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Query No. 30
Subject: Impact of differential treatment to a court approved scheme on the financial statements and audit report in the subsequent years.
A. Facts of the Case
1. Company X Limited is a 100% subsidiary of company Y Limited. The scheme of arrangement (‘Scheme’) is presented under sections 391 to 394 and other applicable provisions, if any, of the Companies Act, 1956 for vesting as a going concern the business undertakings of company X into company Y. The said scheme was approved by the Honorable High Court of Delhi in March, 2013 and the effect of the same was given in the financial statements for the year ended 31st March, 2013.
2. The said scheme prescribes accounting treatment not fully compliant with Accounting Standard (AS) 14, ‘Accounting for amalgamations’. Accordingly, the company X and Y would make disclosures in their financial statements for the year ended 31st March, 2012 as required by AS 14. AS 14 requires that in case of divergence from the requirements of the Standard due to court-approved scheme, certain disclosures are required to be made. In this regard, the following paragraph of AS 14 may be noted:
“42. Where the scheme of amalgamation sanctioned under a statute prescribes the treatment to be given to the reserves of the transferor company after amalgamation, the same should be followed. Where the scheme of amalgamation sanctioned under a statute prescribes a different treatment to be given to the reserves of the transferor company after amalgamation as compared to the requirements of this Standard that would have been followed had no treatment been prescribed by the scheme, the following disclosures should be made in the first financial statements following the amalgamation:
(a) A description of the accounting treatment given to the reserves and reasons for following the treatment different from that prescribed in this Standard.
(b) Deviations in the accounting treatment given to the reserves as prescribed by the scheme of amalgamation sanctioned under the statute as compared to the requirements of this Standard that would have been followed had no treatment been prescribed by the scheme.
(c) The financial effect, if any, arising due to such deviation.”
In addition to above, section 211 of the Companies Act, 1956 states as below:
“(3B) Where the profit and loss account and the balance sheet of the company do not comply with the accounting standards, such companies shall disclose in its profit and loss account and balance sheet, the following, namely:-
(a) the deviation from the accounting standards;
(b) the reasons for such deviation; and
(c) the financial effect, if any, arising due to such deviation.”
Excerpts from an Announcement, ‘Disclosures in cases where a Court/Tribunal makes an order sanctioning an accounting treatment which is different from that prescribed by an Accounting Standard’, issued by the Institute of Chartered Accountants of India (ICAI), should also be noted:
“… if an item in the financial statements of a Company is treated differently pursuant to an Order made by the Court/Tribunal, as compared to the treatment required by an Accounting Standard, following disclosures should be made in the financial statements of the year in which different treatment has been given:
1. A description of the accounting treatment made along with the reason that the same has been adopted because of the Court/Tribunal Order.
2. Description of the difference between the accounting treatment prescribed in the Accounting Standard and that followed by the Company.
3. The financial impact, if any, arising due to such a difference.”
The querist has stated that in addition to the disclosures made in the financial statements, since the amounts recognised by virtue of accounting treatment prescribed under Court scheme were significant, an emphasis of matter paragraph was given in the audit report drawing attention to the accounting aspects which due to the wording of the scheme were not in accordance with AS 14.
3. Auditor’s analysis
(i) Under Indian Generally Accepted Accounting Principles (GAAP), accounting treatment prescribed in a scheme approved by a Court or Tribunal overrides the accounting standards and other constituents of Indian GAAP. Further, it is also well-established that a scheme approved under sections 391-394 of the Companies Act, 1956 (‘the Act’) has an over-riding effect vis-à-vis other provisions of the Act (including the requirements of Accounting Standards prescribed under section 211 of the Act). Thus, as far as the company is concerned, it is bound to follow the accounting treatment prescribed in the scheme. However, the Companies Act as well as the Announcement of the ICAI require certain disclosures in case the accounting treatment prescribed by the scheme is not in compliance with the Accounting Standards/Indian GAAP.
