Intent of Consolidation
Consolidation is a combined representation of financials of a company and its subsidiaries, joint ventures and associates. Consolidated Financial Statements (‘CFS’) reflect the aggregate wealth of the holding company. Section 129(3) of the Act, 2013 mandates the preparation of CFS in addition to Standalone Financial Statements (‘SFS’), in case where the company has one or more subsidiaries.
In case of a not-for-profit organization, the need for consolidation does not arise. However, when such organization is registered under Section 8 of the Companies Act, 2013 (‘Act’), and by virtue of an interest in it by some company, the organization becomes a subsidiary of the other company, the question of consolidation arises. With the help of this article, we try and analyze the matter in question.
Peculiarity of Section 8 companies
Section 8 companies are such companies that are formed with charitable objects. Generally, profits of a subsidiary can be distributed among its members. But, in case of a Section 8 company, special provisions are laid down for utilization of profits:
- intends to apply its profits, if any, or other income in promoting its objects; and
- intends to prohibit the payment of any dividend to its members,
At the time of winding up or dissolution, surplus assets, if any, may be transferred to another company registered under Section 8 having similar objects, subject to such conditions as Tribunal may impose, or the assets may be sold and proceeds thereof credited to Insolvency and Bankruptcy Fund formed under section 224 of Insolvency and Bankruptcy Code, 2016. [Sec. 8(9)]
In case of conversion of a Section 8 company into any other kind of company (except a One Person Company), the Board of directors are required to give a declaration to the effect that no portion of the income or property of the company has been or shall be paid or transferred directly or indirectly by way of dividend or bonus or otherwise to persons who are or have been members of the company or to any one or more of them or to any persons claiming through any one or more of them [Rule 22(4) of Companies (Incorporation) Rules, 2014].Additionally, the Regional Director may impose such condition as s/he may deem fit, to the effect that any accumulated profit or unutilized income of the company brought forward from previous years shall be first utilized to settle all outstanding statutory dues, amounts due to lenders claims of creditors, suppliers, service providers and others including employees and lastly any loans advanced by the promoters or members or any other amounts due to them and the balance, if any, shall be transferred to the Investor Education and Protection Fund within thirty days of receiving the approval for conversion. [Rule 22(9)(c) of Companies (Incorporation) Rules, 2014].
In view of the aforesaid provisions it is abundantly clear that the profits/ proceeds from sale of surplus assets of the Section 8 company cannot revert to the members.
Anatomy of Section 129 and Section 8 of the Act
Examining Section 8 above, we find that all the provisions regarding profit(s) are framed in such a way so as to levy an absolute prohibition on distribution of any profits made by the Section 8 company. No profit can directly or indirectly be distributed among any of the members or shareholders as the case may be. Any income or profit, if any that arises to such a company has to be utilized in the way as prescribed under the Act.
Consequently, it can be safely concluded that a holding company of a Section 8 company is not entitled to any share in profits or income of such subsidiary.
Section 129 prescribes for consolidation of financial statements of a subsidiary company by a holding company.
Considering the intent behind consolidation which is to merge the profits, income and wealth of the subsidiary into the holding company as by the virtue of its holding, the holding company technically owns the wealth (including the profit) of its subsidiary, we consolidate the financials of the holding with that of its subsidiary.
When we consolidate the holding company with a Section 8 company, it will however depict a wrong picture of the wealth of the holding company, as the holding company can never claim any right over the profits of a Section 8 Company. Therefore, the question of consolidation does not arise.
Section 129 mandates preparation of CFS in accordance with applicable accounting standards.
Companies (Accounting Standards) Rules, 2006 issued the Accounting Standards (‘AS’) under the erstwhile Companies Act, 1956. Such entities those are not required to comply with IND-AS provisions still comply with AS 21 dealing with ‘Consolidated Financial Statements’. To understand the applicability of AS 21 on consolidation of a Section 8 subsidiary, we must study the following:
- the pertinent scope of the standards
- definition of ‘control’
- exclusions made under para 11
Pertinent scope of the standards
AS 21 clearly states, “This Standard should be applied in the preparation and presentation of consolidated financial statements for a group of enterprises under the control of a parent.”
Wherefore, AS 21 is prima facie applicable to the matter in question.
