Corporate frauds have emerged as the biggest risk that companies are exposed to and are increasingly becoming a major threat not only to the corporates but equally to the economy at large. Such unwanted incidents have a domino effect on the economy since they cause severe financial stress, loss of investor confidence, erosion of investor wealth and serious reputational damage. It has been observed that most of these incidents involve round-tripping of funds undertaken through a complex chain of pass-through entities for the benefit of the ultimate beneficiary.
The Ministry of Corporate Affairs (MCA) has been cognizant of this ever-increasing threat and has regularly been tightening the framework under the Companies Act, 2013 (‘2013 Act’) through appropriate monitoring, vigilance and disclosure mechanisms. One such mechanism included imposing restrictions on the number of layers that can be created by companies where they create shell companies for diversion of funds or money laundering. Section 2(87) of the 2013 Act read with the Companies (Restriction on Number of Layers) Rules, 2017 imposes a limit of two layers of subsidiaries except for certain exemptions. Similarly, section 186(1) provides that a company can make investments through not more than two layers of investment companies unless prescribed otherwise. The approval mechanism has been prescribed u/s 185 for granting (directly / indirectly) of loans, guarantees, etc., to prescribed persons including any person in whom any of the directors of the company is interested.
In furtherance of this objective and to reduce opacity and enhance transparency, the MCA has further strengthened the framework under the 2013 Act by amending the Companies (Audit and Auditors) Rules, 2014 and Schedule III to the 2013 Act by introducing reporting requirements for the auditors and by providing enabling disclosures in the financial statements, respectively. The new auditors’ requirements are summarised below:
- Whether the management has represented that, to the best of its knowledge and belief (other than as disclosed in the notes to the accounts):
– No funds have been advanced or loaned or invested (either from borrowed funds or share premium or any other sources or kinds of funds) by the company to or in 1Intermediaries;
– No funds have been received by the company from Funding Parties1 with the understanding, recorded in writing or otherwise, that the intermediary (or company – in case of receipt of funds) shall, whether directly or indirectly, lend or invest in Ultimate Beneficiaries2 or provide any guarantee, security or the like on behalf of the Ultimate Beneficiaries.
- Based on audit procedures considered reasonable and appropriate by the auditor, nothing has come to his / her notice that has caused the auditor to believe that the above representations contain any material misstatement.
Through the above amendment, the MCA is attempting to unveil the ultimate beneficiary behind camouflaged funding where transactions relating to loans, investments, etc., are undertaken by a company for some identified beneficiary. The reporting requirements cover transactions that do not take place directly between the company and the ultimate beneficiary but are camouflaged by including a pass-through entity in order to hide the ultimate beneficiary. The pass-through entity acts on the instructions of the company for channelling the funds to the ultimate beneficiary as identified by the company. It might be noted that the reporting obligation includes inbound as well as outbound funding transactions. In a world where financial transactions are used for money-laundering transactions or other suspicious activities, carrying illicit transactions, it is important that the trail of financial transactions is transparent. Hence, it is important to unveil the identity of the end beneficiary and the amendments are a means to address this issue.
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1 Intermediaries / Funding
Parties means – any other person(s) or entity(ies), including foreign entities
2 Ultimate Beneficiaries
means – other persons or entities identified in any manner whatsoever by or on
behalf of the company
The auditor is required to obtain management representation that the management has not identified any camouflaged transactions other than those disclosed in the notes to the financial statements. Further, the auditor is also required to assess that the representation is not materially misstated by performance of appropriate audit procedures. Accordingly, MCA requires the auditor to not only obtain management representation but also independently assess that the representation provided by the management is appropriate. Such an assessment would require the use of judgement and professional scepticism by the auditor.
This article provides an overview of the new reporting requirements and attempts to highlight some of the key aspects in order to generate wider discussion among various stakeholders.
Applicability
The amendments to the Companies (Audit and Auditors) Rules, 2014 and Schedule III issued by the MCA state that these amendments will come into force with effect from 1st April, 2021. The amendment notification does not link these requirements to any particular financial year. One possible view could be that the financial statements should be prepared as per the requirements existing as at the year-end and the audit report should include comments on the reporting obligations which are applicable on the date of issuance of the audit report. It may be noted that the amended rules require the auditor to obtain management representations for transactions ‘other than as disclosed in the notes to the accounts’ thereby implying that relevant disclosures in the financial statements would be essential to enable the auditor to comply with the reporting obligations. Accordingly, if this view is taken then the implications of the above amendments, i.e., relevant disclosures, should be included in the financial statements and audit report for the financial year 2020-21.