(ii) It may be noted that the relevant Announcement of the ICAI requires the disclosure concerning the deviations from normal Indian GAAP and their impact to be “made in the financial statements of the year in which different treatment has been given”. The reference is to ‘the year’ rather than ‘the year(s)’. This view is further strengthened from a reading of AS 14 which requires specified disclosures to be made in the first financial statements following the amalgamation.
(iii) A different position, however, seems to emerge from the following requirements of Standard on Auditing (SA) 700 (Revised), ‘Forming an Opinion and Reporting on Financial Statements', issued by the ICAI, which has become effective for reporting periods commencing on or after 1st April, 2012:
“A32a. There can be situations where an entity or a class of entities obtains written permission from the Central Government of India or a regulator or by order of a court of law having jurisdiction to make such an order, to prepare its financial statements without meeting specific recognition, measurement, presentation or disclosure requirements of the applicable financial reporting framework. Such a change shall be treated as a modification of the financial reporting framework and not as inability of the auditor to obtain sufficient appropriate audit evidence. If the effect of this is material, the auditor shall describe in sufficient detail the resultant deviation from the financial reporting framework in an Emphasis of Matter paragraph in accordance with the SA 706.”
The following requirements of Standard on Auditing (SA) 706, ‘Emphasis of Matter Paragraph and Other Matter Paragraphs in the Independent Auditor’s Report, issued by the ICAI (which also has become effective for reporting periods commencing on or after 1st April, 2012) may also be noted:
“6. If the auditor considers it necessary to draw users’ attention to a matter presented or disclosed in the financial statements that, in the auditor’s judgment, is of such importance that it is fundamental to users’ understanding of the financial statements, the auditor shall include an Emphasis of Matter paragraph in the auditor’s report provided the auditor has obtained sufficient appropriate audit evidence that the matter is not materially misstated in the financial statements. Such a paragraph shall refer only to information presented or disclosed in the financial statements.”
Reference may also be made to the following extracts from ‘Implementation Guide on Reporting Standards (SA 700, SA 705 & SA 706), issued by the Auditing and Assurance Standards Board of the ICAI:
“Question 19: How should an auditor frame his opinion where a statute or court order or government directive/ permission allows an entity to prepare financial statements without meeting a GAAP requirement?
Response 19: Sometimes the Central Government or a court of law, say, at the request of the entity, permits it to follow a specific accounting treatment in respect of a particular transaction. For example, an entity may be permitted to account for a certain type of income or expenditure on cash basis or on a deferral basis that may not be permitted by the Accounting Standards. The question is whether a departure from the framework under such circumstances requires an auditor to qualify his report?
The answer is “no”. In such a situation, the departure is not a non-compliance with the framework but compliance with a modified framework. If the effect of doing this is material, the auditor should describe the resultant deviation from the framework in sufficient detail in an emphasis of matter paragraph.”
From the above, there could be a view that “modification of the financial reporting framework” is not limited to the financial year in which the departure from the applicable financial reporting framework pursuant to permission/order of Government/Court/Tribunal is made. The financial reporting framework remains modified as long as the impact of the aforesaid departure remains material. It can be argued that so long as these departures have a continuing material effect on current period or previous period figures, they should continue to be reported, else a reader would not get a complete picture except in the first year in which the departure is made. Therefore, there can be a view that since the requirements of SA 700 (Revised) have also to be complied with, the relevant disclosures and EoM paragraph should continue in the period commencing on 1st April, 2012, i.e., in the financial statements for the year ending 31st March, 2013 and subsequent years.
(iv) AS 14 requires specific disclosure in the financial statements if the scheme prescribes a different treatment to the reserves from that prescribed by AS 14 in the first financial statements post amalgamation. However, the ICAI Announcement, referred above requires such disclosures for all the deviations in the financial statements of the year in which different treatment has been given.
The objective of a financial statement is to provide information about the financial position, performance and cash flows of an enterprise that is useful to a wide range of users in making economic decisions. Notes are considered to be an integral part of the financial statements which would generally contain additional information that is relevant to the needs of users about the items in the balance sheet and statement of profit and loss. They may include disclosures about the risks and uncertainties affecting the enterprise and any resources and obligations not recognised in the balance sheet.
