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The Companies Act 2013 Simplified - EY India
The Companies Act 2013 Simplified - EY India
Dear reader,
We are delighted to share with you our new publication
Companies Act 2013: Beginning of a new era.
The MCA has so far notified and made effective 283 sections,
out of total 470 sections of the 2013 Act. The MCA has also
issued final rules relating to 19 chapters, covering most of
the notified section. To address practical issues, the MCA has
also amended Schedule II (regarding depreciation), proposed/
issued three orders for removal of practical difficulties and
issued certain General Circulars to provide more clarity.
The enactment is a milestone event with far-reaching
consequences. Companies should not underestimate the
impact of new law. The MCA has addressed some key pain
areas for companies; however, implementation of the
2013 Act isnt still a hassle free process. Implications and
consequences can be severe, if a company fails to take
immediate steps to implement the 2013 Act. A case in point is
directors and auditors reporting responsibilities with regard
to internal financial controls. Though the reporting is needed
at year-end, internal financial controls should exist and be
operating effectively throughout the year. Another example is
the approval required for related party transactions or loans
and investments. There are numerous such issues requiring
immediate action from companies.
We compliment the Government of India, especially the MCA,
for maintaining a highly consultative approach throughout
the process of issuing the 2013 Act and in finalizing the rules.
Nonetheless, a large number of interpretative issues and
concerns continue to exist, and many of those are discussed
in this publication. The most fundamental being the numerous
matters where it appears that the final rules may not be in
consonance with the 2013 Act. Many of these issues can
be addressed through appropriate changes in the rules,
schedules and general circulars. A few others may need some
amendments to the 2013 Act. We believe that this is not the
end of the road, and herein lies a significant opportunity for
the MCA to continue engaging with constituents as it has been
doing so in the past. Ultimately, all of us would like to see a
legislation that is robust, and strikes a sweet spot between
business reality and regulatory needs.
Contents
Financial Reporting
Board report
Disclosures required
Directors responsibility
Auditors responsibility
12
13
17
19
Depreciation 20
Declaration and payment of dividend
23
25
Free reserves
26
27
Re-opening/revision of accounts
28
30
Appointment of auditors
30
Rotation of auditors
32
36
Independence/prohibited services
39
Reporting responsibilities
41
41
Fraud reporting
41
CARO reporting
44
Penalty on auditors
2
45
46
46
46
48
Definition of relative
48
51
Approval process
52
60
Transitional requirements
61
62
62
63
66
Corporate governance
74
74
Woman director
75
Independent directors
77
Audit Committee
79
80
Vigil mechanism
81
Subsidiary companies
81
Internal audit
82
84
Glossary
86
Beginning of a new era |
Financial Reporting
The Central Government has still not constituted the NCLT and
many provisions relating thereto are not currently notified.
Under section 434 of the 2013 Act, certain matters pending
with the High Court, District Courts or the CLB, as the case may
be, which will be within the jurisdiction of the NCLT, would be
transferred to the NCLT from a notified date. Till such time, the
courts and the CLB will continue to function. In the absence
of NCLT, a company may contact the MCA to seek guidance
with regard to which of these authorities they should file an
application for adoption of a financial year other than one
ending on 31 March.
Board report
Disclosures required
The 2013 Act read with the Accounts Rules require several
disclosures about performance, risks, etc. Key disclosures
include:
Outlook
Practical perspectives
Disclosures required under RC49 are similar to those under
the pre-revised 49. However, companies need to ensure proper
synchronization of these disclosures with the new disclosures
under the 2013 Act.
In the case of a listed company, the board needs to disclose
information under the three heads, viz., board report, Directors
Responsibility Statement and MD&A. A listed company may
present MD&A either separately in the annual report or as part
of the board report itself. Though information requirements
of the board report and MD&A are worded differently; from
practical perspective, the presentation of such information
is likely to significantly overlap with each other. A listed
company may need to structure its board report and MD&A
carefully so that meaningful information is presented to users
without duplication, while ensuring compliance with both the
requirements.
Practical perspectives
In many cases, this disclosure for each subsidiary, associate and
joint venture may become very cumbersome for companies.
Also, investors and analysts typically look at performance
and financial position of the consolidated group, as against
each individual entity. Therefore, groups will have to provide
stand-alone performance of each company for complying with
the 2013 Act and consolidated performance for the benefit of
investors and other stakeholders.
Practical perspectives
These disclosures are in many respects consistent with the
disclosures required globally. For example, the Dodd Frank Act
in the US and recent changes in the Company Law in UK require
similar disclosures. It is believed that these disclosures will
bring about greater accountability amongst companies. Also,
disclosure regarding remuneration of the employees, who are
not directors but receive remuneration in excess of the highest
paid director, during the year, may bring to focus the real
decision makers.
The Managerial Personnel Rules clarify that median means the
numerical value separating the higher half of a population from
the lower half and the median of a finite list of numbers may
be found by arranging all the observations from lowest value to
highest value and picking the middle one. Assuming a company
has three categories of employees, i.e., 1150 workers, 550
officers and 299 middle and senior management. The median
remuneration would be what employee number 1,000 would be
earning, if they were arranged in an ascending or descending
order based on their remuneration. In this case, that happens
to be a worker. The comparison of a workers remuneration with
the CEO will reflect a significant disparity and may not give any
meaningful information to the users.
Similar disparity may arise in the case of a company which has
many branches in countries where remuneration is high. In
such cases, inclusion of foreign salaries with Indian workers to
determine the median may reflect a distorted comparison.
To give more meaningful information to users, some companies
may voluntarily disclose category-wise comparison in
addition to the disclosures required as per the Managerial
Personnel Rules. In the above example, comparison of median
remuneration of middle and senior management with CEOs
salary may provide more meaningful information.
