CARO 2020 SERIES: NEW CLAUSES AND MODIFICATIONS DEPOSITS, LOANS AND BORROWINGS

SCOPE OF REPORTING

CLAUSE-WISE ANALYSIS OF ENHANCED REPORTING REQUIREMENTS
Deemed Deposits [Clause 3(v)]:
• The scope has been enhanced to cover amounts which are deemed to be in the nature of deposits as per the Companies (Acceptance of Deposits) Rules, 2014.
Default in repayment of loans / other borrowings and interest [Clause 3 (ix)(a)]:
• The scope of this clause has been extended to cover all borrowings other than loans and hence would include debentures, commercial paper, subordinated debt and inter-corporate deposits.
• The scope of the clause has been expanded to all borrowings from any lender and not just restricted to borrowings from financial institutions, banks, Government or dues to debenture holders, as was the case earlier.
• The scope of reporting has been extended to interest on the borrowings in addition to repayment of principal amount.
• If there is a default in the repayment of borrowings, the format for reporting, the period and amount of default has now been prescribed.

PRACTICAL CHALLENGES IN REPORTING
The reporting requirements outlined above entail certain practical challenges, which are discussed below, in respect of the clauses where there are enhanced reporting requirements as well as new clauses:

Deemed Deposits [Clause 3(v)]:
a) Inclusive nature of the definition: The Act vide section 2(31) provides an inclusive definition of deposits by stating that deposits include:
• any receipt of money by way of deposit or loan or in any other form by a company; but
• does not include such categories of amounts as may be prescribed in consultation with the RBI (no such amounts have been prescribed till date).

In spite of the inclusive nature of the definition, Rule 2(1)(c) of the Companies (Acceptance of Deposits) Rules, 2014, makes certain exclusions from the definition of deposits. These are broadly indicated hereunder:
• Amounts received from the Central or State Government or guaranteed by them, as also from any other statutory or local authorities constituted under an Act of Parliament or any State Legislature;
• Amounts received from foreign Governments or other prescribed foreign sources / entities, subject to the provisions of FEMA and the regulations framed thereunder;
• Amounts received from banks, public financial institutions, insurance companies and regional financial institutions;
• Amounts received against issue of commercial paper or similar instruments in accordance with the RBI guidelines;
• Amount received by one company from another company (inter-corporate deposits);
• Amounts received towards subscription of securities, including share application money, in pursuance of an offer made in accordance with the provisions of the Act. However, such amounts need to be allotted or adjusted within 60 days. If the same are not refunded within 15 days from the completion of 60 days the same would be treated as deposits. Also, no adjustment of such amounts for any other purpose would be permissible;
• Any amounts received from a person who at the time of receipt was a Director of the company, provided that he has submitted a declaration that the amount is not given out of funds acquired by him by borrowings from others;
• Amount raised through issue of bonds or debentures which are secured by a first or ranking pari passu with the first charge on the assets of the Company (other than intangible assets) referred to in Schedule III and which are compulsorily convertible into shares within a period of five years;
• Any amount received from an employee subject to the following conditions:

(i) It does not exceed his annual salary under a contract of employment; and
(ii) It is in the nature of a non-interest-bearing security deposit;
• The following amounts received in the course of or for the purposes of business:
(i) Advances for supply of goods or provision of services provided they are appropriated / adjusted against the supply of goods or provision of services within 365 days from the date of receipt of the advance, unless they are the subject matter of dispute;
(ii) Advance received in connection with the consideration for immovable property under an agreement or arrangement, provided the same is adjusted against the property in terms of the agreement or arrangement;
(iii) Security deposit for the performance of a contract for the supply of goods or provision of services;
(iv) Advances received under a long-term contract for supply of capital goods, other than those under (ii) above.
Accordingly, deposits which are technically not in the nature of deposits by virtue of the definition but substantially having the character of deposits are also required to be reported upon.

b) Higher risk of non-compliance: The risk of non-compliance would be even higher in case of deemed deposits. The auditor should obtain the list of amounts received in the course of, or for the purposes of, the business of the company (e.g., advances, security deposits, credit balances, etc.) and assess whether these amounts comply with the above requirements to determine whether such amounts would constitute deemed deposits. He should also review the internal control systems and processes of the client to ensure that there are adequate checks and balances in place to ensure that there is no non-compliance with the requirements. For example, for any advance / deposits / amount received by a company from a vendor, there would be internal checks to ensure that the balance is appropriated against supply or goods / services
provided by the vendor within the stipulated time limit of 365 days.

