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Tuesday, Jan 07, 2003

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Dealing with accounting defaults — Lessons from Sarbanes-Oxley Act

S. Sivakumar

There is little logic in pushing SEBI and accounting bodies to mandate greater financial disclosure by corporates when the legal framework for punishing companies that fail to follow even the existing guidelines seems shaky. The major achievement of the Sarbanes-Oxley Act, recently legislated in the US, is that it has stipulated severe penalties that will act as deterrents to corporate wrong-doers.

IN THE wake of the series of accounting scandals that shook corporate America, the US Congress passed the Sarbanes-Oxley Act of 2002, which was signed by President Bush on July 30, 2002. The Act contains many far-reaching measures related to financial reporting, corporate ethics, conflicts of interest and the oversight of the accounting profession in the US. Perhaps, the most significant provisions of this Act deal with the pinpointing of responsibility for fair and dependable financial reporting on companies' CEOs and CFOs.

Under Section 906 of this Act, the principal executive officers (`CEOs') and the principal financial officers (`CFOs'), or persons performing similar functions of companies filing periodic reports (including, most importantly, quarterly financial results) to the SEC are required to certify that the signing officer has reviewed the report and that the report does not contain any untrue statement or omits a material fact and that the filed financial statements present a fair view.

The penalties prescribed for any wrongdoing in respect of this certificate are very stiff. The Act specifically provides that anybody who provides a Section 906 certificate knowing that the certification does not meet with the criteria stated above, may be fined up to $1 million and/or imprisoned for up to 10 years.

Furthermore, those who wilfully provide a Section 906 certification knowing that the certification does not meet the required criteria can be punished with a fine of up to $5 million and/or with a prison term of up to 20 years. What is interesting is that this Act seems to make a distinction between non-wilful and wilful defaults only in the area of fixing penalties, with penalties for wilful defaults being significantly higher.

The major achievement of the Sarbanes-Oxley Act is that, apart from pinpointing corporate responsibility for financial reporting, it has also brought in severe penalties that will act as a major deterrent for the corporate (accounting) wrong-doers. It is reported that many European countries are planning to introduce legislation on the lines of the Act.

In India, a lot of confusion prevails in the area of financial reporting by companies, which is subject to a plethora of requirements imposed by the Companies Act and the Listing Agreement. While the listing agreement contains several clauses on financial reporting it would seem that the stock exchanges simply lack the legal muscle to discipline the wrongdoers.

Clause 41 of the Listing Agreement makes it compulsory for listed companies to publish unaudited quarterly financial results, within 30 days from the close of the quarter under different account heads. This Clause has also recently introduced a unique concept of a `limited review' by the companies' auditors in respect of the unaudited financial results declared by companies for the first two quarters of the financial year.

This requires companies to `explain' to the stock exchanges a variation of 20 per cent or more between figures emerging after the auditors' limited review of the accounts and the aggregate of the unaudited figures furnished by companies for the first two quarters, in respect of any of the items covered by the proforma used for publishing unaudited results.

Similar provisions requiring companies to `explain' to the Stock Exchanges exist when variations of 20 per cent or more are noticed between unaudited and audited figures for the financial year, as a whole. While one may argue that the 20 per cent leeway given to companies is rather high, there is no denying that these provisions have, indeed, contributed to better reporting of unaudited financial results by listed companies.

Nevertheless, the big question still remains as to what the exchanges could do if listed companies wilfully flouted these rules. Being essentially contracts in nature, the Listing Agreement gives the stock exchanges no power to deal sternly with companies which fail to comply with its clauses. If the stock exchanges are powerless to act against erring companies, how does the Companies Act, 1956 deal with the situation? First, the Companies Act contains no provisions relating to unaudited financial results and, hence, there is no way companies can be penalised in respect of unaudited results, which is only a listing requirement.

Even the provisions in the Companies Act in respect of annual accounts leave much to be desired. Section 210(5), which states that any person, being a director of a company, who fails to take all reasonable steps to comply with the provisions of this Section, shall, in respect of each offence, be punishable with imprisonment which may extend to six months or with a fine which may extend to Rs 10,000 — a paltry sum, by any standards (this was an unbelievably low Rs 1,000 till December 12, 2000) — or with both.

Predictably, this Section provides two rather easy escape routes for the directors. First, no director can be sentenced to imprisonment under Section 210, unless it is proved that the offence was committed wilfully. Second, the Section gives the director charged (assuming that he can be charged) an easy escape route — he has only to prove that a competent and reliable person (read, a scapegoat) had been assigned with the responsibility to comply with the provisions of this Section and then, as you can guess, the director gets away scot-free.

Further, by not making a clear distinction between non-executive directors and executive directors, who are in control of the companies and who, in most cases, are the largest beneficiaries of any stock market reactions arising out of misleading or false financial information, this Section has left many issues open. Expectedly, over the last four decades that this Section has been in force, there have not been many cases of directors being charged for false or misleading audited annual accounts, though the number of companies that have duped investors by providing grossly incorrect and misleading financial information may run into thousands.

The recently introduced Section 217(2AA), which mandates inclusion of a Directors' Responsibility Statement covering, inter alia, provisions related to accounting standards, etc., in preparation of the annual accounts, in the directors' report to the shareholders, contains clauses which are very similar to Section 210 in terms fixing responsibility on the directors, with the prescribed penalty being imprisonment of six months or a fine of up to Rs 20,000 — or both.

Here, again, imprisonment cannot be awarded unless the offence is proved to be wilful. The provisions are generic and vague. The other Section in the Companies Act, dealing with false statements, Section 628, states that if in any return, report, certificate, balance-sheet, prospectus, statement or other document required by or for the purpose of any of the provisions of the Companies Act, or any person, makes a statement which is false in any material particular, knowing it to be false, or which omits any material fact, knowing it to be material, such person can be punished with imprisonment for a term of up to two years and can also be held liable for a fine.

Though even errant auditors can be penalised under this Section, it is again seen that it is far too general and vague. Not many cases relating to corporate financial reporting have been brought under this Section. The undeniable reality is that the current provisions in the Companies Act relating to punishing corporate wrongdoers in the area of financial reporting are woefully inadequate.

There seems to be little logic in pushing SEBI and institutions such as the Institute of Chartered Accountants of India to introduce new measures to get companies to disclose more financial information when the legal framework for punishing companies that fail to follow even the existing guidelines seems shaky. We need to take a leaf out of the Sarbanes-Oxley Act and work towards introducing clauses in the Companies Act, providing for stringent penalties, including imprisonment for both wilful and non-wilful offences in respect of corporate reporting and, perhaps, pinpoint the corporate responsibility for financial reporting on companies' managing and whole-time directors.

We also need to amend the Companies Act to deal sternly with violations of the Listing Agreement in the area of financial reporting and arm SEBI with adequate powers to implement these provisions.

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