Context
“Forewarned is forearmed” is the cardinal principle underlying company law jurisprudence around the world and the foundation of all disclosure requirements.
Section 129(1) of the Companies Act, 2013 (“Act”), provides that the financial statements (“FS”) shall give a ‘true and fair view’ of the state of affairs of the company, comply with the accounting standards notified under Section 133 of the Act, and also be in the form provided for different classes of companies in Schedule III of the Act.
Further, Section 134(5) of the Act inter alia provides that the Directors’ Responsibility Statement should inter alia state that – (a) in the preparation of the annual accounts, applicable accounting standards had been followed, along with proper explanation relating to material departures; and (b) the directors had selected such accounting policies and applied them consistently and made judgments and estimates that are reasonable and prudent so as to give a ‘true and fair view’ of the state of affairs of the company at the end of the financial year and of the profit and loss of the company for that period.
As noted in Gower and Davies’ celebrated treatise on Principles of Modern Company Law, ‘true and fair view’ “remains an overriding principle, no matter which accounting framework is used for the presentation of the accounts. The director must not approve accounts unless they provide a true and fair view…”[1].
It is interesting to note that the insertion of the concept of ‘true and fair’ in place of ‘true and correct’ was primarily made to do away with the prevailing view that the FS should disclose only arithmetical accuracy[2].
Whilst the Act does not specifically define ‘true and fair view’, the concept, however, was explained by the Supreme Court of India (“SC”) in J.K. Industries Ltd. v. Union of India[3], where it was held that the FS should not only be made out correctly, they should also convey an overall fair view of the state of affairs of the company and should not give any misleading impression. All relevant information should be disclosed in the FS in such a manner that the financial position and the working results are shown as they are. There should be neither an overstatement nor an understatement.
In this regard, it is also instructive to refer to the SC decision in N. Narayanan v. SEBI[4](“Narayanan Case”), where the apex court had held that “Responsibility is cast on the Directors to prepare the annual records and reports and those accounts should reflect “a true and fair view”. The overriding obligation of the Directors is to approve the accounts only if they are satisfied that they give a true and fair view of the profits or loss for the relevant period and the correct financial position of the company”.
But how many directors can put their hand on their heart and confirm that they have scrutinised the FS in detail, before expressing their satisfaction that the FS reflect a ‘true and fair view’? In this article, the authors highlight an ‘inconvenient truth’ about certification of the ‘true and fair view’ of the FS.
Preparation and Approval of the FS – The Process
In any company, the FS are prepared by the management team, headed by the Chief Financial Officer (“CFO”), using the applicable accounting standards. The CFO and his team then get the FS audited by the statutory auditors. The statutory auditor is required to report to the members of the company that to the best of his knowledge and information, the FS give a ‘true and fair view’ of the state of affairs of the company at financial year end. Significantly, in almost all situations, the auditors give their certification based on a detailed representation letter signed by the Chief Executive Officer (“CEO”) and the CFO (“Management Representation Letter”).
The finalised FS are then presented to the Audit Committee for its examination. The Audit Committee is required to confirm to the Board that the FS are properly drawn up, they are prepared in accordance with the applicable accounting standards, and they reflect ‘true and fair view’. The Committee is then required to recommend to the Board to approve the FS. The FS are then presented to the Board for its approval, and in most cases, the Board approves the FS by largely relying on the views of the Audit Committee members, without substantial debate/ deliberations at the Board meeting.
Typically, a brief presentation on the FS is made by the CEO or the CFO and the statutory auditors, and then the Chairman of the Board seeks the confirmation from the directors, whether they are in agreement with the FS, and whether the Board should recommend the same for adoption by the members, at the annual general meeting.
Certification of ‘true and fair view’ by the Board – A mere leap of faith?
In most cases, the draft FS are supplied to the directors just a few hours before the Board meeting, on the purported ground that if the FS are supplied in advance, it may result in insider trading by the directors. Moreover, considering the ‘uniform financial year’ construct and the time-limit for holding the Board meeting within 45 days from the end of the quarter, Board meetings of most listed companies come up very close to each other. This results in a situation where the independent directors (“IDs”) and the non-executive directors (“NEDs”), who serve on multiple Boards and have other pressing commitments, are not in a position to examine the FS in detail owing to paucity of time.
However, the legal architecture casts the responsibility on the entire Board to confirm ‘true and fair view’ of the FS. Despite the clear statutory mandate, in practice, given the time constraints and the ‘rush’ with which the entire process is completed, the Board certifies ‘true and fair view’ without much deliberation, by relying on the Audit Committee’s views. The Audit Committee relies on the certification provided by the auditors. The auditors, in turn, rely and pass the buck on the CEO and CFO by always insisting on the Management Representation Letter. Moreover, on how many occasions are the full FS scrutinised in detail by the auditors, as opposed to scrutinising only sample ‘cherrypicked’ book entries?
