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July 2010

GAPS in GAAP – Accounting Standards v. law of the land

By Dolphy D’Souza | Chartered Accountant
Reading Time 4 mins

Accounting Standards

As per our framework, Indian Accounting Standards can be
overridden by the laws of the land and court orders. SEBI was concerned that
companies were taking accounting and tax advantage of this by obtaining orders
u/s.391, u/s.394 and u/s.101 of the Companies Act that did not require
compliance with accounting standards. For example, companies used ‘securities
premium’ to write off current expenses such as doubtful debts, deferred tax
liability, impairment, etc. by filing a petition for capital reduction.

Consequently SEBI decided to put an end to this, by a
suitable amendment of the listing agreement as follows : “The company agrees
that, while filing for approval any draft scheme of
amalgamation/merger/reconstruction, etc. with the stock exchange, it shall also
file an auditor’s certificate to the effect that the accounting treatment
contained in the scheme is in compliance with all the Accounting Standards
u/s.211(3C) of the Companies Act, 1956.”

A question arose whether the amendment was also applicable to
the schemes of unlisted subsidiaries/associates/joint ventures of a listed
entity. It is clear that SEBI has jurisdiction only over listed entities and not
unlisted subsidiaries, associates and joint ventures of listed entities or
unlisted companies. For example, where the scheme involves an unlisted
subsidiary and a third party, the listed company is not required to file an
auditor’s certificate of compliance with accounting standards with the stock
exchange as it is not a party to the scheme. Thus, the unlisted subsidiary of
the listed entity can obtain the accounting arbitrage, which the listed entity
itself could not.

The other related question is what accounting treatment would
apply in the consolidated financial statements (CFS). Take for instance an
unlisted subsidiary of a listed entity which has got the court approval on a
scheme which is not in compliance with the accounting standards. Can the listed
entity use the treatment prescribed in the court scheme in its CFS ? The SEBI
Circular does not provide any specific guidance on the matter. The author
believes that the Circular is applicable only to a scheme filed by a listed
entity or where it is a party to the scheme. It does not apply to a scheme filed
by a non-listed subsidiary, associate or joint venture, even if it results in a
non-compliance with the accounting standards at CFS level of the listed entity.

This is because SEBI’s rights are more preemptive and apply
only to a listed entity. In other words, under the current listing agreement (as
modified by the amendment) SEBI can stop a listed company from filing a scheme
with the High Court that is not in compliance with the accounting standards.
However, it cannot stop a listed entity’s subsidiary from filing a scheme that
does not comply with accounting standards. Neither can it stop the listed entity
from applying the accounting treatment under the scheme sanctioned by the High
Court in the financial statements of the subsidiary or in its own CFS.

Consequently, there has been a raft of schemes filed by
subsidiaries of listed entities which are not in compliance with the accounting
standards. Let’s take a simple example. Listed entity (LCO) wants to amalgamate
another company into its own self. The amalgamation accounting results in
significant recognition of intangibles and goodwill. LCO is worried that in
subsequent years owing to impairment and amortisation, its future profits would
be adversely impacted. It therefore wants to use S. 391, S. 394 or S. 101 to
write off the intangibles and goodwill against securities premium or reserves.
Unfortunately, SEBI’s Circular preempts that, as LCO is not able to obtain a
certificate from the auditors that the accounting treatment is in compliance
with the accounting standards. To circumvent this problem, LCO floats a
subsidiary, and achieves the relevant objective in the financial statements of
the subsidiary and consequently in the CFS of LCO.

Whilst SEBI’s effort to prevent bad accounting practices is
laudable, because of jurisdictional issues, it may not have been able to achieve
its objective completely. The right medicine would be for the Ministry of
Corporate Affairs to amend S. 391, S. 394 and S. 101 of the Companies Act, to
prevent such accounting arbitrage. The author understands that these sections
will be amended along with the introduction of IFRS in India, since IFRS does
not allow a legal override of accounting standards.

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