Month: May

Background

    The question whether there should be a system of rotation of statutory auditors introduced to avoid repetition of Satyam episode has been raised in some quarters. In the past, the Government had tried to introduce this system by proposing amendments in the Companies Act on two occasions. However, these amendments could not be implemented as the Parliamentary Committees which examined these proposal rejected them in view of the strong protests from our members and the Institute. Investigations about the role of auditors in the Satyam episode are in progress. The reasons for the audit failure are not ascertained and, therefore, it would be premature to make this episode as illustrative. No definite conclusions can be drawn at this stage and it cannot be said that such episode will not be repeated if we introduce the system of rotation of statutory auditors through any legislation. It is reported that no developed country in the world has introduced this system.

Concept of rotation of statutory auditors

    The question of rotation of auditors has been considered in the past. In 1972, it was proposed to add clause (1B) in Section 224 of the Companies Act by the Companies (Amendment) Bill, 1972. This clause sought to introduce the concept of ‘rotation of auditors’. This was proposed with a view to bringing out disassociation of auditors from groups of companies, so that they may not have any temptation to shield shortcomings of the management from shareholders. It was also stated that this would achieve a more equitable distribution of audit work among younger members of the profession.

    There was lot of resistance from members when this proposal was sought to be introduced by amendment of the Companies Act. It was felt that such a proposal would put out of gear complete machinery in respect of audit of corporate sector by members of the accounting profession. It was also felt that this provision would not achieve the proposed objective. As a compromise, it was decided to represent to the Government that if ceiling on audits per member/partner is fixed, it would achieve the objective of wider dispersal of audit.

    The Joint Committee of Parliament appreciated the submissions made by the Institute. The Joint Committee took the view that a ceiling on audits would sufficiently serve to break the evil of continued association of auditors with groups of companies. It was decided to fix the ceiling at 20 as such groups generally consisted of more than 20 companies. It was also decided that out of these 20 companies, not more than ten companies should be having paid-up share capital of Rs.25 lacs or more. In the case of a firm of auditors the ceiling applied was on the basis of each partner in whole-time practice. On the above basis, the Companies (Amendment) Act, 1974, amended Section 224 of the Companies Act to provide for ceiling on company audits on the above basis.

Companies Bill, 1997

    The above provision worked with satisfaction for more than 20 years. Even in the Companies Bill, 1993 the concept of ceiling on audits was accepted. However, the Companies Bill, 1997 once again proposed to provide rotation of auditors in clause 180 (2). Under this clause, it was proposed to increase the ceiling on audits to 25 companies and also provide for rotation of auditors in such a manner that no company would be able to appoint or reappoint an auditor for more than five consecutive years.

    The Council of our Institute strongly opposed the concept of rotation of audit when the above Bill was under consideration. After an in-depth consideration of the matter at various forums in the profession all over the country, the Council came to the conclusion that the proposal relating to rotation of auditors was neither in the interest of the shareholders nor would it lead to better corporate governance and, therefore, it was not in the national interest. The Council, therefore, suggested dropping of the proposal on the following grounds.

    “The legislation in almost all developed countries does not contain any provision regarding rotation of auditors. On the contrary, the concept is that the position of the auditors should be strengthened and the option of the management to change them should be limited to the very minimum. This seems to be the concept behind the spirit of various provisions of the Companies Act in India, which provide for certain special proceedings if an auditor is to be removed or he is not to be reappointed at a general meeting.

    “The system of rotation can be evaded easily and will only result in practices like tie-up arrangements between auditing firms and splitting of existing firms. It would indeed be impossible to implement it in a manner that its perceived advantages are realised.

    “Rotation does not improve the independence of auditors. This is because the management plays one auditor against the other. It considerably reduces the chance of a strict and upright auditor to be appointed after his term, since the management (having been exposed to different auditors) would tend to opt for the ones who are considered more convenient.

    “Rotation of auditors will inevitably result in higher cost since new auditors will have to spend extra time in familiarising themselves with the nuances of the activities of a company. As a matter of fact, research has shown that modern business operations are becoming so complex that an auditor takes at least two years to really understand the intricacies of the input-output relationships and the economic realities behind the financial transactions. It is well known that audit failures are more in the first or second year of an audit. In more advanced countries, certain audit firms have actually developed special expertise in specific industries. The quality of audit will therefore definitely suffer if there is rotation of auditors.

    “The Council of the Institute is fully supportive of all initiatives meant to enhance the independence of the auditors. It genuinely believes that rotation of auditors will be a retrograde step unlike some of other initiatives in the Companies Bill, 1997, e.g. tightening up of provisions regarding disqualification of auditors and constitution of audit committees. The Council has in fact been constantly debating and enforcing a number of steps to improve the qualify of audit. A few initiatives being taken by the Council are (a) working out a system of peer reviews, (b) enforcing audit standards more stringently, and (c) ensuring that an auditor does not have interest in the organisation under audit.

The above Bill was referred to the Parliamentary Standing Committee for its consideration. In its report dated 27th July, 2000, the Committee has considered the suggestions received from the Institute and others and recommended that clause 180 (2) of the above Bill, relating to rotation of auditors, for giving stability to the appointment of auditors, be dropped.

That Committee, has, however, accepted the alternative suggestion made by the Institute that the system of appointment of joint auditors be introduced. The Committee has observed that with the acceptance of this suggestion, the effect will be that the Companies Act will be introducing, for the first time, the concept of joint auditors, which is prevailing in some of the advanced countries. This will ensure that the continuity in audit is not broken. It may be noted that the Companies Bill, 1997, ultimately lapsed and could not be passed.

Naresh  Chandra Committee  report

The Government of India appointed a Committee under the Chairmanship of Shri Naresh Chandra in August, 2002 to examine various issues relating to Corporate Governance. One of the. terms of reference related to examination of measures required to ensure that managements and auditors actually present a true and fair statement of affairs of companies. The whole effort of the Government was to improve corporate functioning and to improve corporate financial reporting. The Committee submitted its report in November, 2002. Besides considering the corporate governance issues, the Committee also considered the issues relating to statutory auditor – company relationship, steps to be taken to preserve independence of auditors, rotation of auditors, measures to improve corporate financial reporting, composition of board of directors, role of independent directors, strengthening the statutory provisions governing Chartered Accountants and other related matters.

On the question  of good corporate  governance,  the Committee observed that two corporate instruments that improve corporate governance are financial and non-financial disclosures and (ii) independent oversight of management. It was observed that independent oversight of management comprises two aspects. The first relates to the role of independent statutory auditors and the second relates to the role of independent directors.

The Committee observed that shareholders appoint auditors who are required to report whether the audited financial statements present a ‘true and fair’ view of the financial health of the auditee. Therefore, the quality and independence of
statutory auditors was fundamental to corporate oversight. While it was the job of the management to prepare the accounts, it was the responsibility of the statutory auditors to scrutinise the same and give an independent report on the same. Auditors have the skills to scrutinise complex accounts of today’s multi-divisional and multi-segmental corporations, but these skills will come to naught if the auditing firm did not have a strict arm’s length independent relationship with the management of the corporate body.