Further, it is essential for the CFO, Audit Committee Chairperson, and the auditor to have regular informal conversations throughout the year, especially during the period from the closure of the financial year till the date on which the FS are presented to the Audit Committee and the Board. But how often does this happen in practice?
It is also interesting to note that on most occasions, the Management Representation Letter and the Directors’ Responsibility Statement are not even placed before the Board, despite the fact that they form the edifice of the entire process for certifying the ‘true and fair view’!
Effectively, the only persons who are aware about the ‘truth’ and ‘fairness’ in the FS are those within the company i.e. the CFO and his team, involved in preparing the FS.
In this entire process of ‘passing the buck’, aren’t the common shareholders/ investors (who are called upon to approve the FS at the AGM) taken for a ride, and can they place faith on the certifications provided by the Board, Audit Committee, auditors and the management?
Another important aspect is that very few directors are familiar with the Ind AS accounting standards, and the complex accounting issues involved for a company with global operations, multiple business divisions and several subsidiaries and associate companies.
Minimal time for the Board and the Audit Committee to scrutinise the FS – Is insider trading prevention a valid justification?
As stated earlier, the central issue is that the draft FS are shared with the directors just a day/ few hours before the Audit Committee/ Board meetings, on the ground that sharing in advance may lead to insider trading by the directors. However, this seems like an excuse and the real objective seems to be to provide as little time to the Audit Committee and the Board to deep dive into the intricacies of the FS.
Should the Audit Committee and Board Meeting be held on the same day?
Another aspect that requires deeper thinking is Para 4(2) of Schedule B of the PIT Regulations, which provides that the gap between clearance of accounts by the Audit Committee and the Board Meeting should be as narrow as possible and preferably on the same day to avoid leakage of material information.
This makes it difficult for the Audit Committee members to brief the other directors on key concerns and highlight red flags. One informal meeting between the Audit Committee Chairperson and the Chairperson of the Board is critical for candid exchange of views on the integrity of the FS.
Ideally, the Audit Committee meeting should be held on the previous day. A large listed company with several subsidiaries and global operations should ideally have a full day Audit Committee meeting, to give an opportunity to the committee to deep dive into the FS, and seek all the relevant explanations and clarifications from the management team as well as the auditors, before endorsing ‘true and fair view’.
Concluding Thoughts
The entire process of examination of FS by the Audit Committee, and its approval by the Board, needs a comprehensive review. The current practice does not give fair opportunity to any director to ask relevant questions, and seek the required information and clarifications, before endorsing ‘true and fair view’. The issues highlighted with regard to inadequate time devoted by directors is equally applicable to review of the quarterly financial results prepared by listed companies.
The current practice is like one blind man helping another blind man navigate the road, which is perhaps the reason why accounting and financial frauds are often not discovered early. If a robust evaluation of ‘true and fair view’ was undertaken, perhaps many accounting/ financial frauds would have been discovered before it was too late.
Given the mad rush with which this process is completed, and the exclusive reliance on confirmations/ representations provided by somebody else, nobody can put their hand on heart and confirm how true the ‘true and fair view’ is.
As noted by the SC in the Narayanan Case – “Disclosure of information about the company is, therefore, crucial for the accurate pricing of the company’s securities and for market integrity”. As investors and other key stakeholders refer to the FS to obtain insight into the company’s health, absence of a robust process for certification of ‘true and fair view’ also significantly affects stakeholder interest.
In most cases of accounting fraud discovered so far, particularly in start-ups, it is the case of an old-fashioned style cooking of books by way of over reporting of revenue and under- reporting of expenditure to get better valuations from the PE investors.
Perhaps it is time to consider an amendment to the Act and the LODR – to specify the timelines for sharing the draft FS with the directors, instead of leaving this on the discretion of companies. The Act and the LODR should also be amended to make it mandatory for the company to place the Management Representation Letter before the Audit Committee and the Board.
While the ICAI has notified a large number of Accounting & Auditing Standards to ensure ‘true and fair view’ of the FS, so long as the intent (नीयत) of the promoter/ CEO/ CFO is not right and the auditor remains a silent spectator, accounting frauds will continue unabated.
The setting up of the National Financial Reporting Authority (NFRA) to regulate the audit profession, coupled with the enforcement focused regulators, activist proxy firms, business media and the judiciary has instilled a sense of fear in the minds of the wrongdoers. However, that does not absolve the Boards and the Audit Committees of its responsibility to devote a far greater time to properly review the FS to ensure that they reflect ‘true and fair view’, before putting them up to the shareholders for adoption.
The undue rush with which the FS are currently prepared and reviewed by the Audit Committee and the Board, raises serious doubts on how true is ‘true and fair view’? It is an ‘inconvenient truth’ that needs to be addressed. The regulators need to step in, to correct some of the current practices.
Until reforms are implemented, the real truth about how true is ‘true and fair view’ will continue to remain buried inside the bulky annual reports of India Inc!
[1]Gower and Davies, Principles of Modern Company Law, p. 764
[2] J.K. Industries Ltd. v. Union of India, (“J.K. Industries”).
