Essel Packaging has become the first company in India to have sought shareholders specific approval to buy back shares. The company proposes to buy back shares not exceeding 15,00,887 equity shares or 10 per cent of the issued and paid-up capital. It has already obtained a certificate from the auditors, MG Bhandari & Co, (the first audit firm in the country to have issued the certificate) that the company will not be rendered insolvent within one year from the date of the general meeting convened to approve, among other matters, buyback of shares. Neither the promoters nor the persons in control of the company will offer shares for buyback.

In all probability, buyback will be through open market-(stock exchange route) and not book-building route, and in the all or none category (either the entire lot offered will be accepted or rejected). Schedule I of Sebi (Buyback of Securities) Regulations, 1998 specifies that the auditors of the company will be required to submit a report tothe board of directors stating that the company will not be rendered insolvent within one year from the date of the general meeting convened to approve the buyback.

The regulations also require that the board has formed the opinion after making full enquiry into the affairs and the prospects of the company that the company will be able to meet its liabilities on the due date and will not be rendered insolvent within a period of one year from the date of the general meeting. For this purpose, the liabilities are to be accounted for as if the company is being wound up and must include contingent and prospective liabilities. Reports indicated that ICAI has asked Sebi to outline the parameters under which solvency certificate is to be issued. Hence, it is useful to understand the methodology employed by the auditors of Essel Packaging.

Explains MG Bhandari, partner, MG Bhandari & Co, "for solvency certificate, the auditor cannot take an accounting approach. It is basically the risk profile analysis. Theliabilities are to be determined as if the company is being wound up. After adjusting for the liabilities (including contingent and prospective), the firm should be able to pay its debt." He explains that when the company is wound up, equity shareholders are the last to get the dues but in buyback, it is exactly the reverse. Equity shareholders gets paid first and that too at the prevailing market price. The auditor has to ensure that interest of entities other than shareholders (secured creditors, workers, unsecured creditors and so on) is protected. It is not like due diligence. In this case, the auditor is not issuing a going concern certificate but certifying that the firm will not be wound up in one year from the date of convening the EGM.

The methodology employed was to adjust for all liabilities including contingent liabilities and debt falling due within a year. Contingent liabilities include those disclosed as footnote in the balance-sheet and also those which come up during the audit/review ofaccounts. There can be no cutting corners since the period covered under the certificate is only one year. Therefore, adjustment is made for a sales tax deferral loan even though it does not fall due within the period. So far as losses from natural calamities are concerned, apprehensions were in any case unfounded since fixed assets are insured. The auditor's job is to check whether assets are fully insured, what types of risks are covered and whether insured at replacement value. Revaluation reserve, if any, has to be ignored and the profit/net worth must be adjusted for qualifications by the auditors. It is basically the calculation of NAV with liabilities including contingent and prospective liabilities also and no allowance for deferred revenue expenditure.

In Essel's case, cash flow statements for the past three years were scrutinised and based on it a view was taken as to whether the trend can be sustained in future (next three years) also. The basic assumptions for profit projections includingsustenance of margins, customers and suppliers profile, market share of the company and its competitors, R&D strategy, key personnel and track record of the management were also verified. The auditors also factored in the rating by the credit rating agencies and business valuation done by an external agency. Though not relevant in this case but the duty structure (if not already as per Chelliah panel proposals) will also play the crucial role. The customer profile is crucial because if a customer on which the company is heavily dependent limits his offtake, impact on bottomline will be severe. The same applies to a critical supplier. Essel itself being critical supplier for few MNCs operating in India, it was audited by two MNCs for Y2K compliance. Not satisfied that the checklist was exhaustive, the auditors also considered the audited accounts of the Chinese subsidiary and scrutinised the achievability of its projected prospects. The investment in JV firms was not included in assets at all. The managementwas also required to furnish sensitivity analysis considering various scenarios.

This checklist obviously cannot be applied to all industries because the weightages of the various parameters will differ. For any software company, for example, ability to retain staff and the nature of work undertaken (heavy reliance on Y2K related jobs) will be the key. Even for a non-software company, these are major issues. Value can't be attached to non-compliance and in any case, most major companies are Y2K compliant. This is basically an issue of risk analysis because if the machinery itself is not Y2K compliant, production will come to an halt. The auditors also considered the impact if any rebates/exemptions are withdrawn. It is mandatory for the company to generate sufficient cash internally to permit buyback and repay debt without recourse to external funding. Extra care will have to be taken for a cyclical industry as one or two bad years may severely hamper the ability to repay debt.

In all probability, ICAIwill be required to issue a guidance note on the subject and the audit plan of Essel's auditor will serve as a useful precedent.

(With contributions by Urmik Chhaya)