Default in repayment of loans / other borrowings and interest [Clause 3 (ix)(a)]:
a. Companies adopting Ind AS: Such companies are likely to face certain specific challenges which need to be kept in mind whilst considering the various reporting requirements which are as under:
• The borrowings need to be considered on the basis of the legal form rather than on the basis of the substance of the arrangements as is required in terms of Ind AS 32 and 109. Accordingly, redeemable preference shares though considered as financial liabilities / borrowings under Ind AS, will not be considered for reporting under this clause since legally they are in the nature of share capital. Similarly, optionally or fully convertible debentures though considered as compound financial instruments or equity under Ind AS, will not be considered for reporting.
• The interest charged to the P&L Account is computed on the basis of the Effective Interest Rate (EIR) method which would include certain other charges. However, for identifying the unpaid interest the contractual payments need to be considered.
• Ind AS 107 requires disclosure of the maturity analysis of the financial liabilities showing the contractual repayments under different liquidity buckets. The auditors shall cross-check the work papers for reporting under this clause with the Ind AS disclosures. Similar considerations would apply to the disclosures with respect to the defaults in loan repayments under paragraphs 18 and 19 of Ind AS 107 as well as under Schedule III.

b. Reschedulement proposals: If the company has submitted an application for reschedulement to the lenders, which is under different stages of processing, the same would also be considered as a default and need to be reported. However, if the application for reschedulement of loan has been approved by the bank or financial institution concerned during the year covered by the auditor’s report, the auditor should state in his audit report the fact of reschedulement of loan. The Guidance Note issued by ICAI has clarified that where reschedulement of loan has been approved subsequent to the balance sheet date, the auditor should report the defaults during the year. However, he may mention this fact in the remarks column.

c. Covid-19 restructuring proposals: In case a company which has availed of the concessions in terms of the Covid regulatory package notified by the RBI, the compliance with the same would not be considered as a default. In such cases, the auditor may consider making an appropriate reference in the report.

d. Challenges for NBFCs and highly leveraged companies: Such companies are likely to face certain specific challenges which need to be kept in mind whilst considering the various reporting requirements which are as under:
• The auditor shall review the company’s internal control systems and test the design and operating effectiveness of the company’s treasury activities and liquidity management to identify defaults on a timely basis since it would not be practical to verify each individual case of default due to the volume of transactions. The auditors shall also verify the procedures that the company has in place to avoid any defaults in repayment of loan or payment of interest. Further, in such cases the auditor can also consider obtaining and reviewing the latest credit rating report and whether there is a mention about any defaults. Similarly, any decline in credit rating should trigger an element of professional scepticism about whether there is a default by the company. Finally, an appropriate representation should be obtained from the management.
• In respect of NBFCs which have issued subordinated debt and perpetual instruments (PDI) in terms of the RBI guidelines, care would need to be taken to check whether any events / triggers have taken place in terms of the RBI guidelines to make repayments, especially of the principal amounts and whether the same have been complied with. The key RBI guidelines which need to be kept in mind are as under:
(i) Subordinated debt is not redeemable at the instance of the holder or without the consent of the supervisory authority of the NBFC;
(ii) Non-deposit-taking NBFCs with asset size of Rs. 500 crores and above shall issue PDI as plain vanilla instruments only. However, they may issue PDI with a ‘call option’ for a minimum period of ten years from the date of issue and the call option shall be exercised only with the prior approval of RBI.

Wilful defaulter [Clause 3 (ix)(b)]:
Additional disclosures under amended Schedule III:
While reporting under this clause, the auditor will have to keep in mind the amended Schedule III disclosures which are as under:
Where a company is a declared wilful defaulter by any bank or financial institution or other lender, the following details shall be given:
a. Date of declaration as wilful defaulter,
b. Details of defaults (amount and nature of defaults),
* ‘wilful defaulter’ here means a person or an issuer who or which is categorised as a wilful defaulter by any bank or financial institution (as defined under the Act) or consortium thereof, in accordance with the guidelines on wilful defaulters issued by the Reserve Bank of India.

