBI, to prepare CFS. CFS provides users a better view of corporate performance, compared to standalone (or unconsolidated) financial statements. Considering India's proposed move towards convergence to International Financial Reporting Standards (IFRS) from 2011 and the increasing need for more transparent financial reporting, introducing CFS within the legislative framework is a progressive move. That said, CFS makes the entire process of financial statements preparation a bit cumbersome, especially for large groups that have complex or deep hierarchical structures. Further, small and mid-sized companies may find that the costs of preparing CFS outweigh its benefits. Ideally, the preparation of CFS should be targeted at specific types of companies (such as listed, to be listed or large companies) which would result in manageable implementation and compliance.

In the past, Schedule VI has come under significant scrutiny and strong criticism. Whilst in its current form, the Bill does not include a prescriptive format of financial statements, one can only hope that if a format is prescribed, that will be contemporaneous with international and Indian financial reporting requirements. There is also a need to understand whether cash flow statements should be prepared as part of financial statements or not.

Another major change is the harmonization of financial year ends to March 31 which is a good move in many ways. This will help minimize the need for separate financial statements for income-tax purposes, where companies otherwise have a different financial year end. Further, comparisons between companies will also become relatively simpler if they have uniform year ends. However, given that many companies (particularly multinationals) often have other financial year ends to comply with, some amount of flexibility in determining year ends is required.

However, there are some drafting errors in the Companies Bill 2008 which should be addressed prior to the Bill becoming an Act. Firstly, the Bill uses the term "financial statement" which is neither correct nor is it defined – ideally, the term used should -be modified to "financial statements" and also, it should be defined in the law (at least by way of reference to Indian GAAP). Secondly, the Bill requires the auditor to report, inter alia, on whether or not the financial statements comply with auditing standards. Financial statements cannot comply with auditing standards, as those only apply to auditors when executing attest services.

Another glaring drafting error is on the requirement of CFS. The Bill requires that where a company has one or more subsidiaries, it shall "…prepare a consolidated financial statement (sic) of all the subsidiaries in the same form...". This implies CFS should be in the same form and manner as that of the other subsidiaries, when it should really be the same form and manner as the parent entity. Further, there are many reasons why it may be neither possible nor practical to present the CFS in the same form and manner as the company's own accounts. For instance, treatment of goodwill on acquisition of a subsidiary may appear in CFS but not in standalone financial statements. The clause should permit an "as near thereto as possible" presentation of the CFS, vis-à-vis the SFS.

The Bill also calls for the formation of an Advisory Committee on Accounting and Auditing Standards. "One more committee?". In consonance with the Bill's efforts to simplify application of law, it may be better to not form this Advisory Committee and instead directly refer to the accounting and auditing standards and guidance issued by the relevant regulator, the ICAI, which will surely make reference and implementation simpler.

Financial reporting provisions of the Bill are reasonably avant-garde, especially considering its immediate predecessor, the Act of 1956. A little more spit and polish will help make the industry and the business community look up to the proposed law rather than look down at it in disdain.

Limited Liability Partnerships

General partnerships have been the one of the most common forms of business enterprise, as they allow their members (partners) to combine their resources, while minimising the cumbersome regulatory and compliance burden that applies to corporates. However, the associated unlimited liability is a clear disincentive for entrepreneurs. Limited Liability Partnerships (LLPs) provide a further benefit, by limiting a partner’s liability while continuing to provide the structural framework of the partnership. Since the early 1990s, LLPs have consistently grown to a position of strength as a preferred form of business organisation. Most professional service firms as well as a substantially large number of other businesses and service organisations have now been structured as LLPs. This form of business organisation is now expected to gain momentum in India as well, as they have the potential to be a very important vehicle for growth in trade, commerce and services. In this regard, LLPs provide the opportunity to smaller businesses to participate in national and international commerce far more than previously.

A Concept Paper on LLP Law was introduced by the Department of Company Affairs in 2005 in view of its inherent advantages and growth prospects for Indian businesses, which was later followed by the LLP Bill 2006. The recently introduced LLP Bill 2008 is a "new and improved" version of the 2006 Bill. However, the underlying concept is the same, combining the limited liability features of a company without relatively greater compliance requirements.

LLPs provide the key feature of limited liability, which reduces the risk of a partner's personal wealth being exposed to claims. This means that the partner can decide the amount of their investment, and risk of losses is restricted to their investment in the LLP, much like investment in shares of a company. However, at the same time, the partner continues to be part of management of the business. This facilitates easier access to financial resources, for the LLP.

LLPs also promote internal flexibility, allowing participation in management while maintaining the ethos of partnership. This, coupled with reduced compliance requirements, will encourage and promote new business ventures and aid commerce. Companies today have a variety of compliance requirements, including filing of forms, periodic statements and returns, holding meetings, approvals to be obtained from shareholders and/or the government in many cases, etc. In contrast, an LLP has no such compliance burdens, which means there is more time to focus on the business and operations.

LLP also has several other benefits like being recognised as a separate and independent legal entity. Technically, there is no cap on the number of partners in an LLP and therefore, it has access to virtually unlimited capital for its business operations. It is also easier for individuals to invest in an LLP because their financial risk is limited and known. A partner in an LLP, is an agent of the firm but not of the other partners, therefore, he is not exposed to the negligent or fraudulent acts of other partners. In all these respects, an LLP scores over a general partnership.

The significant advantages of the LLP form of business is that it provides greater opportunities for general partnerships and unlisted / private companies to convert themselves into and operate as LLPs, as a result, enabling new converged entities to avail benefits of the ‘LLP type of organisation’. It will also result in lower administration needs and costs for the government in regulating corporate entities.

The LLP Bill 2008 parallelly proposes a few stringent requirements in order to ensure adequate compliance, governance and transparency, including unlimited liability in certain cases (such as fraudulent acts) and the need to maintain records and make filings /disclosures on an ongoing basis. Also, the accounts of an LLP need to be audited and an annual return is required to be filed with the Registrar.

Having said that, there are still some areas that need to be addressed by the LLP Bill 2008. These include requirements for LLPs to be adequately insured in order to protect themselves from claims, and greater inclusiveness of third parties who deal with such general partnerships that convert into LLPs, as the limited liability status of the new LLP would affect them directly. Also, more clarity is required as regards taxability of the LLP and also the applicability of duties, etc on conversion of entities into LLPs and the consequent transfer of assets.

All credit to the MCA for progressive steps taken towards LLPs. While there may not be many takers for this form of business initially, the benefits of an LLP significantly outweigh the disadvantages and will eventually find ground in India. Ultimately, the success of this legislation will indirectly contribute to the success and economic progress of a nation that has already demonstrated a lot of promise globally.