Effective date
In the 2013 Act, the board report includes many matters, which
hitherto were not required in the 1956 Act. These matters
to be reported may be very onerous and time consuming to
prepare. Hence, the applicability date is important. Section 134
of the 2013 Act dealing with board report is applicable from 1
April 2014. The MCA has clarified that the rules will also apply
from 1 April 2014. However, neither the 2013 Act nor the
rules clarify as to how this requirement should be applied. The
following three views were possible:
(i)
Auditors responsibility
Section 143(3) of the 2013 Act states that the auditors report,
among other matters, will state whether the company has
adequate internal financial controls system in place and the
operating effectiveness of such controls. This requirement
is applicable to all companies, including non-listed public and
private companies. Neither the 2013 Act nor the Audit Rules
define the term internal financial controls for this purpose.
Table 1
Companies
Coverage
Listed
Non-listed
Boards report
Neither section 129(4) nor any other section of the 2013 Act
requires the provisions concerning preparation of the board
report of a parent company to be applied, mutatis mutandis, to
the consolidated board report. In fact, there is no concept of a
consolidated board report under the 2013 Act. Rather, subrule 8 in the Accounts Rules is clear that board report needs to
be prepared based on the standalone financial statements of a
company. Considering this, directors of a parent company are
not required to comment regarding adequacy/ existence and
operating effectiveness of internal financial controls for the
group as a whole.
11
13
15
17
19
Depreciation
BOT assets
(ii) C
lass II covered companies or assets where useful
lives or residual value are prescribed by a regulatory
authority constituted under an act of the Parliament
or by the Central Government. These companies will
use depreciation rates/useful lives and residual values
prescribed by the relevant authority.
(iii) C
lass III covered all other companies. For these
companies, the useful life of an asset will not be longer
than the useful life and the residual value will not be
higher than that prescribed in Schedule II.
Pursuant to a recent amendment to Schedule II, distinction
between class (i) and class (iii) has been removed. Rather, the
provision now reads as under:
(i) The useful life of an asset shall not be longer than
the useful life specified in Part C and the residual value
of an asset shall not be more than five per cent of the
original cost of the asset:
Provided that where a company uses a useful life or
residual value of the asset which is different from the
above limits, justification for the difference shall be
disclosed in its financial statement.
From the use of word different, it seems clear that both
higher and lower useful life and residual value are allowed.
However, a company needs to disclose justification for using
higher/lower life and/or residual value. Such disclosure will form
part of the financial statements.
Transitional provisions
With regard to the adjustment of impact arising on the firsttime application, the transitional provisions to Schedule II state
as below:
From the date Schedule II comes into effect, the carrying
amount of the asset as on that date:
a) Will be depreciated over the remaining useful life of
the asset as per this Schedule,
b) After retaining the residual value, will be recognised
in the opening balance of retained earnings where
the remaining useful life of an asset is nil.
21
23
(iv) The balance of reserves after such withdrawal will not fall
below 15% of its paid up share capital.
(v) No company will declare dividend unless carried over
previous losses and depreciation not provided in previous
year are set off against profit of the company of the
current year. The loss or depreciation, whichever is
less, in previous years is set off against the profit of the
company for the year for which dividend is declared or
paid.
From the first condition, it appears that a company having
history of dividend can declare maximum dividend upto past
three years average. However, there is no limitation for
companies not having dividend payout history.
(iii) W
riting off debentures and preference share issue
expenses
(iv) P
roviding for premium payable on redemption of
preference shares/debentures
It is understood that the Central Government introduced these
restriction over the use of securities premium to align the
accounting requirement with Ind-AS. Since Ind-AS are currently
not notified, the rules do not define companies which will be
covered under the prescribed class. This implies that currently,
there will be no company covered under the prescribed class
and the above restrictions will not apply.
It may be noted that the ICAI has recently proposed a new
roadmap for implementation of Ind-AS in India and submitted
it to the MCA for its consideration. The roadmap recommends
preparation of Ind-AS accounts only at the CFS level. It seems
that even companies, which are covered under the eligibility
criteria for preparation of Ind-AS CFS, will continue preparing
SFS in accordance with Indian GAAP. A perusal of the section
indicates that for these companies, restrictions on utilization
of securities may apply in both the Indian GAAP SFS and IndAS CFS. We believe that the MCA may further clarify while
prescribing companies to whom Ind-AS and the restrictions on
utilization of securities premium will apply.
25
Free reserves
Practical perspectives
Under the 1956 Act, threshold for minimum DRR varied depending on the class of companies. These thresholds were lower than
those prescribed under the 2013 Act. Table 2 describes minimum DRR required for debentures.
Table 2: Minimum DRR required for debentures
Class of company
1956 Act
2013 Act
Public issue
Private placement
Nil
Nil
50%
25%
Nil
50%
25%
25%
50%
Non-listed companies
NA
25%
50%
27
Re-opening/revision of accounts
The 2013 Act contains separate provisions relating to:
Practical perspectives
Reopening of accounts whether voluntarily or mandatorily is
not an easy process. The draft rules had prescribed several
onerous steps which need to be completed for revision. Also,
there are certain issues which are not clear. Given below is an
overview of key aspects which may need to be considered:
We expect that the MCA may clarify these issues in the final
rules.
29
Appointment of auditors
Like the draft rules, the Audit rules also require the Audit
Committee to recommend auditors for appointment.
The draft rules required that if the board does not agree
with the Audit Committee recommendation and decides
to eventually propose its own nominee at the AGM, the
board will explain the reasons for not accepting the Audit
Committee recommendation in the board report. It was
expected that to avoid such disclosures, there will be
pressure on the board to accept the Audit Committee
recommendation.
