pri Decoding CARO –Proprietary and Governance issues Decoding CARO –Proprietary and Governance issues

Central Government, in exercise of the powers, issued the Companies (Auditor’s Report) Order, 2020, (CARO 2020/ ‘the Order’) vide Order number S.O. 849(E) dated 25th February 2020. CARO 2020 was initially applicable for audits of financial year 2019-20 and onwards. Subsequently, its applicability has been deferred by one year. Accordingly, CARO 2020 is applicable for audits of financial year 2020-21 and onwards.

CARO 2020 has brought in significant change. Objective of the New CARO is to enhance the Trust in financial statements, since number of companies in India have failed which has shaken the investors’ confidence. Traditionally CARO was looked at as compliance reporting, but with the changes it’s much beyond compliance and now covers Disclosure of proprietary and governance issues, which require special attention of the readers of the financial statements e.g Benami transactions, fraud, whistle blower complaints, wilful defaults etc. Further, Solvency aspects are also covered like cash loss, going concern assessment etc. Materiality has now been defined leaving little room for auditors and management judgement, more than 10% deviations in physical verification in each class of PPE and Inventory has to be reported.

Though CARO 2020 is not applicable for consolidated financial statements but any adverse remark of component auditor has to be highlighted in the consolidated CARO, giving overall governance assessment as a group.

Hence, from this CARO bankers, credit rating agencies & regulators will be able to get understanding of the quality of governance, solvency along with compliance status.

Disclosure of proprietary, governance and solvency issues

1. Title of immoveable property not in the name of the company, requires specific disclosure in case title is in the name of promoters/ directors their relatives and employees. The important point is that even employees have been covered.

2. Any proceedings under Prohibition of Benami Property Transactions Act, 1988 (as amended) and rules made thereunder along with a comment on its appropriate disclosure in the financial statements, giving details of the property, its value and the status of the proceedings. This will not apply were the company is a beneficiary under this Act.

3. Any income not recorded in the books but surrendered or disclosed before Tax authorities. Very critical for listed entities, since such issue highlight lack of governance. This may lead to other complications like fraud, misrepresentation and misuse of public funds.

4. Auditors now need to reconfirm that the quarterly / monthly statements / returns filed by the company with banks or financial institutions, reconcile with the books of accounts. Further, Auditors have to do additional procedures like evaluating controls, past trend of physical verification outcome, adequate reconciliation of stock and its valuation as per accounting standard.

Over the years, it was noticed by the bankers that organisations overvalue stock while reporting to them. New CARO will act as reassurance to the lenders on the credibility of the borrower numbers.

5. Any default in repayment to any lender at any time during the year, even if regularised later is to be reported and it now covers all lenders, beyond bank and financial institutions. Such information is of value for the credit rating agencies, as all lenders are not captured in SIBEL, the tool to check credit worthiness. In case any bank, financial institution or government agency has declared the company wilful defaulter, the said fact needs specific reporting.

6. Fraud by or against the company by any one is now covered, earlier it was restricted to “Officers & employees of the company”. These are red flags on controls and is a tool for independent directors who have to ensure adequate ‘Internal Financial Control’ are in place. For this the auditors is also required to review and report on the “Whistle Blower Complaints” along with their resolution / action. Such review and outcome has to be disclosed. In case of any fraud the auditor has to confirm if ADT4 has been filed by them.

7. Auditors are now required to comment on the adequacy of Internal Audit (IA) system, commensurate with the size and nature of its business. Assessing the size and nature of business will require auditors to apply judgement and the basis for such judgement will have to be documented. Further, the auditors have to consider IA reports for the complete period of audit. This is a challenge for listed entities who close and get financial statements approved with in a very short period of the year end.

8. Loans and advances given by companies– CARO now covers all loans & advances (including guarantee) and is no more restricted to related party transactions. These have been under the lenses of regulators for quite some time so the disclosure clauses have been modified to highlight

a. Renewal / extension of loans fallen due

b. Fresh loan given to repay the dues.

c. Overdue loans renewed as fresh loans.

d. Terms and condition of loans not clearly defined or are prejudicial to the interest of the company. A holistic assessment has to be made and judgement applied.

e. Related party disclosure

Such disclosures give an insight on the governance quality and recoverability of financial assets. It is a relevant information for Bankers / lenders / credit rating agencies and regulators. This clause will however not apply to companies whose principal business is to give loans.

9. Loans taken by the company, its repayment and utilisation require specific reporting

a. Any default at any time during the year – auditors need to take confirmation from banks directly.

b. Restructuring / rescheduling of loans

c. Declared as wilful defaulter by any bank / financial institution / government authorities. The above clauses reflect solvency issues and the audit has to apply other methods to reconfirm like SIBEL report etc.

d. Diversion of funds other than for the purpose it was obtained and where diverted

e. Short term loans used for long term purpose – may lead to liquidity and solvency issues.

f. Raising of funds by pledge of security held by Subsidiaries / Joint Venture / Associates.

g. Loans taken to meet obligation of Subsidiaries / Joint Venture / Associates.

Such disclosure may again raise red flag on the financial stability and governance of the company, giving an in site to Bankers / lenders / credit rating agencies and regulators.

10. Going concern assessment– recent failure of some large corporates, without any red flags by auditors has raised concerns, leading to introduction of a new clause requiring the auditors to assess and affirm company’s ability to discharge all liabilities if they fall due with a period of 12 months from the Balance Sheet date. To assess this the auditors have to apply various measure like cash flow for 12 month form the Balance sheet date, Ratio analysis, expected realization of financial assets and repayment of financial liabilities, plans of Board of Directors and other information as disclosed in the financial statements.

To conclude it can be said that the inputs for the new CARO 2020 is a result of failures of many companies. CARO 2020, will improve the quality of financial reporting, make the management agile and boost investor confidence. In this process the responsibility of the auditors have increased many folds.

(Article is authored by  Mr. Darshan Chhajer, Partner at BGJC & Associates LLP.)

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July 2021