In order that auditors are able to preserve their independence, the Committee suggested that auditors should maintain arm’s length relationship with the management. The suggestions of the committee that the auditor should not (i) have financial interest in audit client, (ii) have business or personal relationship with the audit client, (iii) have undue dependence on the audit client, (iv) accept loans or guarantees from audit client, (v) have key management position within two years prior to his appointment and (vi) render certain non-audit services, were incorporated in the Companies Amendment Bill, 2003. Unfortunately, this Bill could not be passed by the Parliament.

The Committee considered the question of rotation of auditors and after detailed discussion with various bodies, came to the conclusion that there was no need to provide for rotation of auditors. It was stated that the Committee had not found sufficient international evidence favouring compulsory rotation of audit firms. Various independent accounting studies made available to the Committee indicated no discernible benefit from rotation. In fact, these studies universally indicated the opposite – that rotation tends to enhance the risk of audit ‘failures in the last year of the tenure of the outgoing auditor and the first two years of the new auditor. Even in the USA the Sarbanes-Oxley Act, 2002 (SOX Act) does not provide for rotation of auditors.

Given the international practice, the Naresh Bombay Chartered Accountant Journal, May 2009 Chandra Committee observed that there was no conclusive proof of the gains while there was sufficient evidence of the risks if the concept of rotation of auditors was accepted. However, the Committee was in favour of compulsory rotation of audit partners as provided in SOX Act in the USA.

According to the Committee, the partners and at least 50% of the engagement team (excluding the articled clerks and trainees) responsible for the audit of either listed companies or companies whose paid up capital and free reserves exceed Rs.10 Crores, or companies whose turnover exceeds Rs.50 crores, should be rotated every five years. Persons who are rotated in this manner can be allowed to return, if need be, after a break-up of three years.

Having emphasised the need for keeping arm’s length relationship with the management, the Committee considered the vexed question of who will audit the auditors? It is true, the auditor performs a critical role in informing the shareholders of the true and fair picture of the state of financial and operational affairs of a company. However, the ability to play this role will depend on the auditor’s knowledge, skills, independence, professional skepticism and integrity. For this purpose, there is a great need to regulate auditors effectively to ensure that they properly discharge their fiduciary responsibilities.

In India the Institute of Chartered Accountants of India (ICAI) has been set up under the Chartered Accountants Act, 1949 to examine and regulate the profession of Chartered Accountancy. The ICAI has set up a system of Peer Review of audit firms. The Committee considered the Peer Review Statement issued by ICAI and observed that this system was indeed a good one. However, the Committee felt that it was time to think of a very indigenous and refined arrangement to ensure the quality of attestation services performed by Chartered Accountants in relation to the technical standards prescribed for them. Although the Committee was satisfied with the above peer review statement which was a self-contained document and which addressed most of the issues regarding ‘who audits the auditors’, the Committee recommended establishment of a ‘Quality Review Board’ as an independent body outside the Council of the Institute. It may be noted that under Sections 28 A to 28 D of the Chartered Accountants Act, as amended in 2006, a Quality Review Board consisting of 5 members nominated by the Government and 5 members nominated by the Council of ICAI has been appointed.

The Companies Bill, 2008

The Companies Bill, 2008, has been introduced in the Lok Sabha on 23.10.2008 to replace the existing Companies Act, 1956. There is no proposal about rotation of statutory auditors in the Bill. However, some of the provisions are proposed to ensure that the independence of statutory auditors is not impaired. In brief, these provisions are as under:

“Special Resolution will be required if an auditor other than retiring auditor is proposed to be appointed.

“An auditor who has direct financial interest in the company or who receives any loans or guarantee from the company or who has any business relationship (other than an auditor) with the company cannot be appointed as auditor.

“A person whose relative is in employment of the company as a director or Key managerial personnel cannot be appointed as auditor.

“If a firm is appointed as auditors, only the partner of the firm, as authorised by the firm, can sign the audit report on behalf of the firm.

“An auditor cannot accept any other assignment from the company like accounting, book keeping, internal audit, design and implementation of any financial information system, actuarial services, investment advisory services, investment banking services, financial services and management services.

“Audit report shall state whether the financial statements comply with the accounting standards and auditing standards. It may be noted that the National Advisory Committee appointed by the Government will now be required to advise the Government about Accounting Standards as well as Auditing Standards. In other words, the auditors will have to comply with Auditing Standards laid down by the Government on the advice of the National Advisory Committee.

“Auditor shall have a right to attend every Annual General Meeting and shall have a right to be heard at such meeting on any part of the business conducted at the meeting.

“If the auditor makes default in complying with the provisions relating to reporting on the financial statements, provisions prohibiting rendering on other services, and allowing any person other than an authorised person to sign audit report, he shall be liable to pay fine of Rs.25,000 which may extend to Rs.5 lacs. If it is found that the auditor has knowingly or willfully contravened any of the above provisions, he shall be punishable with impairment for a term up to one year or with fine of Rs.1 lac which may extend to Rs.25 lacs or with both. It is also provided that in such cases, the auditor will have to refund the fees and also pay for damages to the company or to any other persons for loss arising out of incorrect or misleading statements of particulars made in the audit report.”

From the above provisions proposed in the Companies Bill, 2008, it will be noticed that these provisions are more stringent and are being introduced with a view to achieve the goal to improve/ strengthen the independence of statutory auditors and quality of audit. It must be recognised that the Government is keen to ensure that the independence of statutory auditors is not affected by any weakness in the corporate governance.

To sum up

Our Institute is a regulatory body and its function is to regulate training of articled trainees, conduct examinations, regulate and develop the profession. All our members are taught the importance of independence, integrity, objectivity, confidentiality, technical standards, professional behaviour and technical competence. Therefore, there is a strong presumption that our members are independent and will not succumb to any pressure. One of the reasons advanced in favour of rotation of statutory auditors is that statutory auditors will tend to lose their independence if they are associated with a particular company in that capacity for a long duration. There is no reason to doubt the competence of the Council of ICAI to ensure the virtues of independence, integrity, objectivity, etc. in the members of our profession. If a person qualifies our examination after completing the practical training without imbibing the above virtues, the Council should consider some other measures to improve the quality of education and training. If a member is independent by virtue of his training and qualification in the first three or five years of audit assignment of a company, he will always remain independent irrespective of his continued association with that company. If he has not imbibed the virtues of independence, integrity, etc. during his education and training period, he cannot remain independent even in the first year of his audit assignment even if rotation of statutory auditors is made mandatory.

Another probable argument by those who favour rotation of statutory auditors is that the younger members will get audits of large companies. This argument is also not valid, because the Institute’s representation before the Parliamentary Committee which was considering this amendment proposed in the Companies Bill, 1997, clearly states “the system of rotation can be evaded easily and will only result in practices like tie-up arrangements between auditing firms and splitting of existing firms”. The Institute has also observed in the above representation that “rotation does not improve the independence of auditors”. As stated above, several reasons are given by the Institute and it is possible that our members may adopt unethical means to secure assignments if compulsory rotation is introduced.

Our Institute has grown from strength to strength over 60 years. The reforms introduced in the field of education, training, CPE Programmes, Quality Review process, etc. have moulded our members to withstand pressures from outside. Therefore, the thinking that independence of members will be affected while discharging the attest function because of a long association with a particular client is not all justified.