Another possible view could be that these requirements would apply from the financial year beginning on or after 1st April, 2021. It has been observed that the MCA in the past has been consistently taking a view that the reporting requirements (or relaxations) do not apply to the year ending on or before the date of the notification of the new requirements / relaxations. For example, similar challenges arose when a large majority of the sections of the 2013 Act were made effective on 1st April, 2014. The MCA had clarified that these provisions would apply in respect of financial years commencing on or after 1st April, 2014. In another instance, the MCA had, in June, 2017, provided exemption to the auditor from reporting on internal financial controls of certain private companies. It clarified that this relaxation would apply from the financial years commencing on or after 1st April, 2016.
Pursuant to the consistent position of the MCA in the past it may be possible to take a view that the aforesaid reporting requirements and disclosures in the financial statements would apply from financial years beginning on or after 1st April, 2021.
In order to ensure consistency regarding the applicability and to support seamless implementation, a clarification from the MCA / Institute of Chartered Accountants of India (ICAI) may help the corporates and auditors.
The companies are required to make these disclosures in Schedule III as part of ‘Additional regulatory information’ and amendments have been made to Division I (Indian GAAP), Division II (Ind AS) and Division III (Non-Banking Financial Companies which are required to comply with Ind AS).
Class of companies on which these requirements would apply
The reporting requirements have been prescribed for auditors under the 2013 Act. Accordingly, auditors of all classes of companies, including section 8 companies, would be required to report on these matters. It might be worth mentioning that as per the Companies (Registration of Foreign Companies) Rules, 2014 the provisions of Audit and Auditors (i.e., Chapter X of the 2013 Act) and the Rules made thereunder apply, mutatis mutandis, to a foreign company. Accordingly, these new reporting requirements would be applicable to auditors of foreign companies as well.
Reporting in auditor’s report
In accordance with the requirements of section 143(2) of the 2013 Act, an auditor reports to the members of the company on the accounts examined by him / her and on every financial statement to be laid before the company in the general meeting. An auditor should prepare the report after considering the provisions of the 2013 Act and the requirements specified in the accounting and auditing standards.
Section 143 of the Act read with Rule 11 of the Audit Rules prescribes matters to be included in an auditor’s report. This additional reporting requirement is required under Rule 11 in the section titled ‘Report on Other Legal and Regulatory Requirements’ in the statutory audit report.
Pre-existing transactions
It may be noted that reporting obligations do not provide any transitional provision, i.e., whether these reporting obligations would apply to pre-existing transactions or whether these reporting requirements would apply to transactions initiated on or after 1st April, 2021. As these reporting requirements (and the corresponding disclosures in Schedule III) apply prospectively, it would be logical to argue that the reporting requirements would apply to transactions initiated from the date of notification of the requirements (i.e., 1st April, 2021).
Transactions covered
The funding transactions as envisaged would primarily include three steps: 1) A company raising funds from any source or any kind of fund, e.g., borrowings, share premium (i.e., lender); 2) Lender provides loan / invests funds in intermediary with an understanding that these would be used for the ultimate beneficiary; 3) Such funds are lent / invested by the intermediary to the ultimate beneficiary. The following is one such example:
The following key principles may be kept in mind to understand the transactions covered:
- The intent is to cover funding transactions. Accordingly, normal business transactions such as supplier advance would not be covered. However, advances in the nature of loans would be covered as these are in-substance loan transactions. Whether an advance is in the nature of a loan would depend upon the circumstances of each case, for example, a normal advance against an order in accordance with the normal trade practice would not be an advance in the nature of a loan. But if an advance is given for an amount that is far in excess of the value of an order or for a period which is far in excess of the period for which such advances are usually extended as per the normal trade practice, then such an advance may be in the nature of a loan to the extent of such excess.
- The ultimate beneficiary must have been identified by the lender at the inception itself. This is evident from the wording that the intermediary (or company – in the case of receipt of funds) ‘shall, whether, directly or indirectly’, lend, etc., in the ultimate beneficiaries.
- An understanding with the intermediary that it would transfer funds to the ultimate beneficiary should exist. The words ‘with the understanding, whether recorded in writing or otherwise’ makes it amply clear about such intent and emphasises that all forms of understanding (in writing or otherwise) should be considered by the auditor.
