The government is planning to clear the air on reporting of internal financial controls made compulsory in the new Companies Act.

“We have asked the Institute of Chartered Accountants of India (ICAI) to issue guidelines. We understand the industry’s concerns and hope to clarify them as soon as possible,” said a senior official in the ministry of corporate affairs.

Internal financial controls are defined in a wide way in the Company’s Act, 2013, and cover many aspects of a company’s business. Experts are of the view the scope of internal controls will impose a big burden on companies and auditors.

Internal financial controls are designed to provide reasonable assurance that a company’s financial statements are reliable and prepared in accordance with the law. Such controls gained currency after the Sarbanes-Oxley Act of 2002 added this requirement for most public companies in the US following accounting scandals at Enron, Tyco International and WorldCom in the early 2000.

“Globally, specific responsibility for establishing internal financial controls is restricted to internal controls over financial reporting,” said N Venkatram, managing partner, audit, Deloitte Haskins and Sells.

In India, internal financial controls assumed importance after the Satyam scandal erupted in 2009. “The provisions relating to internal financial controls appear to have been included (in the Companies Act) because of the financial statement frauds witnessed in the last few years,” said Venkatram.

The Companies Act makes it mandatory for the auditors of a company to report that internal financial controls system are in place. Besides, auditors must also explicitly state the operating effectiveness of such controls.

An auditor’s responsibility, experts point out, is limited to financial statements, but this new provision stretches it to operations as well. “This is not what auditors are supposed to do,” said an expert.

There is also confusion over the scope of internal financial controls in the ‘directors’ responsibility statement’ of the board because of different provisions for listed and unlisted companies.

Directors will have to disclose internal financial controls in their report. For unlisted companies the requirement is applicable specifically to financial statements, but there no specific provisions for listed companies which may lead to open interpretations.

“In the absence of explicit provisions for listed companies, the requirements (for directors’ disclosure) seem to be applicable for all internal controls and not just those related to financial statements and financial reporting,” said Yogesh Sharma, partner, assurance, Grant Thornton India.

There are harsh penal provisions, including imprisonment for “every officer of the company”, if a company contravenes these provisions.

Moreover, the Act has not prescribed a framework to benchmark internal financial controls. Industry representatives have asked the ministry of corporate affairs to set up a framework so that there is consistency in reporting by directors and auditors.

“With the application of the new provision, evidence in the form of documentation is required. Companies expect the government to provide guidance on the extent of this documentation,” said Sharma.

The government has asked the ICAI to issue guidelines for this framework.

The other issue is internal financial controls are not mandatory for unlisted companies globally, but only for large listed firms. However, India does not exempt unlisted companies from this provision. “It must not be applicable to unlisted companies,” said Sharma. “The cost burden on  unlisted companies  to follow this provision completely outstrips the benefits,” he added.

Getting hold of the situation

  • Internal financial controls in the Company’s Act, 2013, cover many aspects of a company’s business such as its financial and effectiveness and efficiency of operations
  • A company’s internal financial controls are designed to provide reasonable reassurance that the company’s financial statements are reliable and prepared in accordance with the law
  • Experts are of the opinion that this wide scope of internal controls will create huge burden on companies and their auditors
  • In India, the internal financial controls assumed importance after Satyam scam came to the fore in 2009, besides alleged irregularities in other firms

The article appeared in Business Standard. The article can be found here.