The Commercial Code and Company Valuation (Part IV)

On bringing in-kind contributions to a joint-stock company, the legislator instructs the auditor to issue an opinion on the value of these contributions. But is the legislator justified in presuming that the auditor should deal with this? Continuing the analysis of article 312 of the Code, let's take a detailed look at the issue of the role of the auditor.

The basic question - is it justified and appropriate, in article 312, for the legislator to require the auditor to issue an opinion on the value of in-kind contributions? Personally, I have a lot of respect for the work of auditors. At the same time, it is worth noting that the standard scope of an auditor's work is very remote from carrying out valuations or assessing the valuation methodology applied by another specialist.

The purpose of the work of auditors when examining financial statements – which is mainly what auditors deal with - is to provide an opinion as to whether the financial statements present fairly, in all material respects, the financial position of an entity and the results of its operations and its cash flows for a financial period in accordance with generally accepted accounting principles. Auditors for the most part do not have the proper knowledge or relevant experience to carry out valuations or to assess valuations prepared by other experts. So why did the legislator decide that it was the auditors that should perform the relevant duties provided in article 312?

It is highly recommended that the legislator take note that there are professional experts, separate from auditors, which carry out valuations of different groups of assets – we have real estate valuators, we have specialists in the valuation of machinery and equipment and, finally, we have the appraisers of businesses and intangible assets. Those specialists, more so than auditors, are predisposed to fulfil the roles laid out in article 312 - that is, an assessment of the value of in-kind contributions. An especially odd situation may arise in the case of transfers of real estates as in-kind contributions. Note that, in accordance with the Real Estate Management Act of 21 August 1997 only real estate valuators (rzeczoznawcy majątkowi) shall be entitled to carry out valuations of real estate, or issue an opinion on the value of real estate. If the founders have a real estate appraisal prepared by a real estate valuator, what is the opinion of an auditor that is not a real estate valuator worth?

For the sake of clarity, we should mention the Auditors’ Code of Professional Ethics, which, in paragraph 5.2, provides that "an auditor, by taking up the provision of professional services, should have the necessary competence to execute them, understood as the knowledge, acquired skills and experience and, by providing professional services, to use this competence in full. If the auditor does not have the appropriate competence to carry out specific parts of the service, he should secure advice and assistance of competent specialists." Let us hope that the auditors undertaking the obligations deriving from article 312 of the Code bear this point of the Auditors’ Code of Professional Ethics in mind.

It is worth noting the requirement provided in paragraph 1 article 312 for an assessment whether the fair value of in-kind contributions is equivalent to at least the nominal value of the shares or a higher issue price of the shares. The issue price of the shares being taken by the entity making the in-kind contribution should not exceed the fair market value of the in-kind contribution - that is obvious. A general requirement of the Code on the issue of shares is the determination of the issue price at least at the level of the nominal value. When establishing up a company, typically the issue price coincides with the nominal value of shares. For subsequent shares issues, the issue price, as a rule, is not equal to the nominal value. This is due to the fact that the issue price should reflect the fair value of one share of the company, and this changes over time. The nominal value is generally a fixed number determined at the time of the formation of the company.

For example, if the fair value of the entire company (before the new issue of the shares) has been estimated at 10 million PLN, the share capital consists of 2 000 shares with a nominal value of 1 000 PLN each, while the value of in-kind contributions has been estimated at 3 million PLN, then there should be an issue of 600 new shares with an issue price of 5 000 PLN. The calculations are simple: the fair value of one share - 10 million PLN/2 000 shares = 5,000 PLN/share; the amount of new shares - 3 million PLN/ 5,000 PLN/share = 600 shares. The determination of such parameters of the new issue will be neutral from the point of view of the financial interests of all shareholders – both current and those making the contribution in-kind.

Commercial practice indicates that new share issues covered by in-kind contributions are often designated for majority shareholders or their related entities. In such a situation, the risk arises that an overvaluation of the in-kind contribution would lead, not only to the falsification of the company balance sheet, but would negatively affect the value of the shares held by minority shareholders - of course, to the benefit of the majority shareholders or their related entities. Consequently, the knowledge and experience of the auditor issuing an opinion on the value of in-kind contributions is of vital importance for the overall corporate governance of the company.

Paragraph 2 provides that the auditor shall be designated by the registry court proper for the registered premises of the company. Quite often it happens that the auditor designated to issue an opinion on the in-kind contributions is the ‘regular’ auditor examining the financial statements of the entity. In a situation where the matter concerns a company with a majority and minority shareholders, and an in-kind contribution is being disposed of by the majority shareholder, this practice seems to be highly dubious. Generally, if we have a "long-term" auditor examining the financial statements of the company then, despite the fact that he does not work directly with the majority shareholder, his opinion on the value of an in-kind contribution of the majority shareholder could raise doubts as to the impartiality of the auditor. This is due to the presumption of the willingness of the auditor to continue to examine the financial statements in future years, and to maintain good relations with the majority shareholder – who directly or indirectly influences the choice of entity examining the financial statements. This means that the selection of an auditor that does not simultaneously provide examination of the financial statements services to the company is both desired and recommended.

To conclude this analysis of article 312, let us turn our attention to paragraph 8, which provides that in the event of a difference of opinion between the founders and the auditor, the dispute shall be heard by the registry court at the request of the founders. Such a difference of opinion can, of course, relate to situations in which the auditor issues his opinion on the overvaluation of an in-kind contribution in the founders’ report. The ruling of the court issued as a result of hearing of the application is not subject to appeal. Finally, it is worth noting that the registry court may appoint a new auditor, if it considers it justified to do so.

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The Commercial Code and Company Valuation (Part IV)