From the above discussion it becomes evident that rotation of statutory auditors is not an answer to ensure independence of auditors and quality of audits. The steps taken to strengthen the education and training, ceiling on number of audits per partner, CPE Programmes, Peer Review, etc. are adequate at present. Further, the system of putting additional responsibilities on audit committee and independent directors will go a long way in ensuring independence of auditors and improving corporate governance. As suggested by various committees as well as the Council of the Institute, the system of joint auditors, rotation of partners and audit team of the audit firm can definitely improve the present position. It is also possible to introduce a system by which each audit firm should declare, while accepting the audit, as to under which partner the audit assignment is accepted. An audit firm cannot accept more than the specified number of audits per partner as permitted by the Companies Act. The audit firm should ensure that the audit report is signed only by that partner under whom the audit is accepted. In exceptional cases the audit firm can be allowed to make a change and assign the audit to another partner, subject to the specified number, after making disclosure for the same. In this manner it can be ensured that the system of appointing ‘Signing Partners’, which is in vogue in certain audit firms, at present, will be abolished. This system will ensure that each practising member of the Institute undertakes audit assignment of such number of audits, per partner, as permitted by the provisions of the Companies Act. This will improve the quality of audit.

My article on ‘Daughter’s right in coparcenary’ (BCAJ-January 2009, Page 509) has evinced considerable interest amongst the practising chartered accountants. I have been flooded with number of inquiries and questions. Some of the inquiries have raised interesting supplemental questions, which justify an additional article on broader aspects on the same subject.

As is well known, the Hindu Succession Act, 1956 (‘the Act’) was amended by the Hindu Succession (Amendment) Act, 2005 (‘the Amendment Act’) with effect from 9th September, 2005. S. 6 of the Act, which was substituted by the Amendment Act to the extent it is relevant to this Article reads as under :

    “6. Devolution of interest in coparcenary property. — (1) On and from the commencement of the Hindu Succession (Amendment) Act, 2005, in a joint Hindu family governed by the Mitakshara law, the daughter of a coparcener shall, —

    (a) by birth become a coparcener in her own right in the same manner as the son;

    (b) have the same rights in the coparcenary property as she would have had if she had been a son;

    (c) be subject to the same liabilities in respect of the said coparcenary property as that of a son, and any reference to a Hindu Mitakshara coparcener shall be deemed to include a reference to a daughter of a coparcener :

Provided that nothing contained in this sub-section shall affect or invalidate any disposition or alienation including any partition or testamentary disposition of property which had taken place before the 20th day of December, 2004.

(2) to (5) x x x

Explanation. — x x x”

S. 6 of the Act (as amended by the Amendment Act) inter alia provides that on and from the commencement of the Amendment Act, in a joint Hindu family governed by Mitakshara law, the daughter of a coparcener by birth becomes a coparcener in her own right in the same manner as the son. The Section further provides that any property to which a female Hindu becomes entitled by virtue of the provision shall be held by her with the incidents of coparcenary ownership and shall be regarded as property capable of being disposed of by her by testamentary disposition.

One interesting issue which arises for consideration is as to what happens in case of a daughter of a deceased coparcener of an HUF. The brief facts on which such question can arise could be :

    (a) there is an existing HUF consisting of father A (Karta) and his two sons B and C. Therefore, the HUF would consist of three coparceners, namely, A, B and C.

    (b) A dies before September, 2005 leaving his will whereby he bequeaths his undivided one-third share in the HUF assets to his HUF, so that the HUF continues with two coparceners B and C.

    (c) At the time of the death of A he has left no wife, but two daughters D and E.

    (d) The question is whether after passing of the Amendment Act, D and E get any right in the properties and assets of the HUF.

S. 6 of the Act as it stood at the time of the death of A (i.e., prior to the amendment) reads as under :

“6. Devolution of interest of coparcenary property : When a male Hindu dies after the commencement of this Act, having at the time of his death an interest in a Mitakshara coparcenary property, his interest in the property shall devolve by survivorship upon the surviving members of the coparcenary and not in accordance with this Act :

Provided that, if the deceased had left him surviving a female relative specified in Class I of the Schedule or a male relative specified in that class who claims through such female relative, the interest of the deceased in the Mitakshara coparcenary property shall devolve by testamentary or intestate succession, as the case may be, under this Act and not by survivorship.

Explanation 1 : For the purposes of this Section, the interest of a Hindu Mitakshara coparcener shall be deemed to be the share in the property that would have been allotted to him if a partition of the property had taken place immediately before his death, irrespective of whether he was entitled to claim partition or not.

Explanation 2 : Nothing contained in the proviso to this Section shall be construed as enabling a person who has separated himself from the coparcenary before the death of the deceased or any of his heirs to claim on intestacy a share in the interest referred to therein.

Based on the provisions of S. 6 of the Act as at the time of death of A read with Explanation 1 to the said Section, the share of a deceased coparcener of the HUF is to be determined as if a partition of the property has taken place immediately before his death. Accordingly, in the example given above, there being three coparceners of the HUF A had one-third undivided share in the HUF property, which devolved upon the HUF as per his will.

It is significant to note that S. 6 of the Act (as amended) prescribes that on and from the commencement of the Amendment Act, the daughter of a ‘coparcener’ by birth becomes a coparcener in her own right in the same manner as the son and gets the same rights in the coparcenary property as she would have had if she had been a son. However, on the date of commencement of the Amendment Act i.e., 9th September, 2005, A was no longer one of the coparceners. The two brothers B and C were the only coparceners of the HUF. It, therefore, follows that the two sisters D and E do not fall in the category of being the ‘daughters of a coparcener’ to qualify for any right under S. 6 of the Act as amended. Accordingly, it is submitted that in such a case the daughters would not be entitled to any right in the HUF property and assets.

The conclusion arrived at above is also supported by some court decisions.

The Supreme Court in the case of Sheela Devi and Ors. v. Lal Chand and Anr., [2007(1) MLJ 797] has clearly observed that the Amendment Act would have no application in a case where the succession was opened in 1989 when the father passed away.

In the case of Smt. Bhagirathi and Others v. S. Manivanan and Anr., (AIR 2008 Madras 250), the Madras High Court has held as under :

    “13. A careful reading of S. 6(1) read with 6(3) of the Hindu Succession (Amendment) Act clearly indicates that a daughter can be considered as a coparcener only if her father was a coparcener at the time of coming into force of the amended provision. It is of course true that for the purpose of considering whether the father is a coparcener or not, the restricted meaning of the expression ‘partition’ as given in the explanation is to be attributed.

        In the present case, admittedly the father of the present petitioners had expired in 1975. S. 6(1) of the Act is prospective in the sense that a daughter is being treated as coparcener on and from the commencement of the Hindu Succession (Amendment) Act, 2005. If such provision is read along with S. 6(3), it becomes clear that if a Hindu dies after commence-ment of the Hindu Succession (Amendment) Act, 2005, his interest in the property shall devolve not by survivorship but by intestate succession as contemplated in the Act.

