Schedule VI of Companies Act under revision
The government has decided to revise schedule VI to the Companies Act, which stipulates the manner in which every company prepares and presents its balance sheet and profit and loss account. The revision aims to harmonise and synchronise the general disclosure requirements under schedule VI with those prescribed in International Financial Reporting Standards (IFRS), which India will adopt from April 1, 2011. The draft of the revised schedule VI is available at the web site of the Ministry of Corporate Affairs (http://www.mca.gov.in/).
The extant schedule VI does not require companies to classify assets and liabilities into current and non-current categories. As a result, some items of assets, which should be classified as non-current asset, are included in current assets. Examples are deposits which the company does not expect to realise within 12 months after the balance sheet date, that part of loans and advances that will be recovered after 12 months from the balance sheet date and those items of raw materials and components which are not expected to be consumed within the normal operating cycle. Similarly, non-current provisions and current provisions are clubbed together. At present the total amount of the provision is clubbed together with current liabilities. The draft revised schedule VI requires companies to classify assets and liabilities into current and non-current categories. This will definitely improve the usefulness of the balance sheet.
Conventionally, current asset to current liabilities ratio (current ratio) is calculated to evaluate the liquidity of the company. In absence of proper classification of assets and liabilities into current and non-current categories, this ratio gets distorted. Disclosure in the revised schedule VI will remove this distortion.
It is expected that the Companies Act will be revised to enable companies to classify redeemable preference shares as debt (loan fund). At present redeemable preference shares are classified as equity. IFRS requires that companies should classify redeemable preference shares as debt because a company has no discretion but to repay the capital. Therefore, redeemable preference shares represent an obligation present at the balance sheet date. Accordingly, it should be classified as debt. This classification will improve the analysis of financial statement. Provision in the Companies Act relating to preference shares, including provisions related to redemption of preference shares will require change.
Another important revision is the requirement to present accumulated loss as a negative amount under reserves and surplus. The proposed revision of schedule VI to the Companies Act 1956 stipulates multi-step format for the presentation of profit and loss account. It requires companies to disclose gross profit in the profit and loss account. It also requires allocation of operating expenses into selling and marketing expenses and administrative expenses. This will bring a significant change in the current structure of profit and loss account. This will require a company to apportion common expenses to different functions/activities. Companies should apply the Cost Accounting Standards, wherever applicable.
The disclosure of gross profit by companies will be useful in analysing financial statements. Gross profit is the difference between the amount of net sales (that is sales less excise duty) and the cost of goods sold. Revised schedule VI uses the term cost of sales instead of the term cost of goods sold. In a merchandising business the cost of goods sold is the total of costs incurred to bring the goods to the location and condition of sale. Thus, it includes expenses on inward logistics. For a manufacturing company cost of goods sold is total of costs incurred to manufacture the goods sold and the costs to bring the goods to the location of sale. Analysts use the gross profit ratio to evaluate the manufacturing efficiency of a manufacturing business and the efficiency of procurement and inward logistics of a merchandising business. However, the ratio is less relevant for a company that has significant operating expenses. The reason is that the gross profit ratio may be improved by improving sales through advertising and product promotion expenses and expenses on improving the efficiency and effectiveness of the distribution channel. Sales promotion and similar expenses are included in operating expenses and not in cost of goods sold. Therefore, gross profit ratio might be misleading.
The next level of profit is the operating profit. This is the difference between the gross profit and selling and marketing expenses and administrative expenses. Operating profit to sales ration measure the operating efficiency of the company. Operating expenses to sales ratio (operating ratio) is complementary to the operating profit to sales ratio. Certain expenses which do not have a direct cause and effect relationship with the revenue for the year are called discretionary expenses. Examples of discretionary expenses are training expense and research expense. The proposed schedule VI does not provide guidance on whether they should be included in cost of goods sold or in general and administrative expenses. If they are included in cost of goods sold, the amount of gross profit will be distorted. Therefore, they should be included in general and administrative expenses. The final revised schedule VI should provide adequate guidance on this issue.
Sometime analysts calculate earnings before interest, tax, depreciation and amortisation (EBITDA) to sales ratio to evaluate the profitability. The ratio is called cash profit ratio. This ratio is useful to calculate the margin over current expenses, particularly in capital intensive industries like the telecommunication industry. Profit and loss account provides information required to calculate EBITDA.
Revision of schedule VI is due for a long period. The government has taken it up now because of the compulsion to bring it in conformity with the requirement of IFRS. It is true that the format and requirements for the preparation of financial statements cannot be revised frequently. Frequent revision has the potential to confuse the investors. Therefore, after this revision, the next revision will wait for long. Therefore, the government should take this opportunity to make it mandatory for companies to disclose the amount of economic value added (EVA), in addition to the disclosure of earning per share.
EVA is calculated as follows: Invested capital × (ROIC - WACC). ROIC is the return on invested capital and WACC is the weighted average cost of capital. If a company fails to earn return on investment higher than the WACC, it destroys value. If a company earns return on investment higher than the WACC, it creates value. When a company's return on investment is just equal to WACC, it neither creates value nor destroys value.
EVA cannot capture the total value created by a company that creates value by managing intangibles because most intangible assets are not recognised in the balance sheet. EVA is being considered the most relevant measure to assess the operating efficiency in a particular year. Many companies disclose EVA voluntarily.
India will adopt IFRS from April 1, 2011. It is the time to speed up the changes in the regulatory environment for seamless implementation of IFRS.