In the Audit Rules, the language has changed and
it is stated that the board will record reasons for its
disagreement with the Audit Committee and send its own
recommendation to the AGM. Though the Audit Rules
do not specifically require disclosure in the board report,
section 177(8) of the 2013 Act requires that if the board
has not accepted any recommendation of the Audit
Committee, the same will be disclosed in the board report
with reasons. Hence, the position as mentioned in the draft
rules will continue.
The draft rules required that before recommending
31
Rotation of auditors
In accordance with the 2013 Act, listed companies and
companies belonging to the prescribed class cannot appoint
or re-appoint the auditor for: (a) More than two terms of five
consecutive years, if the auditor is an audit firm; (b) More
than one term of five consecutive years if the auditor is an
individual. Under the draft rules, the prescribed class included
all companies excluding one-person companies and small
companies. This is changed in the Audit Rules. Under the
Audit Rules, auditor rotation applies to the following classes
of companies excluding one person companies and small
companies:
The auditor, who has completed his term, will not be eligible for
re-appointment as auditor in the same company for five years
from completion of the term. The same restriction applies to the
audit firm which has common partner(s) with the outgoing audit
firm at the time of appointment.
Incoming auditor/audit firm is also not eligible for appointment
if they are part of the same network as the outgoing auditor.
In simple words, the auditor has to be rotated outside the
network firm and not within the network firm. The term same
network has been explained to include the firms operating or
functioning, hitherto or in future, under the same brand name,
trade name or common control.
If a partner in the outgoing audit firm, who is in charge of the
firm and also certifies financial statements of the company,
retires from the said firm and joins another firm of chartered
accountants, such other firm will also not be eligible to be
appointed as auditor for a period of five years.
Transitional requirements
Like the draft rules, the Audit Rules are clear that holding of
the office by the auditor prior to the commencement of the
2013 Act will be included to determine the time of rotation. In
other words, rotation applies retrospectively. In determining
the time of rotation, service period also includes period served
by network firms. For example, firm A audited Client X for the
first four years. Thereafter, it moved to firm B which is the firm
under the same network. Hence, service period completed
by firm A and firm B will be included to determine the time of
rotation.
Effective date
Section 139 (2) of the 2013 Act dealing with auditor rotation
is applicable from 1 April 2014. The Audit Rules also apply
from the same date. One of the provisos to section 139(2)
of the 2013 Act states that existing companies, which are
covered under auditor rotation requirement, should comply
with those requirements within three years from the date of
commencement of the 2013 Act. Section 1(3) of the 2013 Act
states that different dates may be appointed for bringing into
force different provisions of the 2013 Act and any reference
in any provision to the commencement of the 2013 Act will
be construed as a reference to the coming into force of that
provision. Hence the three year period in this regard starts from
1 April 2014. Illustration 2 given in paragraph 6(3) of the Audit
Rules also confirm this point. One heading in the illustration
indicates that three years countdown starts from the AGM held
after the commencement of section 139(2), i.e., from the first
AGM held on or after 1 April 2014.
33
Under the 2013 Act, an audit firm is appointed for two 5 year
terms, which is then followed by a 5 year cooling off period. In
the case of RBI, an auditor is appointed for 4 years, followed
by a two year cooling off period. Thus, one may also raise an
issue of whether a 5 year cooling off period is relevant in the
case of a bank. Similar concern is also relevant in the case of an
insurance company. We suggest that the MCA, the RBI and the
IRDA should provide an appropriate clarification on the same.
In accordance with the Audit Rules, a break in the term for
a continuous period of five years is considered as fulfilling
the requirement of rotation. In other words, an audit firm
becomes eligible for fresh appointment only if there has
been a break in the audit service for a continuous period of
five years. Is this requirement applicable prospectively or
retrospectively?
Let us assume that a company has changed its auditor two
years-back. Before the change, the audit firm had audited
the company for a continuous period of more than 10 years.
From the current financial year onward, the company desires
to appoint the same audit firm as its auditor. In this case, will
the previous period of service be also included to decide the
auditor rotation period?
Consider second example. An audit firm had previously
audited a company for five continuous years. After this, there
was a break in the service of the audit firm for 3 years. The
same audit firm was appointed auditor again and is auditing
the company for past 3 years. In this case, to decide auditor
rotation period is there a requirement to consider earlier
service period also? Or will it be sufficient compliance if the
auditor rotation period is decided only based on the current
history, ignoring five year audit services performed in the
earlier past?
Explanation II to paragraph 6(3) of the Audit Rules states as
below:
For the purpose of rotation of auditors:
a) A break in the term for a continuous period of
five years shall be considered as fulfilling the
requirement of rotation
35
Practical perspectives
We suggest that the MCA/ ICAI may clarify this issue. In the
absence of any guidance/clarification, the wording used
indicates that limits apply person/relative-wise; however,
limits includes that persons indebtedness, etc., to the
company, its subsidiary, holding or associate company
or subsidiary of such holding company. Example below
explains this principle in the context indebtedness of an
auditors relative.
Business relationship
Under the 2013 Act, a person or an audit firm are not eligible
for appointment as auditor, if it, directly or indirectly, has
business relationship with the company, its subsidiary, its
holding, or associate company or subsidiary of such holding
company or associate company. The draft rules explained the
term Business relationship to mean any transaction entered
into for a commercial purpose except professional services
permitted to be rendered by an auditor.
Hence, there was a concern that an auditor cannot purchase/
avail goods/services from the auditee company, its subsidiary,
its holding, or associate company or subsidiary of such holding
company or associate company. This was likely to pose serious
practical problems not only to the auditors but also to the
companies they audit. For example, an auditor of a hospital
would not have been able to avail services of that hospital even
if the hospital charged the same price as it would have to any
other patient, and it would not have mattered if that was the
only hospital available to the auditor.