        In the present case, the death of the father having taken place in 1975, succession itself opened in the year 1975 in accordance with the existing provisions contained in S. 6. If the contention of the petitioners is accepted, it would amount to giving retrospective ef-fect to the provisions of S. 6 as amended in 2005. On the death of the father in 1975, the property had already vested with Class-I heirs including the daughters as contemplated in the unamended S. 6 of the Act. Even though the intention of the amended provision is to confer better rights on the daughters, it cannot be stressed to the extent of holding that the succession which had opened prior to coming into force of the amended Act are also required to be re-opened. In this connection, we are also inclined to refer to the decision of M. Srinivasan, J., as His Lordship then was, reported in 1991(2) MLJ 199 (Sundarambal and Others v. Deivanaayagam and Others). While interpreting almost a similar provision, as contained in S. 29-A of the Hindu Succession

    Act, as introduced by the Tamil Nadu Amendment Act 1 of 199, the learned single Judge had made the following observations :

    “14.    Under sub-clause (1), the daughter of a coparcener shall become a coparcener in her own right by birth, thus enabling all daughters of the coparcener who were born even prior to 25th March, 1989 to become coparceners. In other words, if a male Hindu has a daughter born on any date prior to 25th March, 1989, she would also be a coparcener with him in the joint family when the amendment came into force. But the necessary requisite is, the male Hindu should have been alive on the date of the coming into force of the Amended Act. The Section only makes a daughter a coparce-ner and not a sister. If a male Hindu had died before 25th March, 1989 leaving coparcenary property, then his daughter cannot claim to be a coparcener in the same manner as a son, as, on the date on which the Act came into force, her father was not alive. She had the status only as a sister-a-vis her brother and not a daughter on the date of the coming into force of the Amendment Act . . . . . .”.

    It is submitted that the sentence “But the necessary requisite is, the male Hindu should have been alive on the date of the coming into force of the Amend-ment Act” quoted by the Madras High Court in the said judgment is from the same Court’s earlier judgment in Sundarambal’s case, is quite significant and throws light on the hypothetical question raised in this article.

    There is one more court decision on the effect of the Amendment Act, again from the Madras High Court. In the case of Valliammal v. Muniyappan, [2008 (4) CTC 773], the Madras High Court has observed as under :

    “6.    In the plaint, it is stated that the father of the plaintiffs died about thirty years prior to the filing of the suit. The second plaintiff as P.W.1 has deposed that their father died in the year 1968. The Amendment Act 39 of 2005 amend-ing S. 6 of the Hindu Succession Act, 1956 came into force on 9-9-2005 and it conferred right upon female heirs in relation to the joint family property. The contention put forth by the learned Counsel for the appellant is that the said Amendment came into force pending disposal of the suit and hence the plaintiffs are entitled to the benefits conferred by the Amending Act. The Amending Act declared that the daughter of the coparcener shall have the same rights in the coparcenary property as she would have had if she had been a son. In other words, the daughter of a coparcener in her own right has become a coparcener in the same manner as the son insofar as the rights in the coparcenary property are concerned. The question is as to when the succession opened insofar as the present suit properties are concerned. As already seen, the father of the Plaintiffs died in the year 1968 and on the date of his death, the succession had opened to the properties in question. In fact, the Supreme Court in a recent deci-sion in Sheela Devi and Ors. v. Lal Chand and Anr., 2007 (1) MLJ 797 (SC) considered the above question and has laid down the law as follows :

      19.  The Act indisputably would prevail over the old Hindu Law. We may notice that the Parliament, with a view to confer the right upon the female heirs, even in relation to the joint family property, enacted the Hindu Succession Act, 2005. Such a provision was enacted as far back in 1987 by the State of Andhra Pradesh. The succession having opened in 1989, evidently, the provisions of Amendment Act, 2005 would have no application.

    In view of the above statement of law by the Apex Court, the contention of the appellant is devoid of merit. The succession having opened in the year 1968, the Amendment Act 39 of 2005 would have no application to the facts of the present case.”

    Based on the above and other supporting decisions, the Madras High Court has in the recently decided case of S. Seshachalam v. S. Deenadayalan and Ors., (MANU/TN/1956/2000) taken a similar view rejecting the claim of daughters of a coparcener, who had died in 1965.

    Therefore, it is clear that a daughter would get benefit of the Amendment Act only if her father is alive at the time of coming into force of the Amendment Act. Going back to the hypothetical question raised in this article, the two sisters D and E would not be entitled to any right under S. 6 of the Act as amended.

1 Introduction

    1.1 We are currently in the diamond jubilee year of our Republic as well as of our Institute. The motto of our nation is Satyameva Jayate (Truth alone triumphs). We can only dream of poetic justice of truth winning over untruth. In this Kaliyug, real life events often shatter this fond belief. The recent episode of ‘Satyam Computers’ has evoked a storm in our profession as well. The motto of our Institute of Chartered Accountants of India is ‘Ya esha Supteshu Jagarti’ (He who is awake when others are asleep.) This was actually spoken about the ‘Soul’ — the ‘Atman’ in the Upanishadas. It implies that our conscience should always be awake. Unfortunately, the overall scenario is such that not only others but our own professionals have started losing faith in the profession. The situation calls for a good degree of introspection and self-criticism.

    1.2 In recent years, there was a spate of complaints against our professional brothers for alleged misconduct. I had occasion to handle quite a few such cases which gave me some insight in the field. It is not only torturous for the respondents whom I represented, but even more stressful to me. I have, therefore, taken it as a mission to spread awareness of this subject and caution our fellow-members, since prevention is always better than cure.

    1.3 The topic is too vast. The experiences which I wish to share are often frightening and depressing. But unless all of us develop positive attitude, assertive approach and collective action, the future seems to be very gloomy. Not much can be expected from our leaders. It is the same state of affairs as in our Indian democracy. Our own indifference and inaction will put us into deeper trouble. Time has come to really wake up and get out of our slumber.

    The purpose of this article is to make readers conscious of the grave reality. I have consciously avoided technicalities and focussed on practical aspects.

2 Some glaring statistics

    2.1 When the Chartered Accountants’ Act was originally passed in the year 1949, the ‘Disciplinary Committee’ consisted of 5 persons. viz. President, Vice-President, two other elected members of Central Council and one Government Nominee. This Committee was supposed to hear the cases all over India. Today our membership is nearing 1,50,000 and till 2007, the same committee was discharging this function.

    2.2 Times have changed. General tolerance level of people has gone down. People have not only become aware of nuisance value, but have started using it. In the first 30 to 40 years of our Institute’s existence, there might have been about 300 to 400 complaints; whereas now the rate is about 500 to 600 hundred per year.

    2.3 Due to various scams, mass scale complaints are received by the Council or initiated suo moto based on ‘Information’. Such scams add 100 to 200 cases in one stroke.

    2.4 A complaint can be filed within 10 years from the occurrence of the event complained against — Regulation 14 of the ICAI Regulations, 1988. Unfortunately, there is no time-limit prescribed for disposal. For example, even today, a few cases filed in the year 1996 in respect of accounts for the year 1987-88 might have remained undecided.

    After the passage of CA Amendment Act, 2006, the new procedure seeks to cut short the time by introducing a procedure for summary disposal.

    2.5 A survey carried out in the USA revealed that 95% of the complaints against professionals (doctors) are filed out of ego problems —mainly due to improper communication by the professionals.

3 Certain fundamental principles

    3.1 A complaint once filed could not be withdrawn under the old system. Under the new system, it can be withdrawn subject to the permission of Director Discipline and Board of Discipline.

    3.2 For holding a member guilty, the following points are considered absolutely inconsequential —

    (a) Whether the complainant or anybody is aggrieved or not.

    (b) Whether the complainant, although aggrieved, wants to pardon a respondent.

