Royal Orchid: How classifying a 'subsidiary' as an 'associate' helped inflate profits by 638%

The regulator examined if the company could be be considered a subsidiary under the Companies Act and by using the Indian Accounting Standards.(Photo by Pixabay: Pexels)

A rose by any name may smell as sweet but a company may not.

In fact, a wrong name/classification may raise an unpleasant smell that catches the regulator's attention, as the case involving Royal Orchid Hotels Limited has shown.

Recently, the Securities and Exchange Board of India (SEBI) fined the company, its promoters and directors for wrongly classifying a subsidiary as an associate company. The accounting treatment this misclassification entailed had seen its profit for FY22 balloon over sevenfold or by 638 percent.

According to the regulator's classification, if the subsidiary Ksheer Sagar Developers Private Ltd (KSDPL) had been shown as one, Royal Orchid would have reported a profit of Rs 3.62 crore in FY22. Instead, when it was listed as an associate, Royal Orchid could report a consolidated profit of Rs 26.78 crore.

Also read: Sebi asks all listed and unlisted MIIs to declare and monitor shareholding details

As the SEBI order states, "ROHL, through headline misstatement of consolidated financial statements for FY2021-22, inflated its profits by INR 23.15 crore." Moneycontrol has written to Royal Orchid and this article will be updated when the company responds.

A subsidiary company is one in which the holding company controls the composition of the board of directors or exercises/controls more than half the share capital either on its own or together with one or more subsidiary. An associate company is one in which the parent company simply owns a significant but minority stake. While a subsidiary's financials are aggregated in the parent company's consolidated statements, an associate company's financials are not.

KSDPL had been a loss-making subsidiary for six financial years before FY22. According to the regulator's findings, this company's net worth had "fully eroded".

In FY21, Royal Orchid had recorded a consolidated loss after tax of Rs 40 crore.

By not considering the loss-making KSDPL as its subsidiary in FY22, Royal Orchid had de-recognised all the assets and liabilities of KSDPL. Royal Orchid recorded a re-measurement gain of Rs 23.26 crore under the exceptional item header in the consolidated financial statement for FY22 and reported its profit after tax for the year as Rs 26.78 crore.

Background
KSDPL is jointly owned by Royal Orchid and Tambi Group, each holding a 50 percent stake. The company owns and operates a property under the Royal Orchid brand in Jaipur.

On March 4, 2022, Royal Orchid informed the stock exchanges that KSDPL was no longer its subsidiary.

According to the company, this declaration was made because its nominee directors no longer made up for the majority of KSDPL's board.

Under the memorandum of understanding that had been signed earlier, KSDPL would have five directors, three nominated by Royal Orchid and two by Tambi Group. On March 2, 2022, two independent directors were nominated, taking the total directors to seven. With this, Royal Orchid no longer could constitute the majority of the Board of KSDPL (three out of seven).

Therefore, when it published its financials on May 30, 2022, it excluded the financials of KSDPL as a subsidiary, according to the SEBI order.

How the matter was decided
When SEBI examined the operations, it found that Royal Orchid was in a position to control the composition of the KSDPL board. It found that the MoU stated that KSDPL's board would always have a chairman from Royal Orchid and that this chairman will have the casting vote if there is a tie on a decision. Thus, it had control over the outcome of any ordinary resolution in a general meeting of shareholders of KSDPL particularly in the appointment and removal of directors.

KSDPL was hence found to be a subsidiary as defined in the Companies Act.

Then the regulator examined if it could be considered a subsidiary under Indian Accounting Standards.

Here, too, the regulator found that Royal Orchid was given as the owner under the hotel operation agreement and was more than just an operator of the property. It found that the company had the ability to control the relevant activities of KSDPL through the MoU, that it had exposure to variable returns from its involvement with KSDPL and that it was a decision-maker with the ability to use its power to affect the returns of KSDPL.

Since it satisfied all three conditions given under the accounting standard, the regulator found that it could be called a subsidiary of Royal Orchid.

The order issued by SEBI's whole-time member Ananth Narayan stated, "In their (Royal Orchid's) replies, the repeated defence taken is that the decision to reclassify KSDPL as an ‘associate’ was based on the composition of the board of directors and that once independent directors were appointed to the Board, ROHL lost control over KSDPL. Therefore, according to the noticees, the ‘subsidiary’ status of KSDPL had to be changed and the financial statements had to be consolidated accordingly. This premise is fundamentally flawed."

The order added, "The determination of how" the financial statements must be consolidated is based on the Ind AS and not based on the composition of the board."

SEBi fined the company, its promoter entities Chander Kamal Baljee and Keshav Baljee, and its CFO Amit Jaiswal Rs 6 lakh each, or Rs 24 lakh in total.

It has also asked them to disclose the financial statement of KSDPL along with an audit report for FY22, FY23 and FY23 within a month. The regulator also asked Royal Orchid to file a report detailing the impact on its consolidated financial statements for FY22, FY23 and FY24 due to the wrong classification.