In the Audit Rules, exemption regarding professional services
permitted to be rendered by an auditor has been retained. To
address the above concern, the Audit Rules additionally allow
parties to enter into commercial transactions that are in the
ordinary course of business of the company at arms length
price, e.g., sale of products/services to auditor as customers in
the ordinary course of business, by companies engaged in the
business of telecommunications, airlines, hospitals, hotels and
such other similar businesses.
Practical perspectives
37
Practical perspectives
Under the 1956 Act read with the ICAI rules, a person/partner
cannot audit more than 30 companies, including private
companies, per year. Out of this, maximum 20 companies
can be public companies. The 2013 Act has reduced the
maximum limit to 20 companies (including private companies)
with immediate effect from 1 April 2014. The auditors/audit
firms with more than 20 audits (individually/per partner) stand
disqualified from being appointed/reappointed as auditor of
excess companies. This is likely to result in casual vacancy in
the office of the auditor, requiring companies to search for a
replacement auditor immediately. In certain cases, it may be
difficult to find a suitable auditor in a very short period of time.
We recommend that the MCA may address this issue though
the order for removal of difficulties.
We believe that from an audit firm perspective, the above limit
will apply on a global basis and not per partner. To illustrate,
let us assume that an audit firm has 5 partners. It can accept
appointment as auditor of maximum 100 companies. However,
it is not the case that each partner should audit a maximum of
20 companies. That limit can be exceeded, subject to an overall
limit of 100 companies for the firm. Whilst this view is clear
from reading of the section; to avoid differing practices, ICAI
may confirm this.
Independence/prohibited services
Under the 2013 Act, an auditor is allowed to provide only such
non-audit services to the company as are approved by its board
or audit committee. However, the auditor is not allowed to
render the following services either directly or indirectly to the
company, its holding or subsidiary company:
Internal audit
Actuarial services
Management services
Transitional requirements
If an auditor has been rendering non-audit services to a
company on or before the commencement of the 2013 Act, the
auditor will need to comply with the above restrictions before
the end of the first financial year. This implies that:
39
Practical perspectives
In certain cases, the independence requirements of the 2013
Act are stricter than those currently applicable. To illustrate,
under the IESBA code, an auditor is prohibited/restricted from
rendering non-audit services to the parent of its non-SEC listed
audit client, only if the audit client is material to the parent. In
case of non-listed non-SEC audit client, there is no restriction
on rendering non-audit services to the parent if the parent
is also a non-listed entity. Under the 2013 Act, restriction/
prohibition will apply in all these cases. This requires companies
as well auditors to consider various non-audit services being
rendered to a company, its holding or subsidiary company. If it
is determined that certain services are not permitted, the same
needs to be completed/terminated by 31 March 2015.
Management services
Under the 2013 Act, an auditor is not allowed to render,
among other services, management service to the company,
its holding or subsidiary company. However, this term is not
defined either in the 2013 Act or in the Audit Rules. In the
absence of clear definition, one may argue that guidance can
be taken from the IESBA Code. The IESBA code provides the
following guidance on management responsibilities:
290.162 Management of an entity performs many
activities in managing the entity in the best interests of
stakeholders of the entity. It is not possible to specify
every activity that is a management responsibility.
However, management responsibilities involve leading
and directing an entity, including making significant
decisions regarding the acquisition, deployment and
control of human, financial, physical and intangible
resources.
Reporting responsibilities
Internal financial controls
Reporting responsibilities of the auditor concerning internal
financial control both with respect to SFS and CFS are
discussed elsewhere in this publication.
Fraud reporting
The 2013 Act requires that if an auditor, in the course the
performance of his duties as auditor, has reasons to believe
that an offence involving fraud is being or has been committed
against the company by its officers or employees, he will
immediately report the matter to the Central Government
within the prescribed time and manner. Under the draft rules,
reporting to the Central Government was required only for
material frauds. Material frauds were defined as (a) fraud(s)
happening frequently, or (b) fraud(s) where the amount
involved or likely to be involved is not less than 5% of net profit
or 2% of turnover of the company for the preceding financial
year. For immaterial frauds, the auditor was required to report
only to the Audit Committee/Board.
41
Both the 2013 Act and the Audit Rules require an auditor to
report frauds being committed to the Central Government.
The following key issues need to be considered regarding this:
a) Is an auditor also required to report suspected frauds to
the Central Government?
b) If response to (a) is yes, at what stage an auditor should
report matter to the Central Government? Consider
that under the vigil mechanism, an employee has raised
complaint about a potential fraud being committed by an
officer of the company. The company is in the process of
collecting necessary data and verifying the complaint.
It is expected that the management/Audit Committee
need approximately three months to verify the accuracy
or otherwise of the complaint. Is the auditor required to
report the matter to the Central government, without
waiting for the outcome of the inquiry?
c) Is the auditor also required to report those matters of
suspected frauds to the Central Government where
the management/Audit Committee have ultimately
concluded that no fraud is involved?
a) For fraud reporting, the use of the phrase is being
committed is not clear. However, a reading of the 2013
Act and related the Audit Rules indicate that it is not
necessary for a fraud to be finally concluded to trigger an
auditors reporting to the Central Government. Rather,
an auditor may also need to report matters of suspected
frauds to the Central Government. Please refer response to
issue (b) regarding the stage at which an auditor may need
to report suspected frauds.
b) One view is that the Audit Rules require an auditor to
report on all cases of suspected fraud to the Central
Government within 60 days. Hence, as soon as, an
auditor becomes aware of any complaint about a potential
fraud, the auditor will report the matter to the Central
Government within 60 days by adopting the procedure
prescribed. Hence, auditor should not wait for completion
of inquiry being conducted by the management/Audit
Committee.