    (c) Whether the complainant has approached the Council with clean hands or whether the complainant himself is a confirmed criminal or has committed contributory negligence.

    (d) Whether the respondent has compensated the complainant for the loss that was incurred by him due to negligence of the respondent.

    (e) Whether the complainant backs out and remains absent during the hearing.

    3.3 Nevertheless, the basic duty of adducing evidence against the respondent does lie on the complainant. These are quasi-criminal proceedings and the Disciplinary Committee has the powers of the Civil Court.

    3.4 The basic objective of the Council is to examine whether the respondent is fit to continue as a member. This is as per a Calcutta High Court decision. The Council does not have jurisdiction to examine the conduct of the complainant or a non-member. It is primarily concerned with safeguarding the credibility and image of the profession. A clear message should go to the public at large that an unscrupulous member is severely punished; and that the Code of Ethics is religiously and rigorously enforced.

    3.5 A general feeling in the society is that complaints are not processed expeditiously. There are delays and members are treated leniently. The Society expects that the Code of Ethics should be strictly implemented.

4. Reasons for delays

    4.1 Many a time, complaints are filed even after 6 to 7 years of the occurrence of alleged misconduct. The permissible time is 10 years as per Regulation 14.

    4.2 Sometimes, the complaints remain unattended at the Council for a number of years — may be due to administrative pressures or due to sudden shifts in priorities.

4.3 After a complaint is received by the Council, it is forwarded to the respondent asking him to file an explanation (written statement). That written statement is forwarded to the complainant with a request to send a rejoinder. To that rejoinder again, the respondent is asked to give his comments. Thus, both the parties get two innings. This was under old regime.

In the amended system, the last limb (comments on the rejoinder by respondent) has been eliminated. This is in respect of complaints filed on or after 28th day of February 2007. However, the Disciplinary Directorate may seek further information from the concerned parties, if required.

4.4 After this preliminary data, the Director Discipline forms a prima jacie opinion as to whether the Respondent is ‘prima facie’ guilty. Under the old system, this decision rested with the Council of 30 members. One can imagine the delay inherent in the old system.

4.5 The instant reaction of any person on receiving a complaint against him is either total nervousness; or a serious anger against the complainant. Both these extremes result in loss of objectivity. The respondent on some pretext or the other seeks extension of time to write a reply.

4.6 Normally, a member tries to hide this from his friends and colleagues; and approaches some lawyer. Lawyers can seldom appreciate the substance of the complaint in the context of our profession. If it requires knowledge of accounting standards and audit technicalities, lawyers may have serious limitations. They usually write a legalistic reply which is often in the nature of counter-attack on the complainant. As stated earlier, the Council is not much concerned with the conduct of the complainant. Thus, the reply becomes either verbose or irrelevant, in the context of our Council’s perception. It is necessary to write a concise and objective reply, by briefly describing the background. In most of the cases, a member is made a scapegoat, as an arm-twisting pressure tactic, in the dispute of the complainant with some other party. (for interesting instances, see para 6)

When a person is found ‘prima facie’ guilty, the disciplinary proceedings are deemed to have commenced. The disqualification or ineligibilities for allotment of bank audits, C & AG Audits, etc. become applicable from this point of time. It should be noted that these ineligibilities are as per the norms of the appointing authorities and not of the ICAI.

4.8 Hearing of cases under the new system is just commencing. At present, the old cases are still pending. The Disciplinary Committee (DC) has its sittings for one or two days each at various important cities in the country. In Mumbai, for example, it might visit on 4 to 5 occasions in a year.

4.9 Duration of a hearing may range from half-an-hour to 8 to 10 hours. Once or twice, a case may be adjourned at the request of the parties. During the hearing, there are witnesses summoned, examined and cross-examined, evidences adduced, submissions made, and complainants as well as respondents are interrogated. Proceedings are tape-recorded and verbatim report (minutes) are made available to the parties. There is a high degree of transparency. Sometimes, submissions are so voluminous that they may run into a couple of thousand pages.

4.10 After the hearing is concluded, it takes normally not less than 10 to 12 months to receive a report. Basically, the DC members are themselves very busy professionals.

They are on tours off and on and have many other issues to deal with. Sitting in judgment against fellow-members is a very delicate task, far from pleasant. Ordinarily, out of five members, only three of them actually sit for hearing. Either the President or the Vice-President presides over the proceedings.

4.11 The report of the DC is basically in the nature of fact finding. It is not conclusive. Under the old system, the DC report is considered by the entire Council. Members of the DC who had sat for the actual hearing at DC cannot sit in the Council while their report is considered. So also, a few other members may be disqualified. In the Council again, both the parties are represented and heard.

Before the DC, a lawyer or any member of ICAI could represent; but before the Council, only a member can represent.

4.12 After the hearing, the Council takes the decision immediately, usually by a majority vote. The Council may take any of the following decisions :

a) Send back the matter to the DC for reconsideration.

b) In case of misconduct specified in schedule I, decide whether a member is guilty and if yes, to award punishment. Since, for Schedule I, the Council’s decision is as good as final, the Council gives one more hearing to the respondent before awarding punishment – Sec. 21(4) of CA Act, 1949.

c) In respect of offences in the second Schedule, the Council has only a power to recommend to the High Court – both the aspects – viz. Whether the Respondent is guilty and if yes, what is the punishment.

For First Schedule, in case the punishment recommended is suspension of membership for a period exceeding 5 years or for life, then also, the Council has to refer it to the High Court.

4.13 Readers may be aware that the High Court in turn may take a few more years. It is thus possible that the decision may become final (unless contested in the Supreme Court) after about 15 to 20 years from the occurrence of the alleged misconduct.

5 Types  of punishment

Under the old system, there were only two types of punishment-

For First Schedule-

i) reprimand  or

ii) suspension of membership for not exceeding five years.

For Second  Schedule-

i) reprimand  or

ii) suspension of membership for any length of time.

6 Interesting (and alarming) instances

6.1 As mentioned earlier, the chartered accountant has become a very soft target. The role of a CA, especially as an auditor, is very vulnerable. There is an increasing tendency to make him a victim of disputes between two parties. The CA is totally unconnected with the dispute.

6.2 I am not trying to say that the work of the CAs in these instances was flawless. There were lacunae; but by no stretch of imagination there was any serious lapse or negligence or mala fide intention or misbehaviour. It was sheer misfortune that brought them into trouble. One very important lesson one should learn is ‘not to do anything in good faith’.

6.3 So far, I have had occasion to handle quite a few cases. The following live instances can really be eye-openers-

6.3.1 For co-operative  Societies, there is a system  that  after  consecutive   two years, the auditor should be changed. Audits are in individual name. There was a couple, both CAs. The wife did a particular audit for 2 years; followed by the husband doing it. Unfortunately, there was a legal separation proceeding between the two; and the wife lodged a complaint that the husband accepted the audit without communicating with the previous auditor.

6.3.2 A private limited company, only two shareholders – brothers; and both were directors. A reputed CA firm doing audit for more than 15 years. In one particular year, since the younger brother was busy in visa formalities since both were to travel together -auditor signed the accounts when only one – elder brother – who was MD with 60% holding – signed the accounts.

Income-tax return was filed thereafter, younger brother refused to sign and filed a complaint that the auditor signed without signature of two directors – Sec. 215 of the Companies Act.