Definition of ‘control’
The definition of ‘control’ stipulates two conditions, exclusive of each other, meaning thereby that even if only one of them is satisfied, control shall construe to exist. The conditions are following:
- “the ownership, directly or indirectly through subsidiary(ies), of more than one-half of the voting power of an enterprise; or
- control of the composition of the board of directors in the case of a company or of the composition of the corresponding governing body in case of any other enterprise so as to obtain economic benefits from its activities.”
Holding company holds at least half of the shares of its Section 8 subsidiary company, which implies that condition a. is satisfied. However, there’s no extraction of any kind of economic benefit from a Section 8 company; so even if there exists control of board composition, condition b. ought to remain unsatisfied.
Since condition a. above proves to be satisfied, hence control does exist under AS 21, thereby holding company exercises ‘control’ on the Section 8 subsidiary. Thus far, these standards are applicable on the matter in question.
Exceptions made under para 11
Given are exceptions made in AS 21, conditioned that if the case fits in any of these exceptions, AS 21 shall not be applicable and thereby no consolidation should be required:
- “control is intended to be temporary because the subsidiary is acquired and held exclusively with a view to its subsequent disposal in the near future” or
- “it operates under severe long-term restrictions which significantly impair its ability to transfer funds to the parent”.
Studying the above, we find the following:
Whether the control of a holding company in its Section 8 subsidiary company is temporary or not is a highly situational analysis and thus cannot be said to apply currently.
Besides, the second exception is dealing with inability of a subsidiary to transfer its funds to parent due to ‘severe long-term restrictions’. We break down the exception in two parts:
- Inability to transfer funds- Given the earlier arguments in the article, it is now well settled that a Section 8 company being a subsidiary to another company cannot transfer any funds (more particularly, the profits). So yes, there does exist ‘inability to transfer funds’.
- Inability is due to severe long term restrictions- to understand the nature of the restriction, we look into the fact of registration of a Section 8 company. License u/s 8 is granted subject to permanent compliance of the given restrictions regarding usage of funds in such a company. So, in order to keep the status of a Section 8 company intact, the restrictions are meant to be followed up till and for winding-up. We can now safely state, that restrictions of a Section 8 company shall fall under the ambit of ‘severe long-term restrictions’ and thus the matter in questions does fall under the second exception, meaning thereby a holding company of a Section 8 company is precluded from preparing and presenting CFS under AS 21.
The new Indian Accounting Standards, as may be applicable states no specific exclusion similar to the one in AS 21. So to check whether these standards would be applicable, we shall analyse whether Section 8 company would come under the ambit of a company on which the holding company has any ‘control’, since this AS applies to companies which controls other company(s).
Accordingly, para 7 of the standards lays down three cumulative conditions, where ‘if and if only’, all of these conditions are satisfied, only then we could contemplate that the investor controls the investee. These conditions are analysed below:
Condition 1: Power over the investee
As per the given matter, the sub-conditions of para 10-14 seem satisfied. By virtue of its holding, investor satisfies this condition.
Condition 2: Exposure, or rights, to variable returns from its involvement with the investee
By virtue of its registration as a Section 8 company, it is prohibited to give any right over its profits to any of its members. Hence, there’s neither any exposure nor any right over any kind of returns from investee. This condition is thus not fulfilled. (para 15-16).
Condition 3: The ability to use its power over the investee to affect the amount of the investor’s returns
As discussed in condition 2 above, investor holds no right to variable returns. When there exists no such right, the question of ability to affect the same should not be discussed. (Para 17-18).
Since only condition number 1 is satisfied, we cannot say that investor has any control over investee, or a holding company has any control over its Section 8 subsidiary company as per these standards. Since, financial statements are to be prepared in accordance with AS, therefore the question of Consolidation of a Section 8 company does not arise.
In support of the above arguments, and given the status quo of the matter, It is correct to not prepare Consolidated Financial Standards, in order to merely comply with Section 129 of the Act, 2013. The respective accounting standards provide adequate grounds as to why the consolidation may not be needed. If CFS is prepared, the company would be making a wrong representation, depicting a distorted picture of its wealth. Hence, there is a need to review the current practice of consolidation of any Not-for-profit organization including a company registered under Section 8 of the Act’, 2013.
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