43
CARO reporting
Under the 1956 Act, the Central Government issued the CARO
2003. CARO 2003 contains various matters on which the
auditors of companies (except exempted companies) have to
make a statement in their audit report. The Audit Rules issued
under the 2013 Act do not contain a similar order. Rather, the
Audit Rules require an auditor to comment on the following
three additional matters:
Practical perspectives
The requirements contained in clauses (a) and (b) in any case
require an auditor to qualify/modify the audit report if provision
for foreseeable losses and litigations is not made, and the
amounts involved are material. However, because of specific
requirements contained in the 2013 Act, the auditor may
provide a greater focus on these issues in the audit.
Transitional requirements
In addition to specific issues/aspects, one pervasive and key
issue for auditor reporting was related to the applicability date.
In accordance with the notification, new requirements apply
from 1 April 2014. However, it was not clear as to how exactly
this requirement will apply. It appeared that the following three
views were possible:
(i)
Penalty on auditors
Section 147(5) of the 2013 Act states that where, in case
of audit of a company being conducted by an audit firm, it is
proved that the partner or partners of the audit firm has or
have acted in a fraudulent manner or abetted or colluded in any
fraud by, or in relation to or by, the company or its directors or
officers, the liability, whether civil or criminal as provided in this
Act or in any other law for the time being in force, for such act
shall be of the partner or partners concerned of the audit firm
and of the firm jointly and severally.
Practical perspectives
The Audit Rules have clarified the position only with respect to
the criminal liability but not the civil liability. Hence, one may
argue that for civil liability, joint and several liabilities of the
partners and the firm can be enforced even if all the partners
have not colluded in committing the fraud.
45
Related parties
transactions
Common directorship
The definition of related parties in the 2013 Act provided
that related party with reference to a company, among other
matters, includes a public company in which a director or
manager of the company is a director or holds along with his
relatives, more than 2% of its paid up share capital (emphasis
added).
To explain, assume that ABC Limited and DEF Limited are two
public companies. There is no relation between the companies,
except relation below.
(ii) D
irector or manager holds along with his relatives more
than 2% of paid up share capital in the public company
47
Definition of relative
The 2013 Act defines the term relative as with reference to
any person means anyone who is related to another, if:
(i)
Daughter
Daughters husband
Sons wife
Practical perspectives
(1) Among other matters, the definition of relative is likely
to have significant impact on aspects such as coverage of
related party transactions or appointment, qualification
and disqualification of auditor and independent directors.
We believe that rationalization of the list of relatives is an
improvement from the definition contained in the draft
rules and it may somewhat reduce challenges in ensuring
continuing independence of the auditor/independent
directors. However, the fact remains that a person may
not be able to control/influence actions of other person if
the other person is not financially dependent on him/her.
Similarly, a person may be able to influence other persons
who are financially dependent on him or her, even if they
are not covered in specific list or relations. Going forward
this aspect may be revisited by the MCA.
Also, it may be noted that the proposed order is relevant only for the identification of public company as related party. There is no
change in the criterion to determine whether a private company is related party to the company. Also, it is pertinent to note that the
above differentiation between private and public companies is from the perspective of the company who is being identified as related
party and not the company who is identifying its related party. Table 4 explains this aspect from ABC Limiteds perspective:
Table 4: Related party identification
ABC Limited
Public/Private
Public/Private
Public/Private
Public/Private
DEF Limited
Public
Public
Private
Private
Common director
Yes
Yes
Yes
Yes
2%
Nil
2%
Nil
Nil
2%
Nil
2%
Yes
No
Yes
Yes
Yes, if ABC is a
private company.
No, if ABC is a public
company.
49
(3) Whilst the RC49 uses the terms such as close member of family, joint venture and group, it does not define those terms.
It may be argued that since definition of related parties is based on Ind-AS 24, a listed company should refer Ind-AS for
appropriate definition of these terms.
(4) The definition of related party under the RC49 is much more exhaustive. Related parties under section 2(76) of the 2013 Act
are just one element of related party relationships covered under the RC49. RC49 is likely to result in identification of much
higher number of related parties and identification on a more consistent basis. Consider the example in diagram 1 below:
Diagram 1
Company Z
Company H
50%
50%
Company A
Company S
30%
Identification of relevant
transactions
Section 188 of the 2013 Act deals with the related party
transactions with respect to:
a) Sale, purchase or supply of any goods or materials
b) Selling or otherwise disposing of, or buying, property of
any kind
c) Leasing of property of any kind
d) Availing or rendering of any services
e) Appointment of any agent for purchase or sale of goods,
materials, services or property
f)
51
Approval process
Though related party transactions both under the 2013
Act and RC49 require approval of similar bodies, there are
differences in the conditions which trigger such approvals.
Particularly, RC49 does not exempt material related
party transactions from special resolution of disinterested
shareholders based on the criteria, viz., (i) transaction is in
the ordinary course of business and at arms length, or (ii)
prescribed thresholds regarding transaction value and share
capital are not breached. Listed companies need to consider
the requirements carefully and apply the same in a manner
that compliance with both requirements can be ensured. In
other words, they need to comply with stricter of the two
requirements.
(I)
There is no change in approval process under the Board Rules. However, monetary thresholds for passing special resolution have
increased vis--vis the draft rules. See Table 5.
Table 5: Monetary thresholds for passing special resolution
Criteria
Board Rules
Draft rules
`1 crores or more
Revised Clause 49
Under RC49, all related party transactions require prior
approval of the Audit Committee, irrespective of whether
they are material or not. RC49 also requires all material
related party transactions to be approved by the shareholders
through special resolution. Related parties should abstain from
voting on such resolutions. Unlike the 2013 Act, RC49 does
not exempt material related party transactions from special
resolution of disinterested shareholders based on the criteria,
viz., (i) transaction is in the ordinary course of business and at
arms length, or (ii) prescribed thresholds regarding transaction
value and share capital are not breached.
53
To comply with RC49, a listed company needs to get all related party transactions approved by the Audit Committee.