- In some cases, there might be a time gap between the receipt of funds by the intermediary and the transfer of funds to the ultimate beneficiary as illustrated below:
A narrow reading of the requirements might indicate that the reporting obligations envisage back-to-back funding transactions and hence the above transaction is not covered as there is a time gap. Such a reading may not be in line with the overall objective of the MCA of identifying camouflaged funding transactions. The time gap between the receipt of funds by the intermediary and providing loan, etc., to the ultimate beneficiary has no relevance while reporting under this clause.
Amount to be reported – whether discounted amount or nominal amount
Loans, guarantees, etc., should be understood from a legal perspective. The accounting requirements / definitions have no relevance while reporting under this clause, e.g., Ind AS 109, Financial Instruments which provides that accounting considerations for financial guarantee contracts should be ignored. Accordingly, amounts reported by the auditor (if any) should be the nominal amount and not the discounted amount as per the relevant Ind AS. This is also supported by the Guidance Note on CARO issued by ICAI which states that it may happen that under the Ind AS framework certain term loans (for example, mezzanine loans) may either be classified as equity or may be compound instruments and, therefore, are split into equity and debt components. However, such instruments will be classified as debt under the AS framework. It is clarified that the basic character of such loans is debt and accordingly the auditor should consider utilisation of the entire amount for the purpose of reporting under this clause irrespective of the accounting treatment.
Audit procedures – key considerations
The auditor is required to perform appropriate audit procedures and state that nothing has come to notice that has caused the auditor to believe that these representations contain any material misstatement. The inherent complexities in auditing camouflaged funding transactions might pose significant challenges to the auditor in conducting audit procedures, for example, the auditor is required to assess understanding of the company with the ultimate beneficiary (which may not be in writing in certain cases). This would require the auditor to perform additional audit procedures to obtain sufficient appropriate audit evidence. However, the auditor should consider that these procedures are to be performed in relation to audit of financial statements and should be in the course of performance of his duties as an auditor. It may be noted that u/s 143(9) read with section 143(10), the duty of the auditor, inter alia, in an audit is to comply with the Standards on Auditing (SAs). Further, section 143(2) requires the auditor to issue his / her report in accordance with the SAs and accordingly the auditor should consider the requirements of the SAs in planning and performing the audit procedures to address the risk of material misstatement as stated above. The auditor may perform the following auditing procedures:
- Obtain representations from management that to the best of its knowledge and belief there are no camouflaged funding transactions other than those disclosed in the financial statements. These representations should be provided by those responsible for the preparation and presentation of the financial statements and knowledge of the matters concerned, for example, chief executive officer, chief financial officer.
- Identification of sample funding transactions undertaken during the year (refer SA 530 Audit Sampling).
- Critical assessment of the internal controls including controls regarding approval process and assessment of management’s rationale in approving the funding transaction, e.g., assessment of genuineness of funding needs of the borrower, clearly defined purpose for proposed use of the funds.
- Relationship with the borrower, e.g., related party. If funding is provided to an unrelated party, then auditor is required to understand and evaluate the strategic reason for funding.
- Financial credentials of the borrower.
- Compliance with the approval matrix and compliance with applicable laws and regulations, such as section 185 / 186 of the 2013 Act and the relevant RBI norms.
- Internal controls to track usage of funds, that is, whether periodic report obtained to indicate the usage of funds.
- Written representations should be dated as near as practicable to, but not after, the date of the auditor’s report.
Applicability of reporting – if no instances identified
The auditor is required to obtain management representation for every audit report issued under the 2013 Act. This is evident from the words which state ‘Whether the management has represented that…’ Accordingly, the auditor would need to obtain management representations and assess its appropriateness even where no instances of camouflaged funding transactions have been identified by the management during the year under audit.
BOTTOM LINE
These new reporting obligations pose onerous responsibilities on the auditor. The auditor would need to carefully assess the implications as the ambit of the reporting matters is wide and covers all inbound and outbound funding transactions. It may be noted that section 186(4) requires a company to disclose in the financial statement the full particulars of the loans, etc., given and the purpose for which these are proposed to be utilised by the recipient. The amendment to Schedule III and auditors’ reporting obligations supplements the existing disclosure requirements. In order to meet these enhanced requirements, the management would need to establish an adequate internal control mechanism so that adequate information is made available to the auditor. These amendments further highlight the importance of establishing a proper mechanism to track the end use of the funds. Considering all these aspects, the auditor should engage with the stakeholders to iron out implementation challenges if any and ensure strict compliance with the reporting requirements.
