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Premium for quality financial reporting
November, 05th 2012

Over the past few weeks, the Securities and Exchange Board of India issued several notifications as part of its efforts to improve the IPO (initial public offer) process. While some measures focus on use of issue proceeds and greater participation by retail investors, others focus on the quality of financial reporting by issuers. Additionally, there is guidance from the Institute of Chartered Accountants of India on the preparation of pro-forma financial information for inclusion in the prospectus related to acquisitions and divestitures.

FACING REJECTION

On October 9, 2012, SEBI specified the factors that may lead to the rejection of draft offer documents filed by companies. Many of them relate to disclosures or preparation of financial information that is not of the desired quality.

For instance, draft offer documents may be rejected if the accounting policies are found to have been changed recently with a resulting improvement in reported earnings, profitability or future prospects, and the change is against generally accepted accounting norms. Similarly, a sudden change in reported earnings or assets preceding the filing of draft offer documents may also result in rejection in the absence of a satisfactory explanation.

Consistent with its previous announcement on scrutiny of qualified audit reports, SEBI has stated that companies with qualified audit reports (including those of subsidiaries, joint ventures or associates) may also face rejection.

Companies preparing for an IPO should ensure they have a well-established history of transparent financial reporting.

The selection and changes in accounting policies ahead of the IPO should be adequately documented with reference to the rationale and the likely impact. Further, companies with a significant volume of transactions with related parties or a complex capital structure involving several intercompany loans or investments should ensure there are sufficient disclosures to support these transactions and their commercial rationale.

ANNUAL UPDATES

On October 12, SEBI amended its Issue of Capital and Disclosure Requirements regulations, requiring annual updates for disclosures in the draft red herring prospectus. Hence, the company should prepare certain additional disclosures annually even though these are not needed in the annual financial statements.

Moreover, as part of the due diligence certificate given along with the draft offer document, merchant bankers now have to certify that the profits from related party transactions pertain to legitimate business transactions.

PRO-FORMA STATEMENTS

SEBI had earlier amended its regulations requiring issuers to prepare pro-forma financial statements where:

An acquisition or divestment is made by the issuer after the latest disclosed annual financial results in the offer document due to which certain entities become, or cease to be direct or indirect subsidiaries; and

The financial statements of such acquired or divested entity are material to the financial statements of the entity.

The CA Institute recently issued a guide on reporting such pro-forma financial statements. The pro-forma financial information would include audited financial information of the issuer; historical financial information of the acquired/divested entity; adjustments made to effect the acquisition/divesture; and final pro-forma amounts after adjustments.

This measure will enable investors understand the impact of recent acquisitions and divestitures on the financial statements and future results of the company. It is in line with international reporting and disclosure requirements.

Potential issuers should be prepared to meet the new requirements. Adequate and advance planning will ensure a smoother IPO process.

(Jamil Khatri is Global Head of Accounting Advisory Services, KPMG in India)

 
 
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