It also needs to get all material related party transactions approved by the Board and Special Resolution of Disinterested
Shareholders. The exemptions given under the 2013 Act will not apply.
(II) F
or immaterial transactions of listed companies and all related party transactions of non-listed entities, approval requirements
of the 2013 Act apply. It is noted that due to differences in criteria, even an immaterial related party transaction (as per RC49)
may need board/disinterested shareholder approval under the 2013 Act. For example, this may arise because transaction is
not in the ordinary course of business and/or not on arms length basis, and the share capital or transaction vale thresholds are
breached.
Diagram 2 below explains practical applicability of the approval process. The diagram illustrates approval requirements of both the
2013 Act and RC49.
Yes
Yes
Listed company?
No
NO
NO
Yes
NO
NO
NO
Yes
Special resolution of
disinterested
shareholders is
required.
Special resolution of
disinterested
shareholders is
not required.
Under the 2013 Act, non-listed companies, which do not meet the prescribed criteria, are not required to constitute Audit Committee. In such case, Audit Committee approval requirement does not apply.
Yes
Report dated 31 May 2005 issued by the Expert Committee on the Company Law, chaired by Dr. Jamshed J. Irani.
55
Investor A
20%
Public
shareholding
29%
Subsidiary
S
Diagram 3
Parent P
51%
Neither the 2013 Act nor the Board Rules nor RC49 are clear
which related parties are not entitled to vote. This is likely to
result in multiple views on the matter.
The fourth view is that related parties of both S and P (who are
shareholders in S) are not entitled to vote.
We believe that the first view is logically correct and probably
reflects the intention of the legislator. It may be appropriate
for the MCA and the SEBI to clarify. Until such guidance or
clarification is provided, it may be appropriate for a company to
consult legal professionals before taking any final view.
Master agreements
With regard to the Audit Committee/Board/disinterested
shareholders approval required on related party transactions,
can a company take a view that it will be sufficient compliance
if it obtains the required approval on the master agreements
(MA) with broad terms agreed therein? Or is it mandatory
to obtain separate approval on each transaction?
Neither the 2013 Act nor the Board Rules nor RC49 provide
any guidance on whether a company needs to obtain separate
approval of the Audit Committee/Board/disinterested
shareholders, as applicable, on each contract/transaction or
it is sufficient compliance if the company obtains the required
approval on the MA with the broad terms agreed therein.
Under the second view, the company does not require separate
approval for any sub-agreement/purchase order executed
between parties.
One view is that section 188 refers to any contract or
arrangement. Therefore, separate approval for each contract,
including sub-agreement, is required. However, the second view
is that the term arrangement has wider meaning than the term
contract/agreement. Hence, one may argue that for standard
contracts involving sale/rendering of goods/services, it is
possible to obtain the requisite approval only on the MA, which
lays down all critical terms and conditions such as type of good/
service, pricing arrangement, credit period and payment terms.
Based on the terms agreed in the MA, subsequent transactions
are consummated and these transactions are closely aligned
with the terms agreed in the MA. In this case, one may argue
that subsequent purchase orders/sub-agreements are merely
an execution of what has already been agreed and approved.
They do not result into any new contract/arrangement. Hence,
there is no need for obtaining any separate approval on the
same. However, if the sub-agreement contains terms, which are
different from the MA, or there is any modification in terms or
the underlying circumstances have changed, separate approval
is needed. Also, for the contracts, which are highly complex
and specialized in nature, it may not be possible to define all
critical terms under the MA. Rather, a company needs to obtain
separate approval for each such contract.
Since the 2013 Act or Board Rules or RC49 do not deal with
this aspect, a company may need to evaluate its specific facts
and circumstances and consult professionals, including legal
professionals, before taking any final view.
57
Non-reciprocal relationship
As mentioned earlier, identification of related parties under
the 2013 Act is not based on the principle of reciprocity. It
is possible that one company identifies other company as its
related party. However, it does not necessarily mean that the
second company will also identify the first one as its related
party. Let us assume that ABC Limited and DEF Limited are
two public companies. Based on its evaluation and criteria
prescribed, ABC determines that DEF is its related party.
However, for DEF, ABC is not a related party. ABC is proposing
to sell a big piece of land to DEF. It is determined that the
transaction is not in the ordinary course of business. Also, the
prescribed threshold criteria are breached.
In the above case, how the approval process will work? Do
both ABC and DEF need to obtain approvals required for
related party transaction?
It appears that the identification of related parties and
related party transactions is an independent exercise for each
company. Such identification is likely to determine, among
other matters, approvals required. In the example above, ABC
has identified DEF as its related party and, therefore, proposed
land deal is related party transaction from ABCs perspective.
This requires ABC to obtain the requisite approvals, viz., the
Audit Committee and Board approval and special resolution of
disinterested shareholders, as appropriate.
From DEFs perspective, ABC is not a related party. Hence,
one may argue that proposed land deal is not a related party
transaction for DEF. Basis this, it may be argued that DEF need
not obtain approvals required for related party transactions.
Arms length
Since RC49 does not contain any exemption from the approval
process based on the arms length criterion, this discussion
is not directly relevant under RC49. However, demonstrating
that a transaction has been entered into by a company on
an arms length basis is likely to help in the approval process
and demonstrating good corporate governance. Hence, the
following discussion may be useful even under RC49 from this
perspective
Are there any specific methodologies/approaches to be
used for identifying whether a related party transaction
has been entered into on an arms length basis? If no such
methodologies/approaches are prescribed under the 2013
Act, can a company use the methodologies/approaches
prescribed under other statutes, e.g., the Income-tax Act?
What are other key factors to be considered?