At this juncture, let me point out that in terms of Sec. 215, it is not enough that two directors have signed. What is more important is the approval of accounts in a Board Meeting. This aspect is often overlooked. I would advise that the auditor should retain at least one copy of accounts signed by not only two, but all directors or partners as the case may be.

Interestingly, the reason behind this complaint was that the auditor had declined the complainant’s personal request to accommodate his daughter as a ‘dummy article’.

6.3.3 Mr. A – held Certificate of Practice. – but never pursued it. He was always into a business with Mr. B – Both promoters and co-directors. B’s son completed articleship under A. Unfortunately, there was a dispute between A and B. B’s son files a complaint that A was engaged in a business without obtaining the Council’s permission.

6.3.4 Situation  is all the more vulnerable in co-operative housing  societies. Invariably, there are internal quarrels. A co-operative housing society received a large sum on sale of FSI five years ago. There was no issue with the Income Tax. Due to the disputes among members and also the managing committee, one member files a case that as an honest citizen, he will approach the LT. authorities to issue notice u/s 148, make the society pay the tax and recover from auditor since he did not give proper advice! The purpose was to exert pressure on the other party by threatening the auditor.

6.3.5 A fraudulent lady entered into an ‘arrangement’ with the proprietor of 100% export business. The auditor who was basically a tax practitioner, used to do the audit basically for Sec. 44AB and 80HHC of the Income Tax Act. There was total exemption under Income Tax as well as Sales Tax. The lady in collusion with the businessman and CMD of a nationalised bank, fraudulently got a huge loan disbursed. She herself took away the money. All the three (the lady, the businessman and CMD of bank) were chargesheeted by CBI. And the lady files a complaint that she was misguided bv the audited figures. It could be r roved beyond doubt that the auditor and the accounts had no role to play in the entire deed.

Nevertheless, certain shortcomings which are inherent in any accounts were exposed and the otherwise innocent chartered accountant had to face disciplinary proceedings.

6.3.6 One proprietor CA signed the tax audit report of a medium-scale CA firm – all the partners of which were his close friends. The total collection of the firm about 10 years ago was nearing Rs. two crores.

Unfortunately, in the scrutiny assessment of the firm, it was found that on one particular day, there was a negative cash balance of a few hundred rupees. The Assessing Officer intimated this to the ICAI as a misconduct.

I repeat that in none of the cases one could say that there was no mistake at all. However, the courts have held that the charge in terms of Clause (7) of Part I of Second Schedule is that of ‘gross negligence’ and not of ‘inefficiency’. Every mistake is not a gross negligence. I am sure, these stories are representative of the present scenario.

Our fellow members will be well-advised to proceed with utmost care and caution.

What is essential is a positive perception and conviction that the Code of Ethics is for our protection. It is not a burden, but a shield.

I wish all the readers a trouble-free practice and good luck.

6.3.7 In a deal of immovable properties between Mr. A & Mr. B, Mr. C – a CA was representing Mr. B. In the course of documentation, there were certain differences. C’s presence was felt inconvenient by A and his lawyer. Hence, a complaint was filed against C that he was rendering services of ‘legal drafting’ which is not permissible for a CA.

Under the amended law, there are three types of punishments prescribed.

For First Schedule

i) reprimand

ii) suspension of membership for not exceeding 3 months; or

iii) fine not exceeding Rs. one lakh.

For Second  Schedule

i) reprimand

ii) suspension of membership for any length of time.
    
iii) fine  not  exceeding Rs. five lakhs.

Further, under the new system, the Council’s function is now entrusted to an Appellate Tribunal of five constituents.

Note: After the amendment in the year 2006, the procedure has undergone a radical change. The same will be dealt with in a separate article. At present, a number of old cases are still pending and readers need to know the real position in its perspective.

Introduction :

    Till today the law on the subject of repairing and maintenance of roads and other infrastructural facilities was clear in the minds of all stakeholders (barring a few service tax commissionerates).

    There was this discussion that maintenance and/or repairing of roads may be a taxable activity, but a conclusive view came across from most corners that no such taxing is possible because the law itself was clear enough.

    This view was based on a sound principle of law which says that if a service activity is specifically excluded from the purview of taxation from one service category, it cannot be included in some other category unless and until specific inclusion thereof is provided for it in that Section.

    The Central Board of Excise and Customs (CBEC) has now come up with a Circular No. 110/2009, dated 23.02.2009 clarifying the doubts in respect of levy of service tax on repair/renovation/widening of roads.

    The Circular has tried to give extra-judicial meaning to 2 sections involved :

    1. Commercial or industrial construction service [Section 65(105) (zzq)]

    2. Management, maintenance or repair service [Section 65(105) (zzg)].

Legislative Background :

I. Commercial or Industrial Construction Service :

As per Section 65(25b) of the Finance Act, 1994 (Act), ‘Commercial or industrial construction service’ means —

(a) construction of a new building or a civil structure or a part thereof; or

(b) construction of pipeline or conduit; or

(c) completion and finishing services such as glazing, plastering, painting, floor and wall tiling, wall covering and wall papering, wood and metal joinery and carpentry, fencing and railing, construction of swimming pools, acoustic applications or fittings and other similar services, in relation to building or civil structure; or

(d) repair, alteration, renovation or restoration of, or similar services in relation to, building or civil structure, pipeline or conduit,

which is —

(i) used, or to be used, primarily for; or

(ii) occupied, or to be occupied, primarily with; or

(iii) engaged, or to be engaged, primarily in,

commerce or industry, or work intended for commerce or industry, but does not include such services provided in respect of roads, airports, railways, transport terminals, bridges, tunnels and dams;

    The above defining Section clearly spells out that all kinds of repairing, alteration, renovation, restoration or similar services provided in relation to any infrastructural facilities including roads is completely non-taxable. Therefore it can be safely said that there was and still exists a specific exclusion from charging of service tax on repairing and related services in respect of roads.

II. Management, Maintenance or Repair Service :

    As per section 65 (64) of the Act,

    “management, maintenance or repair service means any service provided by —

    (i) any person under a contract or an agreement; or

    (ii) a manufacturer or any person authorised by him,

    in relation to,

    (a) management of properties, whether immovable or not;

    (b) maintenance or repair of properties, whether immovable or not; or

    (c) maintenance or repair including reconditioning or restoration, or servicing of any goods, excluding a motor vehicle.

    [Explanation : For the removal of doubts, it is hereby declared that for the purposes of this clause, —

    (a) ‘goods’ includes computer software;

    (b) ‘properties’ includes information technology software;]

    This section puts in place a charge on management, maintenance or repair services in relation to all movable and immovable goods and properties. This Section was first amended w.e.f. 16.06.2005 to include maintenance services in respect of immovable properties and it was further amended from 1.05.2006 to include repairing services therein also.

    Legal Importance of circular :

    It is an accepted rule of law that an Act passed by the Parliament is supreme in authority and its provisions cannot be re-defined by issuance of Circulars. Circulars can only be guides to law and law cannot be re-defined by these instruments. Many Circulars have been struck down by Courts. In the case of Commissioner of Sales Tax vs. Indra Industries, (2001) 248 ITR 338 (SC), the apex court has opined that,

    “A Circular by tax authorities is not binding on the Courts. It is not binding on the assessee.”