Thus, on a combined reading of the above, it seems that the note and the emphasis of matter paragraph should continue to be given till the impact is material to the financial statements/results.
(v) However, the above view could have an impact on the schemes sanctioned in the earlier years. In other words, in case there are deviations with the notified GAAP for transactions consummated prior to 31st March, 2012, then as per the new Standard, these transactions, irrespective of the timing of their consummation and irrespective of their manner of reporting in the prior periods would be brought out as an Emphasis of Matter/modification in the subsequent years by the auditor, if material, to the financial statements. This would have a severe implication on all financials presented in the past involving accounting as per a Court approved scheme and would accordingly, require the management and auditors to revisit the accounting implications of such transactions for accounting period commencing on or after 1st April, 2012. This would not be feasible for the auditor if the prior year financial statements have been audited by another auditor and a disclosure as per ICAI Announcement and an emphasis of matter paragraph as per pre-revised SA 700 was not included in the financial statements and auditor’s report.
(vi) Therefore, in the above case, the EoM paragraph and note in the financial statements for Court schemes sanctioned prior to April 2012 should not be continued in the year ended 31st March, 2012 and subsequent years.
B. Query
4. Based on the above facts, the querist has sought the opinion of the Expert Advisory Committee on the following issues:
(i) Whether a note stating the effect of the merger scheme and an emphasis of matter in the audit/review report will be given in the financial statements of the year in which different treatment has been given, i.e. in the previous year ended 31st March, 2013 and 31st March, 2014 (as comparative) or will it continue in subsequent financial years, till the time the amounts to which differential treatment is given, are material to the financial statements of the company?
(ii) Whether a similar disclosure in the notes to the financial statements and an emphasis of matter paragraph in the audit/review report will be given for the scheme sanctioned prior to the applicability date of the revised standards, i.e., SA 700, SA 705 and SA 706? For example, a company may have created a reserve and would debit impairment losses arising in future years directly against such reserves. Such direct debit to reserve would tantamount to non-compliance with the principles of Accounting Standard (AS) 5, ‘Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies’.
C. Points considered by the Committee
5. The Committee, while answering, has examined only the issues raised in paragraph 4 above and has not examined any other issue that may arise from the Facts of the Case, such as, propriety of accounting treatment made pursuant to Court Scheme, accounting treatment including disclosures in the financial statements for financial year 2011-12 for a scheme of amalgamation approved by the Court in March 2013, etc. Further, as the Scheme of amalgamation was approved in March 2013, the Committee has examined the issue in the context of the Companies Act, 1956.
6. With regard to the issue regarding disclosure in the notes to accounts stating the effect of the merger scheme in the financial statements of the year in which different treatment has been given and in the subsequent financial years also, the Committee notes paragraph 23 of Accounting Standard (AS) 14, ‘Accounting for Amalgamations’, relevant extract from the Announcement of the Institute of Chartered Accountants of India (ICAI) on ‘Disclosures in cases where a Court/Tribunal makes an order sanctioning an accounting treatment which is different from that prescribed by an Accounting Standard’, as below:
AS 14
“23. The scheme of amalgamation sanctioned under the provisions of the Companies Act, 1956 or any other statute may prescribe the treatment to be given to the reserves of the transferor company after its amalgamation. Where the treatment is so prescribed, the same is followed. In some cases, the scheme of amalgamation sanctioned under a statute may prescribe a different treatment to be given to the reserves of the transferor company after amalgamation as compared to the requirements of this Standard that would have been followed had no treatment been prescribed by the scheme. In such cases, the following disclosures are made in the first financial statements following the amalgamation:
(a) A description of the accounting treatment given to the reserves and the reasons for following the treatment different from that prescribed in this Standard.
(b) Deviations in the accounting treatment given to the reserves as prescribed by the scheme of amalgamation sanctioned under the statute as compared to the requirements of this Standard that would have been followed had no treatment been prescribed by the scheme.
(c) The financial effect, if any, arising due to such deviation.”