The 2013 Act or the Board Rules do not prescribe
methodologies and approaches, which may be used to
determine whether a transaction has been entered into on an
arms length basis. One may consider the following aspects in
this regard:
59
Section 188 (2) of the 2013 Act requires that every contract/
arrangement entered into under section 188 (1) will be referred
to in the board report along with justification.
RC49 prescribes the following additional disclosures for listed
companies:
Transitional requirements
The 2013 Act or the Board Rules do not contain any specific
transitional provisions. The SEBI Circular regarding amendment
to the RC49 states as below:
The provisions of Clause 49(VII) as given in Part-B shall
be applicable to all prospective transactions. All existing
material related party contracts or arrangements as
on the date of this circular which are likely to continue
beyond 31 March 2015 shall be placed for approval of
the shareholders in the first General Meeting subsequent
to 1 October 2014. However, a company may choose to
get such contracts approved by the shareholders even
before 1 October 2014.
61
Loans and
investments
Practical perspectives
From a reading of the Board Rules concerning section 185 and
186, the following position emerges:
Omnibus resolution
One of the paragraphs in the Board Rules states that special
resolution passed at a general meeting to give any loan or
guarantee or investment or provide any security will specify the
total amount up to which the board of directors is authorized
to give such loan or guarantee, to provide security or acquire
investments. This suggests that omnibus resolution will be
permitted. The draft rules had permitted omnibus resolution
only for guarantees.
63
Transitional requirements
One paragraph in the Board Rules state that where the
aggregate of the loans and investment so far made, guarantee
and security so far provided, along-with the investment,
loan, guarantee or security proposed to be made, exceed the
limits prescribed, then no investment or loan will be made
or guarantee will be given or security will be provided unless
previously authorized by special resolution passed at the
general meeting.
An explanation to the above paragraph of Board Rules clarifies
that it would be sufficient compliance if such special resolution
is passed within one year from the date of notification of this
section.
65
Corporate social
responsibility
The 2013 Act requires that every company with net worth of
`500 crore or more, or turnover of `1,000 crore or more or
a net profit of `5 crore or more during any financial year will
constitute a CSR committee.
The CSR Rules state that every company, which ceases to
be a company covered under the above criteria for three
consecutive financial years, will not be required to (a) constitute
the CSR Committee, and (b) comply with other CSR related
requirements, till the time it again meets the prescribed criteria.
Some people argue that the CSR Rules are changing the
requirements of the 2013 Act. Hence, an issue arises whether
a subordinate legislation can override the main legislation.
However, most people are likely to welcome the clarifications
provided in the CSR Rules.
CSR expenditure
In accordance with the 2013 Act, the board of each company
covered under the CSR requirement needs to ensure that
the company spends, in every financial year, at least 2% of
its average net profits made during the three immediately
preceding financial years in pursuance of CSR policy. Neither
the 2013 Act nor the CSR Rules prescribe any specific penal
provision if a company fails to spend the 2% amount. However,
the board, in its report, needs to specify the reasons for not
spending the specified amount.
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67
69
71
Transitional requirements
The requirements concerning CSR are applicable from 1 April
2014. For companies covered under the requirement, how
does the requirement concerning 2% expenditure apply in the
first year?
A reading of the 2013 Act and the CSR rules suggests that
in the first year of application, a company covered under
the requirement needs to incur 2% of its average net profit
for past 3 years (i.e., financial year 2011-12, 2012-13 and
2013-14) on the CSR activities. Let us assume that a company
covered under the CSR requirements has earned net profit of
`50 crores, (`12 crores) (net loss) and `34 crores during the
immediately preceding three years. In this case, the companys
average net profit is `24 crores i.e., one-third of (`50 crores `12 crores + `34 crores). Hence, the company needs to spend
2% of its average net profit, i.e., 2% of `24 crores, on CSR
activities.
For companies having other than 31 March year-end, an
additional issue is whether they are required to apply the CSR
requirements from 1 April 2014 or from the beginning of their
next financial year. Will a company having 31 December yearend apply the requirement from 1 April 2014 or 1 January
2015 onward?
Interestingly, the CSR Rules state that reporting requirements
of the 2013 Act will apply to financial years commencing on or
after 1 April 2014. However, there is no such clear guidance on
the constitution of CSR committee and/or CSR expenditure.
One view is that a company determines if it meets the
thresholds specified in section 135(1) on a financial year
basis. Once the applicability criteria is met, the company sets
up a CSR committee and starts spending 2% of its average net
profits determined in accordance with section 198 of the 2013
Act. Thus, a company with a calendar year end will examine
this requirement at 1 January 2015 and start spending for the
calendar year 2015. Thus, it will not be required to spend on
CSR for the year ended 31 December 2014.
73
Corporate
governance
Practical perspectives
From a practical perspective, unlike an ID, an NED is not
expected to be independent of the company and its promoters/
shareholders, etc. At the same time, an NED does not form part
of the executive management team.
In accordance with the Higgs Report published by the British
government in 2003, NEDs are expected to play key role in the
following areas:
(I)
(II) P
erformance: NEDs should scrutinise and monitor the
performance of management.
(III) Risk: NEDs should satisfy themselves that financial
information is accurate and that financial controls and
systems of risk management are robust and defensible.
(IV) P
eople: NEDs are responsible for determining appropriate
levels of remuneration of executive directors and have a
prime role in appointing and where necessary removing
senior management, and in succession planning.
For the purposes of this publication, other non-executive directors, i.e., non-executive directors, other than independent
directors, are referred to as NED.
Woman director
The 2013 Act requires prescribed class of companies to have at least one woman director on the board. In accordance with the Act,
existing companies meeting the prescribed criteria need to comply with the requirement within one-year.
The Directors Appointment Rules contain criteria for appointment of woman director which is similar to what was proposed under
the draft rules. See table 6 below.
