STRUCTURE AND PROCESSES OF COMPANIES

Companies are bodies incorporated under the Companies Act. Registrar of companies registers them after putting them through the prescribed processes. Companies are regulated under the Companies Act, and also by their articles of association and memorandum of objectives/purposes. If they are listed on the stock exchange, Securities and Exchange of Board of India (SEBI) watches over certain operations especially to protect the interests of small shareholders (who it is believed are often taken for a ride by the companies).

Companies are owned by shareholders. Companies need money to create the initial capital facilitiesfor startingoperations andthenrunningthem.Companiesoperateinvarious sectors of the economy such as infrastructure, manufacturing, finance, banking, trade and services. The type of equipment, machinery, factory site, offices and other facilities they require depend on the nature of their activity. Companies have to incur capital expenditure upfront for creating these facilities. Companies generate revenue or cash by selling whatever they produce or by rendering services. Companies have to incur capital expenditure before they start receiving cash from their operations.

Companies are set up by entrepreneurs or promoters. They put some money of their own and collect the balance from others. This is called share capital or equity. The amount is divided into units (normally each with a value of Rs 10 or Rs 100). Each contributor or shareholder receives shares in proportion to his equity. If X has contributed Rs 10,000 and if each share has a value of Rs 10, he will get 1000 shares. People invest in shares because they expect returns in the form of annual dividends and also because they expect the value of share to go up. The value of Rs 10 in our example is the initial book value of the share. If the company does welland makes profit, the share value will increase. If the company is listed in stock exchange, the share may, for example, sell for Rs 50. This is its market value.

Normally, a major part of share capital comes from promoters and the institutional investors. These are Life Insurance Corporation of India, general insurance companies, provident funds, Trusts (to the extent permitted), pension funds, investment funds and hedge funds. No project is funded wholly by equity. The promoters borrow money from banks and other institutions. Normally, projects are financed with 30% of share capital and 70% of loans or debt. Loans are repaid over a time with the revenue generated from the operations of the company.

Companies run on the basis of corporate democracy. In a democracy, each adult has one vote. But in a company the ‘voting power’ depends on share capital holding. If an individual or institution owns 10% of share capital, it commands 10% of votes. The promoter and his partners generally hold the required percentage of shares for management control and for taking necessary decisions. We can straightway note a problem here. As promoters have a controlling ownership of shares, they (along with institutional investors) ‘call the shots’. In the process, the interests of small investors get neglected.

The affairs of the company are managed by a board of directors. This is what ‘board room’ means. It is the dream of MBAs and other professionals to make it to this sanctum sanctorum. The managing director is the chief executive who runs the day to day operations. He is responsible to the board. The directors are classified into three groups: (i) those representing the promoters,

(ii) nominee directors who represent the financial institutions and (iii) independent directors. The independent directors are selected on the basis of their expertise, experience, proven track record and impeccable integrity. Independent directors have a special role as custodians of corporate ethics. We will consider this aspect later in greater detail.

One writer hasdescribedthe board of directors as the epicentre of thecompany’soperations. The board is actually more of a policy making body. It does not handle the company’s daily operations. The board devisesthecompany’s longtermstrategy, createstheorganizational structure,lays down broad policy, prescribes necessary processes, and works out suitable mechanisms of external and internal control. Normally, it meets every month to review performance and take necessary policy decisions.

The operations of the company are divided into different areas depending on the nature of its activities. The normal divisions are production, purchase, marketing, finance, logistics, human relations (HR), communications and company law. The structure consists of managers at senior, middle and junior level. The managers carry out the operations in the different areas. Three areas are of particular importance for corporate governance – finance, audit and corporate law (which ensures compliance with regulations). Chief financial officer and company secretary play critical parts in corporate governance.

The results of a company’s operations over the financial year are placed for approval before the general body of the shareholders. The results are reflected in the profit and loss account for the year and the balance sheet (as on 31st March of the financial year ended). Profit and loss account shows all the revenues and expenditures and any resulting profit. The accounts are audited by both internal and external auditors.

Before concluding this preliminary account, we may note that many malpractices involve the manipulation of accounts. Accounts have to convey a fair and accurate picture of the company’s financial position. TheInstitute of Chartered Accounts has prescribedthe ‘accounting standards’or the correct ways of writing accounts. To put it simply, a company’s profit is a resultant figure derived from calculations of thousands of revenue and expenditure elements (or pluses and minuses). By showing such elements in different ways, the levels of income and expenditure can be changed.

The profit can be increased or decreased, only within a narrow range, by tweaking the numbers. The auditors may not accept such procedures if they deviate too far from normal accounting conventions. We need not get into the details which involve intricacies of accounting. But we may note that accounts can be slightly manipulated to show higher profits. Nowadays, a whole bunch of financial analyststrack theperformance of companies, and project estimated profits. If a company’s profitsfall belowthese estimates, its stock takes a beating on the stock market thereby eroding some of its shareholders’ wealth. This is one reason why accounts are to some extent manipulated.

This is obviously wrong. There can be more sinister motives such as increasing share price for selling it on market to unsuspecting small investors. They will suffer losses when in due course the stock value dips to its realistic level. There can be various other irregularities like embezzlement,

divertingCompany’smoney to personal uses andtaking money in purchasesand sales.Incidentally, the Companies Act prescribes the procedure for calculating net profit. The method of calculating profits also follows from accounting standards.

Before proceeding further, let us consider some examples which illustrate financial wrong doing.