Announcement on Disclosures in cases where a Court/Tribunal makes an order sanctioning an accounting treatment which is different from that prescribed by an Accounting Standard
“… if an item in the financial statements of a Company is treated differently pursuant to an Order made by the Court/Tribunal, as compared to the treatment required by an Accounting Standard, following disclosures should be made in the financial statements of the year in which different treatment has been given:
1. A description of the accounting treatment made along with the reason that the same has been adopted because of the Court/Tribunal Order.
2. Description of the difference between the accounting treatment prescribed in the Accounting Standard and that followed by the Company.
3. The financial impact, if any, arising due to such a difference.
…”
The Committee also notes that section 211 of Companies Act 1956, inter alia, states as below:
“ …
(3B) Where the profit and loss account and the balance sheet of the company do not comply with the accounting standards, such companies shall disclose in its profit and loss account and balance sheet, the following, namely:-
(a) the deviation from the accounting standards;
(b) the reasons for such deviation; and
(c) the financial effect, if any, arising due to such deviation.”
…
(6) For the purposes of this section, except where the context otherwise requires, any reference to a balance sheet and profit and loss account shall include any notes thereon or documents annexed thereto, giving information required by this Act, and allowed by this Act to be given in the form of such notes or documents.”
From the above, the Committee notes that the Announcement of the ICAI and section 211 of the Companies Act, 1956 requires the above disclosures to be made in the financial statements of the year in which different treatment has been given. Therefore, the Committee is of the view that as long as treatment given in the financial statement(s) pursuant to Court Order is different from the treatment prescribed in the Accounting Standards, disclosure should be given in the notes to accounts in the year(s) in which such different treatment is given in the financial statement(s). In other words, if the effect of a deviation from the treatment prescribed by an Accounting Standard continues in the financial statements of the succeeding financial years also, the financial statement of those years should also comply with the requirements of the Announcement. With regard to disclosures in the notes to accounts for the above-mentioned deviation where such deviation or impact thereof is forming part in the figures of comparatives only, the Committee notes the requirements of Schedule VI (Revised) to the Companies Act, 1956, in the ‘General Instructions for the Preparation of Balance Sheet and Statement of Profit and Loss of a Company’ and paragraphs 25 and 42 of the Framework for the Preparation and Presentation of Financial Statements, issued by the ICAI as follows:
General Instructions for Preparation of Balance Sheet and Statement of Profit and Loss of a Company
“5. Except in the case of the first Financial Statements laid before the Company (after its incorporation) the corresponding amounts (comparatives) for the immediately preceding reporting period for all items shown in the Financial Statements including notes shall also be given.”
Framework for the Preparation and Presentation of Financial Statements
“25. Qualitative characteristics are the attributes that make the information provided in financial statements useful to users. The four principal qualitative characteristics are understandability, relevance, reliability and comparability.”
“42. Users wish to compare the financial position, performance and cash flows of an enterprise over time. Hence, it is important that the financial statements show corresponding information for the preceding period(s).”
From the above, the Committee notes that one of the qualitative characteristics of financial statements is ‘comparability’ and that comparative figures including those appearing in the notes are an essential part of the current year’s financial statements for understanding these statements. Accordingly, the Committee is of the view that if the disclosure of deviation in the accounting treatments of the previous year (as comparative) is necessary for understanding the financial statements of the current year, the company should disclose in the notes to accounts, such deviation, reason thereof and its financial effect on the financial statements as required by the above-reproduced ICAI’s Announcement and the Companies Act, 1956.