Table 6: Criteria for appointment of woman director
Company
Listed companies
Draft Rules
All companies
Turnover
75
Independent directors
The 2013 Act states that every listed company will have at least one-third of total number of directors as independent directors, with
any fraction to be rounded off as one. In addition, the 2013 Act empowers the Central Government to prescribe minimum number of
independent directors for other class of public companies.
In accordance with the Gazette Copy of the 2013 Act, existing companies meeting the prescribed criteria need to comply with the
requirement within one-year5.
The draft rules stated that public companies covered under the prescribed class should have at least one-third of the total number
of its directors as independent directors. In the Directors Appointment Rules, minimum number of directors for non-listed public
companies meeting prescribed criteria has been changed to 2, irrespective of the board size. Also, the criteria for appointment of
independent directors have changed in the Directors Appointment Rules. See table 7 below.
Draft rules
Two
Turnover
The Directors Appointment Rules rules also state that a nonlisted public company, which ceases to fulfil any of the three
conditions laid down in the rule for three consecutive years, will
not be required to comply with these provisions until such time
as it meets any of the conditions.
77
Revised clause 49
RC49 requires that where the Chairman of the board is a
non-executive director, at least one-third of the board should
comprise independent directors. In case the Chairman is an
executive director, at least half of the board should comprise
independent directors. Since the requirement under RC49
is stricter, a listed company will need to comply with RC49
requirements. Some other key differences between the 2013
Act and RC49 are given below:
Audit Committee
The 2013 Act requires each listed company and such other class of companies, as may be prescribed, to constitute the Audit
Committee. In the Board Rules, thresholds for constitution of the committee have been made more stringent vis--vis the draft rules
(see table 8 below). These changes in the criteria will require more companies to constitute the Audit Committee.
Table 8: Criteria for constitution of the Audit Committee
Company
Listed companies
Board Rules
All companies
Draft Rules
All companies
Turnover
No such criterion
Due to the use of the word or in the third criterion for nonlisted public companies, there seems to be a confusion whether
a company needs to consider loans separately, debentures
separately and deposits separately or they should be considered
in totality. In our view, from the use of the word aggregate,
it is clear that all of them have to be considered together. To
illustrate, a non-listed public company, which has outstanding
bank loan of `20 crores, outstanding debentures of `23 crores
and outstanding deposits of `12 crores, has met third criterion
under the Board Rules. Hence, it needs to constitute the Audit
Committee.
Revised clause 49
RC49 requires all listed companies to constitute the Audit
Committee. Given below is an overview of differences relating
to the Audit Committee between the 2013 Act and RC49:
79
Board Rules
All companies
Draft Rules
All companies
RC49
All companies
NA
Turnover
No such criterion
NA
NA
Both the 2013 Act and RC49 requires that NRC will comprise of
three or more non-executive directors, out of this, atleast onehalf should be independent directors. RC49 specifically requires
that the Chairman of NRC should be an independent director;
however, there is no such requirement under the 2013 Act.
The 2013 Act allows the chairperson of the company (whether
executive or non-executive) to be appointed as a member of the
NRC. However, the person cannot chair NRC. RC49 does not
give such an option.
Vigil mechanism
Subsidiary companies
Under the 2013 Act, each listed company and such other class
of companies, as may be prescribed, need to establish a vigil
mechanism for directors and employees to report genuine
concerns. In addition to listed companies, the draft rules
required the following companies to establish vigil mechanism:
The Board Rules require that vigil mechanism will provide for
adequate safeguards against victimization of employees and
directors using this mechanism. Also, in exceptional cases, a
company should give such employees/directors a direct access
to the Audit Committee Chairperson or the director playing the
Audit Committee role, as the case may be.
81
Internal audit
The 2013 Act requires such class or classes of companies, as may be prescribed, to appoint an internal auditor to conduct internal
audit of the functions and activities of the company. The draft as well Accounts Rules require all listed companies to appoint internal
auditor. In the Accounts Rules, the threshold for appointment of internal auditor by non-listed public companies has changed. Under
the Accounts Rules, private companies meeting prescribed criteria are also required to appoint internal auditor. This was not required
under the draft rules. Table10 provides comparison of the two criteria.
Accounts Rules
All companies
Draft rules
All companies
No such criteria
Practical perspectives
A perusal of the 2013 Act read with the Accounts Rules
indicates that a company may either engage external agency
or have internal resources to conduct internal audit. Further,
a firm not registered with the ICAI may also be appointed as
internal auditor.
83
Mergers,
amalgamation and
reconstruction
85
Glossary
10 Lakh
1 Million
1 Crore
10 Million
100 Crore
1 Billion
1956 Act
2013 Act
AFS
AGM
AS 5 Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies
AS 5
AS 6 Depreciation Accounting
AS 6
AS 10
AS 11
AS 21
AS 23
AS 25
AS 26 Intangible Assets
AS 26
AS 27
AS 29
AS 30
BOOT
BOT
CARO
CDR
CEO
CFO
CFS
Clasue 41
CLB
CPP
CSR
DRR
EAC
Executive Director
ED
EGM
ESOP
FCD
GAAP
Government of India
IASB
ICAI
Independent Director
ID
IEPF
IESBA
IESBA code
IFRS
Income-tax Act
Ind-AS
Ind-AS 24
Indian GAAP
IRDA
Information Technology
IT
KMP
LA / Listing Agreement
Master Agreement
MA
MCA
MD&A
NACAS
NBFC
NCLT / Tribunal
NED
NFRA
Notified AS or AS
NRC
P&L
PPP
RBI
RC49
Registrar of Companies
RoC
SA
SA 240
SA 550
SEBI
SFS
SOCIE
SOX
TP guidelines
United Kingdom
UK
Unites States
US
US SEC / SEC
WDV
Accounts Rules
Audit Rules
CSR Rules
Dividend Rules
Board Rules
SCD Rules
Definition Rules
87
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