    Hence Circulars at best are instruments in the hands of administrators to clear doubts where they exist, but unfortunately these are being used to create doubts where none exist.

    Defining the Circular

    Circular no. 110 is issued in response to clarification sought by the Nashik Commissionerate on the issue. The Circular has tried to clarify 2 issues —

    a. Whether management, maintenance or repairs of roads is taxable under similar service head or not.

    b. Segregation of activities in relation to roads into 2 distinct heads as under :

    i. Maintenance & repair activities

    1. Resurfacing

    2. Renovation

    3. Strengthening

    4. Relaying

    5. Filling of potholes

    ii. Construction Activities

    1. Laying of a new road

    2. Widening of narrow road to broader road (such as conversion of a two-lane road to a four-lane road)

    3. Changing road surface (gravelled road to metalled road/metalled road to black-topped/blacktopped to concrete, etc.).

In simple language, as per this Circular all activities of management, maintenance or repairing in respect of roads will be taxable with retrospective effect at least from 1.05.2006 if not earlier. It has tried to define what activities are classifiable as Maintenance or Repair services and what can be defined as Construction. As there is no legal standing of the Circulars, its impact cannot be retrospective in nature.

If we believe this Circular to be sacrosanct, then at least from 1.05.2006 all jobs of resurfacing, renovation, strengthening, relaying or filling of potholes in respect of roads will become taxable.

This can be stretched to mean that if a road is constructed once – all relaying work done on it for as many years to come – would be a taxable activity given that the quality of surface of the road is not changed from gravelled road to metalled road/metalled road to blacktopped/blacktopped to concrete, etc.

Mistake of Omission:

The Circular fails to recognise one important sub-clause of section 65 (25b) of the Act.

As explained earlier, this Section defines the words “Commercial or Industrial Construction” – wherein sub-clause (d) of Section 65 (25b) clearly includes all kinds of repair, alteration, renovation, restoration or similar services. Thereby meaning that repairs is also a sort of Construction.

The definition further has an the exclusion clause which says that,

“but does not include such services provided in respect of roads, airports, railways, transport terminals, bridges, tunnels and dams.]”

The words “Such services” – refer to sub-clause 65 (25b) (a) to (d) – which means that all repairing, renovation, etc., jobs in relation to roads are NOT TAXABLE at all.

Why was this clause not referred to before issuance of the impugned Circular is a question that only the Board can answer. It is clear that they have not considered this sub-clause and this mistake of omission would give birth to serious litigation issues for the infrastructure sector as a whole.

Conclusion:

As far as repairing jobs of roads, etc., is concerned there was no iota of doubt in the legislative intent, because infrastructure is the need of the day and upkeep of the infrastructural facilities is a core area in which the Government is working hard. Unfortunately this Circular may undo all the good intentions of law.

It is not as if the law is silent on the issue. On the contrary, the law is crystal clear and specifically excludes all kinds of repair jobs done in respect of all infrastructural facilities like roads, airports, railways, transport terminals, bridges, tunnels and dams as explained above.

This Circular must be withdrawn with immediate effect and all efforts must be taken by all stake-holders to force the Central Government into withdrawing it. The Circular, in any case according to me, is Void-ab-initio and will not stand the scrutiny of Tribunals and courts in the long run. But till that happens, it would have played the mischief it is intended to. The litigation-creating potential of this Circular is immense and immediate.

This Circular would  proverbially open a Pandora’s box for the maintenance and repairing of infrastructural facilities sector as a whole, because the logic of this circular, if accepted, would mean that similar services in relation to infrastructural facilities other that roads -like airports, tunnels, dams, etc., – will also be taxable and that too retrospectively.

This Circular has all the right ingredients to do all the wrong things !

In Parts One and Two, we discussed definition, recognition, classification and measurement principles of financial assets and financial liabilities. In this part, we will discuss the definition and accounting for derivatives including principles of hedge definition, recognition and accounting.

Derivatives

    A derivative is a financial instrument or other contract which has all the following 3 characteristics (para 8.1 of AS-30) :

    · Its value changes in response to changes in an underlying (the underlying could be a specified interest rate, a financial instrument, a commodity, a currency, an index, a credit rating or index, or other variable).

    · It requires no or small initial net investment (than the investment that would be required if an entity were to enter into other contracts that would be expected to have a similar response to changes in the price of the underlying).

    · It is settled at a future date.

    Common examples of derivatives are forwards, futures, calls, puts and swaps. Derivatives may be exchanged, traded or over-the-counter contracts. If the underlying is a non-financial variable, the standard specifies that the variable should not be specific to a party to the contract. Derivative contracts may be net settled or gross settled. The definition and accounting of a derivative does not depend upon the method of settlement. In both settlement systems, the accounting remains the same.

    If a company buys crude oil futures on a commodity exchange, it typically pays a small initial margin that may range from 5 to 20%. The company is exposed to risk arising from movements in the price of crude oil, which will impact prices of crude oil futures resulting in gains or losses. The contract will be settled at a future date. In practice, most futures contracts are net settled. If the company bought futures at a price of $ 41 per barrel and on the date of expiry the price of spot and futures (which will converge on expiry) is $ 47, the company would have gained $ 6 per barrel, which would be paid to the company on expiry in a net settlement framework. In a gross settlement framework, the company would pay $ 41 and receive delivery of crude oil.

Recognition and Measurement

    A derivative instrument is by default classified as a financial asset or a financial liability held for trading. Derivatives which are financial guarantees or designated as hedging instruments are exceptions. Assets and liabilities held for trading fall under the broader category ‘Financial Assets and Li-abilities held at fair value through Profit and Loss’.

    Accordingly, derivatives (other than exceptions above) are initially recognised at fair value on the date of acquisition or issue (para 47 of AS-30). Transaction costs are recognised as expenses. Subsequently, they continue to be carried at fair value without deduction for transaction costs that may be incurred on sale or disposal (para 51 and 52 of AS-30).

    As a consequence of continuous fair valuation of derivative positions, corporates will be exposed to earnings volatility. Derivative fair values are known to fluctuate substantially and a high exposure to derivatives which do not qualify for hedge accounting treatment is a major challenge that corporates need to manage well.

Example of a Forward Contract

    The accounting community will be familiar with recognition and measurement of forward dollar contracts under the AS-11 framework. The principles of AS-30 are quite different and it may be useful to compare the two methodologies.

    Corporate XYZ Ltd. buys a three-month forward dollar contract for $ 1 on May 1, 2009 at a forward rate of Rs. 50.25. The spot rate on that day was Rs. 49.65 and the premium paid on the forward was Rs. 0.60. The contract was entered into to hedge an import payment that is due three months later.

    Let us assume that the spot rate on June 30, 2009 was Rs. 51 and the forward rate of a one month forward on June 30, 2009 was Rs. 51.12.

AS 11 Framework

    The premium of Rs. 0.60 will be amortised over three months. The June quarter financials will therefore recognise an expense of Rs. 0.40 (two months proportionate amortisation). On June 30, 2009, the forward contract will be revalued to spot Rs. 51.00. However, the underlying payable will also be revalued to Rs. 51.00. The impact of revaluing the underlying payable and the long forward will offset each other so that the impact on the profit would be zero.

