End to Accounting Jugglery in Mergers?! – SEBI amends listing agreement to end deviation through disclosure

SEBI has directed, vide circular dated 5th April 2010, the modification of the listing agreement focusing on certain deviations from Accounting Standards commonly carried out as part of Schemes of mergers, demergers, etc.

SEBI has done this cleverly and indirectly but with apparently with more effect than it would have done it directly. It has also attempted to kill several birds with one stone. Or has SEBI attempted too much and ended up with a provision with limited effect?

In essence, SEBI has required that companies proposing certain Scheme of mergers, demergers, etc. shall submit in advance a certificate from their auditors that the matters contemplated in the Scheme are in compliance with Accounting Standards.

Let us consider some background.

Schemes of mergers, demergers, etc. (“Scheme(s)”) provide for transfer of assets and liabilities and/or provide for other form of restructuring. Accounting of various transactions under mergers, etc. is so important that, some years back, it was as controversial (more in fact) as the accounting for ESOPs. Accounting Standard 14 provides for accounting of certain transactions for amalgamations.

Just as earlier in case of ESOPs, there is an apparent loophole, if one could call it so. The AS states that if the Scheme provides for treatment of reserves otherwise than what the AS requires, the Scheme should be followed but certain disclosures should be given, particularly about what would be the effect if the AS was followed. In other words, deviations would be possible but through disclosure.

It is quite common then that such Schemes provide for an alternate accounting treatment of reserves, etc. and Courts usually approve them. Thus, there is a fairly widespread practice of what I would call deviations through disclosure.

Of course, it is not as if every deviation is an attempt to avoid the spirit of the Accounting Standard and at times, the intention may be bonafide including avoidance of some archaic provisions of law or simply to give a better picture of the underlying commercial reality. There is also at least the small safeguard of disclosure. However, it is also true that this carte blanche power enables companies to adopt practically any deviation so long the Scheme is approved by the Court.

SEBI has said in the circular that in some recent Schemes filed before the High Courts, the accounting treatment of “various items” is not in accordance with the applicable Accounting Standards (“AS”). It has now required that every listed company proposing a Scheme to file with the Stock Exchanges, in advance, alongwith the draft Scheme, a certificate from the auditors that the accounting treatment under the Scheme is in compliance with applicable accounting standards. More importantly, the actual amendment further provides that a mere disclosure as permitted under the AS giving certain details relating to a departure from the AS is not sufficient.

The amendment, as I said earlier, is clever. No Regulation has been laid down (which would have required certain law-making procedures to be followed) to make such requirement. Nor has SEBI needed to plead to the MCA to amend its Rules relating to Accounting Standards. Indeed, no substantive requirement has been made at all even in the listing agreement to follow the accounting standards. Instead, a simple procedural requirement is made that the auditors’ certificate will be obtained – in advance – stating that accounting standards have been complied with in respect of matters covered in the Scheme. And further, the usual route of deviating by disclosing would not be permitted.

Does this plug the accounting jugglery/loopholes through such Schemes? And make such Schemes fully in compliance with Accounting Standards?

The amendment does make the company indirectly comply with accounting standards and the specific requirement that deviation through disclosure is not permitted makes it effective.

Note several implications and limitations though.

The auditors certificate is required for compliance of all accounting standards and not merely Accounting Standard 14. In fact, the deviation through disclosure is allowed only for accounting treatment for reserves and not for other requirements of even this standard. In other words, even the deviation through disclosure was permissible only in respect of treatment of reserves.

Secondly, the certificate is required for all types of Schemes – whether of mergers, demergers, reduction of capital, etc. – in fact, it was required for all schemes/petitions to be filed before any Court or Tribunal under sections 391, 304 and 101 of the Companies Act, 1956. The AS 14 is, however, applicable only to amalgamations and not to other type of Schemes. Courts have also held that the said AS 14 applies only to amalgamations and hence its applicability cannot be raised in other schemes (see, e.g., Gallops Reality’s case 150 Comp. Cas. 596 (Guj.)).

Having said that, the requirement applies only to compliance of accounting standards and not to accounting of transactions where Accounting Standards do not apply.

Note another limitation to Accounting Standard 14. AS 14 relating to reserves only applies to the net surplus after adjusting the other losses. These losses could not have been otherwise adjusted under normal principles of accounting or even under law. However, if this is done under the Scheme then this would be fully in compliance even with the AS. It would not thus be in violation even of the new SEBI requirement.

Further, if certain restructuring of reserves is carried out under a statutory provision, the clause cannot apply. A good example is restructuring of capital reserves such as share premium or other similar capital surpluses. Even though SEBI has sought to cover Schemes involving reduction of capital, it is arguable that since the accounting of share premium is strictly not covered by Accounting Standards, the new provisions will not apply. To repeat, AS 14 in any case does not apply to Schemes of Reduction of Capital.

Consider another aspect that is not touched by the Accounting Standards and therefore remains untouched by the amendment. If a reserve is treated as a “capital reserve” as so required by the AS, that by itself does not make it a “capital reserve” for the purposes of the Companies Act, 1956, particularly for the provisions relating to reduction of capital. Thus, for example, such reserve would not become thereby at par with “Share Premium”. Importantly, it will also not be at par with “Revaluation Reserve” (though, indeed, in reality, its source may be revaluation). Thus, while one could argue that such Capital Reserve cannot be used for distribution of dividends, it can be used for issuing bonus shares.

In the end, it is seen that SEBI’s shot has limited effect. It has limited coverage of types of transactions and Schemes. It does not cover all types of reserves – indeed, in practice, it may not cover statutory reserves such as Share Premium, etc. and the impact on other reserves is also limited.

However, the amendment does bring a partial end to the route of deviation through disclosure as far as reserves are concerned.

SEBI has thus attempted to hit several birds with one stone, but apparently it has brushed, not even hit, one bird but that, I guess, is better than nothing.

– Jayant Thakur, CA

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CA Jayant Thakur

1 comment

  • Sir, could you please explain the following better please, i was not able to follow the same completely.
    "Thus, for example, such reserve would not become thereby at par with “Share Premium”. Importantly, it will also not be at par with “Revaluation Reserve” (though, indeed, in reality, its source may be revaluation). Thus, while one could argue that such Capital Reserve cannot be used for distribution of dividends, it can be used for issuing bonus shares."

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