7. With regard to Emphasis of Matter (EoM) in the audit/review report in respect of different accounting treatment given in the financial statements, the Committee notes that Standard on Auditing (SA) 706, ‘Emphasis of Matter Paragraphs and Other Matter Paragraphs in the Independent Auditor’s Report’, issued by the ICAI defines ‘Emphasis of Matter Paragraph’ as “A paragraph included in the auditor’s report that refers to a matter appropriately presented or disclosed in the financial statements that, in the auditor’s judgment, is of such importance that it is fundamental to users’ understanding of the financial statements”. The Committee further notes paragraph A32a of Application and Other Explanatory Material to Standard on Auditing (SA) 700, Forming an Opinion and Reporting on Financial Statements and paragraph 6 of SA 706 as stated below:
Application and Other Explanatory Material to SA 700
“A32a. There can be situations where an entity or a class of entities obtains written permission from the Central Government of India or a regulator or by order of a court of law having jurisdiction to make such an order, to prepare its financial statements without meeting specific recognition, measurement, presentation or disclosure requirements of the applicable financial reporting framework. Such a change shall be treated as a modification of the financial reporting framework and not as inability of the auditor to obtain sufficient appropriate audit evidence. If the effect of this is material, the auditor shall describe in sufficient detail the resultant deviation from the financial reporting framework in an Emphasis of Matter paragraph in accordance with the SA 706.”
SA 706
“6. If the auditor considers it necessary to draw users’ attention to a matter presented or disclosed in the financial statements that, in the auditor’s judgment, is of such importance that it is fundamental to users’ understanding of the financial statements, the auditor shall include an Emphasis of Matter paragraph in the auditor’s report provided the auditor has obtained sufficient appropriate audit evidence that the matter is not materially misstated in the financial statements. Such a paragraph shall refer only to information presented or disclosed in the financial statements.”
On a combined reading of the above paragraphs, the Committee notes that whentreatment given in the financial statements of an enterprise is different from the treatment prescribed in the applicable Accounting Standards (viz., the financial reporting framework) due to Court’s order, the impact of which is material and if in the auditor’s judgement, it is fundamental for understanding the financial statements from users perspective, then the auditor should describe the resultant deviation from the reporting framework in sufficient detail in an emphasis of matter paragraph. Accordingly, the Committee is of the view that in the extant case, after SA 700 and SA 706 coming into effect w.e.f. 1st April, 2012, the auditor should assess the impact of the deviation in the accounting treatment followed by the company on the financial statements, including figures of the current reporting year and comparatives for previous year and if such impact is material, then the auditor should describe in sufficient detail the resultant deviation from the financial reporting framework in an Emphasis of Matter paragraph in accordance with the requirements of SA 706.
8. As regards the second issue on whether a similar disclosure in the notes to the financial statements and an emphasis of matter paragraph in the audit/review report for the scheme sanctioned prior to the applicability date of the revised standards, i.e., SA 700, SA 705 and SA 706 (i.e., April 1, 2012) is required, the Committee is of the view that this is a hypothetical issue as in the extant case, the scheme is sanctioned in March 2013, i.e., after the applicability date of these standards. Accordingly, this issue cannot be answered by the Committee as per the Rule 3 of the Advisory Service Rules of the Committee.
D. Opinion
9. On the basis of the above, the Committee is of the following opinion on the issues raised by the querist in paragraph 4 above:
(i) If the effect of a deviation from the treatment prescribed by an Accounting Standard continues in the financial statements of the succeeding financial years also, the financial statement of those years should also comply with the requirements of the Announcement and the Companies Act, 1956 and accordingly, the company should give disclosure in the notes to the financial statements of the year(s) in which different treatment has been given, i.e., in the first year of amalgamation as well as in subsequent years, as discussed in paragraph 6 above. Further, if the disclosure of deviation in the accounting treatments of the previous year (as comparative) is necessary for understanding the financial statements of the current year, the company should disclose in the notes to accounts, such deviation, reason thereof and its impact on the financial statements as required by the ICAI’s Announcement and Companies Act, 1956. If there is any material impact of differential accounting treatment of the scheme, and if in the auditor’s judgement, it is fundamental for understanding the financial statements from users perspective, the auditor should describe in sufficient detail the resultant deviation from the financial reporting framework in an Emphasis of Matter paragraph in accordance with the requirements of SA 706, as discussed in paragraph 7 above.
(ii) This issue is a hypothetical issue, as discussed in paragraph 8 above, and therefore, cannot be answered by the Committee in view of Rule 3 of the Advisory Service Rules of the Committee.
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[1]Opinion finalised by the Committee on 7.11.2014.
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