AS-30 Framework

    There is no concept of amortisation of forward premium. The derivative contract would be recognised at fair value on the date of inception. A typical on-market forward would have a fair value of zero on the date of inception. In other words, if the corporate were to turn around and square up the contract immediately after inception, it would be able to do so at the same forward rate as it contracted.

    At quarter end, the derivative contract will be fair valued. If the contracted forward rate was Rs. 50.25 and the forward rate on June 30, 2009 was Rs. 51.12, the corporate has generated a gain of Rs. 0.87. This will be present valued (discounted) as there is one month left for expiry. Suppose the present value comes to Rs. 0.86. This is the fair value of the derivative to be recognised as an Asset in the Balance Sheet as at June 30, 2009. Please note that the spot rate of the dollar on June 30, 2009 is not relevant for fair valuing the forward contract, but would be relevant for revaluing the underlying payable.

    The second effect of this fair valuation could either be recorded as a gain in the Profit and Loss account or could be carried to Hedging Reserves, depending upon whether the derivative contract qualifies as a hedge and the type of hedge definition.

Hedge  Accounting

Hedge Accounting is a choice of accounting policy which corporates mayor may not exercise. Hedge accounting allows the corporate to offset the volatility which earnings are exposed to as a consequence of derivative fair valuation at the end of every reporting period. It allows the corporate to either recognise an offsetting gain or loss in the profit and loss itself (and thus negate the derivatives impact) or to recognise the derivative gains or losses
directly in reserves. While it is common to hedge using derivative instruments, it is possible to use regular financial non-derivative instruments for hedging.

The AS-30 framework envisages primarily two types of hedged risks:

(a) those arising from changes in fair values of existing assets, existing liabilities or unrecognised firm commitments (Fair Value Hedging), and

(b) those arising from changes in future cash flows (which could emanate from existing assets, existing liabilities, as well as from highly probable forecasted transactions) (Cash Flow Hedging).

Both risks should affect profit and loss of the entity in order to qualify for hedge accounting treatment. Some examples of underlyings, risks, classification for the purpose of hedging and type of hedge are provided below. The type of hedge indicated here is the one most commonly designated, but it is possible to argue that a cash flow hedge also exposes a corporate to a fair value risk and vice versa and hence such designations need to be effected with care.

Each hedge should be formally documented in an elaborate manner. The documentation will include a formal risk management policy, the hedging instrument, the hedged item, the hedged risk, effectiveness testing methodology to be adopted by the corporate and approval processes. This area needs involvement of non-accounting managers from the corporate, including the top management, operations and treasury.

Effectiveness testing is required on a prospective basis to establish that the hedge is expected to be effective in managing the risk which it seeks to mitigate. At each reporting period end, the hedge needs to be retrospectively tested to establish whether it was de facto effective in its stated objective. The standard specifies that the change in the fair value of the hedging instrument should retrospectively fall between 80% to 125% of the change in the value of the hedged item attributable to the hedged risk. If the hedge is not effective, hedge accounting principles cannot be applied.

Accounting for Fair Value Hedges

In fair value hedges, gains and losses arising from both instruments, viz., the hedged item and the hedging instrument are recognised in the statement of profit and loss, thus creating an offset such that the net gains or losses impact the reported profit. In more formal terms, the following treatment is adopted:

•     Gain or loss arising from re-measuring the hedging instrument at fair value is recognised in the statement of profit and loss.

•     Gain or loss arising from the hedged item attributable to the hedged risk is recognised in the statement of profit and loss.

Example –    Export Receivables

Corporate XYZ has exported merchandise for $ 100,000 recognised at spot rate of Rs. 50 on the day of export. The corporate sold 3-month forward dollars at Rs. 50.60 on the same day. At the quarter end, the spot rate was Rs. 50.75 and forward rate (of an equivalent tenor as that outstanding on that forward) was Rs. 51.02.

The corporate needs to designate the risk sought to be hedged in a precise manner. This risk can be defined in two ways (a) risk of the volatility of the spot dollar (b) risk of the volatility of the forward dollar. Each designation will lead to difference in hedge accounting measurements as well as effectiveness.

Risk of Spot Volatility

The spot has moved by Rs. 0.75 while the forward has moved by Rs. 0.42 between the date of export and the period end. The forward would be discounted to present value as the realisability of the forward is expected only on its final settlement. Let us assume the present value of the forward gain is Rs. 0.41. Hedge effectiveness percentage would come to 55% and the hedge would fail. The derivative fair value will be charged to the profit and loss statement while the receivable would be revalued under AS-l1 and the restatement gain taken to the profit and loss statement.

Risk of Forward Volatility

The forward element of the receivable has hypothetically moved by Rs. 0.41 (when fair valued) and the forward contract has also moved by Rs. 0.41 (when fair valued). Thus the hedge is effective. This loss on the forward would be recognised in the statement of profit and loss, while the movement in the spot would be recognised under AS-II in the profit and loss.

The final impact on the net profit is the same in this illustration, irrespective of whether the hedge is effective or otherwise. However, the line item classification within the statement of profit and loss may differ. Hedged items related gains and losses are commonly classified along with the underlying transactions while gains and losses on ineffective hedges are classified as derivative losses, which, if material, would merit a separate line item disclosure in the statement of profit and loss.

Cash Flow Hedge Accounting

Gains and losses on hedging instruments designated as cash flow hedges, if effective, are recognised directly in equity (generally in Hedging Reserves). These gains and losses are recycled into the statement of profit and loss when the underlying transaction impacts the statement of profit and loss.

Example – Forecasted Revenue

Corporate ABC forecasts dollar revenues of $ 10mio for the year to end March 2010. These sales relate to the month of January 2010. It faces a risk of dollar volatility and has sold forward dollars for each month in this financial year so as to hedge itself at Rs. 51.27 today, when the spot dollar was Rs. 50. At the end of the June quarter, spot dollar was Rs. 50.65 while the forward dollar of equivalent tenor was Rs. 51.75.

The corporate needs to designate the hedged risk in a precise manner. In particular, the hedged risk may be defined as (a) the risk of volatility in the spot or (b) the risk of volatility in the forward.

If the spot risk is designated, hedge effectiveness will be tested as under. Change in the value of the hedging instrument (based on forward dollar) is Rs 0.48, while the change in the value of the hedged item (i.e., forecasted revenues based on spot dollar) is Rs. 0.65. The hedge effectiveness ratio will work out to 74% and the hedge will be considered ineffective. Please note that the forward dollar will need to be present valued to arrive at the fair value, but that process will make the hedge further ineffective.

The loss on the forward will be recognised in the statement of profit and loss as the hedge is ineffective.

If the forward risk is designated, hedge effectiveness will be computed at 100% (as both the hedging instrument and the hedged item will change by the same amount of the present value of Rs. 0.48). The loss on the forward will therefore be recognised in equity. This accounting process will shield the present earnings from derivative volatility.

In the quarter in which the revenue forecasted actually happens (in our example the Jan.-March 2010 quarter), the cumulative gains or losses parked in reserves will be recycled into the statement of
profit and loss.

Conclusion
Derivative accounting and hedge accounting are complex areas which need a deep understanding of economic hedging, derivative instruments, risk management concepts as well as the accounting standard requirements. Systemic challenges around hedge definitions and accounting are stringent and corporates need to plan in advance to establish these systems well. In many cases, a committed involvement of operational managers as well as information technology is required to implement hedge accounting successfully.