CA Vivek Rajan. V
1. Background : The Ministry of Corporate Affairs [ MCA] vide its notice dated 9th February 2016 had invited suggestions/ comments along with justification in brief on the draft Companies ( Auditor’s Report) Order, 2016, (CARO, 2016). This article contains the suggestions/ comments.
2. Suggestions/ Comments
“The Act” means the Companies Act, 2013
Part I – On clause that is covered in the Draft CARO, 2016
a. Para No 3, clause (iii) and
b. Para No 3, clause (xiii)
Clause as existing in Draft CARO, 2016
“Whether the company has granted any loans, secured or unsecured to companies, firms or other parties covered by clause (76) of Section 2 of the Companies Act, 2013. If so …” (the rest of the clause is not covered for sake of brevity)
Whether all transactions with the related parties are in compliance with Section 188 and 177 of Companies Act, 2013 where applicable and the details have been disclosed in the Financial Statements etc as required by the accounting standards and Companies Act, 2013.
It is suggested to retain the corresponding clause of CARO, 2015. The said part of the clause (Para 3, clause (iii) of CARO 2015,) is as under
“Whether the company has granted loans, secured or unsecured to companies, firms or other parties covered in the register maintained under Section 189 of Companies Act, 2013. If so …”
The objective of the clause shall be to cover the situation where loans are granted to certain parties where the relationship between the parties influences the terms and conditions of the loan.
Under the existing CARO, 2015, the objective above has been perfectly captured by making the register under section 189 as the criterion for reporting under the clause.
The impact of the change in the criterion under CARO 2015 and under the Draft CARO 2016 is brought out with the help of an illustration.
X Private Limited has a wholly owned subsidiary, Y Private Limited. In Y Private Limited, 99% of the share capital is held by X Private Limited and the remaining 1% is held by Z, director of X Private Limited (representing X Private Limited).
X Private Limited extends loan to Y Private Limited at Rate of Interest of 15% (Market Rate 15%).
Section 2 (76) – Related Party
Section 184 – Disclosure of interest by director
Section 188 – Related party transactions
Section 189 – Register of contracts or arrangements in which directors are interested”
Reporting under CARO, 2015
In my view, Y Private Limited is not a party covered under the register under Section 189 of the Act as
a. X Private Limited has in ordinary course of business and in the capacity of member has extended loan to Y Private Limited. It is also on arm’s length as the loan is extended at market rate of interest. Hence requirements of Section 188 of the Act, is not satisfied.
b. Z as a director holds only 1% stake in Y Private Limited. Since it is lesser than 2%, the requirements of Section 184(2) of the Act, is also not satisfied.
Since the requirement of both Section 188 of the Act and Section 184(2) of the Act is not satisfied, requirement to report about this loan under CARO 2015, rightfully, does not arise.
Reporting under Draft CARO, 2016
With the same facts, the illustration becomes a reportable transaction under Draft CARO 2016 as the register Section 189 of the Act is not the criterion, but the provisions of Section 2(76) of the Act. The said section defines a related party and accordingly the illustration, a simple transaction at arm’s length becomes a reportable transaction. Such reporting in my view is not required as is it will be excessive disclosure of transactions.
Further, in the eventuality of inclusion and possible retention of Clause 3(xiii), where the auditor is required to express opinion on the compliance with Section 188 of the Act and Section 177 of the Act, I suggest that clause (iii)’s applicability can be restricted to parties covered under register to be maintained under Section 189.
======================End of Part I==========================
Part II – Clauses not there in Draft CARO, 2016 but suggested for inclusion
I suggest the introduction of the following clauses both of which were there either in CARO, 2003 and CARO 2015, as the case may be.
A. Short Term funds used for long term investment
“Whether the funds raised on short-term basis have been used for long-term investment. If yes, the nature and amount is to be indicated. [Paragraph 4 (xvii), CARO 2003)]”
a. As can be seen from the above clause, under the erstwhile CARO, 2003, the auditor was required to comment on whether the funds raised on short-term basis have been applied for long-term purposes, if so, the quantum thereof also had to be stated.
b. According to principles of financial management, long -term assets of an enterprise should be financed from long-term funds.
c. The reasoning behind this principle is that if funds raised from short-term sources are used for sourcing long-term investments, the enterprise can face liquidity issues, when the repayment for short-term sources fall due.
d. Further, if a company has consistently used funds raised on short-term basis for long-term investment (for example for a period of more than five years), then this indicates excessive dependence on short-term borrowings.
e. Such excessive dependence on short-term borrowings is one of the financial indicators that cast doubt on the entity’s ability to continue as going concern [SA -570(R) GOING CONCERN] (For the purpose of citing the importance of this clause, a reference is resorted to SA-570, with an understanding that the auditor will eventually consider the requirement of SA -570 (R) and report about the same suitably).
f. Reporting on this clause on yearly basis ( i.e as part of every years audit report) wherever applicable will not only serve the interest of lenders and members but will also be an additional impetus on the company to ensure that the appropriate financial balance is achieved and maintained.
B. Companies having accumulated losses and cash losses
Whether in case of a company which has been registered for a period not less than five years, its accumulated losses at the end of the financial year are not less than fifty per cent of its net worth and whether it has incurred cash losses in such financial year and in the immediately preceding financial year [Paragraph 3(viii) of CARO 2015 and Paragraph 3 (xvii) of CARO 2003).
The above clause was a performance indicator of companies having accumulated losses and incurring cash losses. Further substantial operating losses, negative operating cash flows are few of the financial indicators that casts a doubt on Going Concern assumption (SA 570 (R) GOING CONCERN]. (For the purpose of citing the importance of this clause, a reference is resorted to SA-570, with an understanding that the auditor will eventually consider the requirement of SA -570 (R) and report about the same suitably). Reporting on this clause on yearly basis ( i.e. as part of every years audit report) wherever applicable will not only serve the interest of lenders and members but will also be an additional impetus on the company to ensure that the appropriate financial balance is achieved and maintained.
Even though a person with knowledge of financial principles will be able to appreciate about the implications of these two clauses from the financial statements, without it being mentioned in the auditor’s report, I opine that matters as important like these warrant an inclusion in the auditor’s report.
The above article is based on the draft CARO 2016 issued by Ministry of Corporate Affairs and the Companies Act, 2013 prevailing as at date of publishing this article. The article needs to be altered after the issue of CARO 2016 and also in case of change in laws in the future. Every effort has been made to avoid errors or omissions in this article. In spite of this errors may creep in, which are unintentional. The readers are requested by the writer, to bring to his notice any mistake or error or contrary opinion for which act, the writer shall be ever grateful. The writer is a Chartered Accountant in Practice in Chennai and can be reached at firstname.lastname@example.org.