Whilst reporting, the auditor should make a cross-reference to the above disclosures made in the financial statements to ensure that there are no inconsistencies.

Before proceeding further, it is important to analyse the key requirements as per the RBI guidelines for identification and classification of wilful defaulters, since that acts as the trigger-point.

Key requirements as per the RBI Guidelines (RBI Circular RBI/2014-15/73DBR.No.CID.BC.57/20.16.003/2014-15 dated 1st July, 2014):
Wilful default: A ‘wilful default’ would be deemed to have occurred if any of the following events is noted:
• The unit has defaulted in meeting its payment / repayment obligations to the lender even when it has the capacity to honour the said obligations;
• The unit has defaulted in meeting its payment / repayment obligations to the lender and has not utilised the finance from the lender for the specific purposes for which finance was availed but has diverted the funds for other purposes;
• The unit has defaulted in meeting its payment / repayment obligations to the lender and has siphoned off the funds so that the funds have not been utilised for the specific purpose for which finance was availed, nor are the funds available with the unit in the form of other assets;
• The unit has defaulted in meeting its payment / repayment obligations to the lender and has also disposed of or removed the movable fixed assets or immovable property given for the purpose of securing a term loan without the knowledge of the bank / lender.

The identification of the wilful default should be made keeping in view the track record of the borrowers and should not be decided on the basis of isolated transactions / incidents. The default to be classified as wilful should be intentional, deliberate and calculated. The key trigger-points for identification of wilful default indicated by RBI are:
• Diversion of funds
• Siphoning of funds

Diversion of funds:
This would be construed to include any one of the undernoted occurrences:
a) Utilisation of short-term working capital funds for long-term purposes not in conformity with the terms of sanction;
b) Deploying borrowed funds for purposes / activities or creation of assets other than those for which the loan was sanctioned;
c) Transferring borrowed funds to the subsidiaries / group companies or other corporates by whatever modalities;
d) Routing of funds through any bank other than the lender bank or members of the consortium without prior permission of the lender;
e) Investment in other companies by way of acquiring equities / debt instruments without approval of lenders;
f) Shortfall in deployment of funds vis-à-vis the amounts disbursed / drawn and the difference not being accounted for.

Siphoning of funds:
The term ‘siphoning of funds’ should be construed to occur if any funds borrowed from banks / FIs are utilised for purposes unrelated to the operations of the borrower, to the detriment of the financial health of the entity or of the lender. The decision as to whether a particular instance amounts to siphoning of funds or diversion of funds would have to be a judgement of the lenders based on objective facts and circumstances of the case. Generally, siphoning of funds would occur when the funds are diverted to group companies without proper approvals.

Keeping in mind the above reporting requirements, the following are some of the practical challenges that could arise in reporting under this Clause:
a) If the company has not been declared a wilful defaulter but has received a show cause notice in accordance with the RBI Circular, the auditor may consider disclosing this fact under this Clause. In case a show cause notice is not received by the company, the auditor should also obtain a representation letter from the management that the company has neither been declared as a wilful defaulter nor has it received any show cause notice. This would normally be the case when the company has defaulted and the same has been reported under Clause 3(ix)(a) earlier.

b) It is possible that the company is legally disputing the bank’s / financial institution’s declaration of the company as wilful defaulter. In that case, the auditor shall consider performing the audit procedures under Standard on Auditing SA 501 Audit Evidence – Specific Considerations for Selected Items that requires the auditors to perform certain procedures, as indicated hereunder, as also make appropriate disclosures whilst reporting under this Clause as well as in the financial statements under the amended Schedule III.
• Obtain a list of litigation and claims;
• Where available, review the management’s assessment of the outcome of each of the identified litigation and claims and its estimate of the financial implications, including costs involved;
• Seek confirmation from the entity’s external legal counsel about the reasonableness of management’s assessments and provide the auditor with further information if the list is considered by the entity’s external legal counsel to be incomplete or incorrect;
• If the entity’s external legal counsel does not respond appropriately to a letter of general inquiry, the auditor may seek direct communication through a letter of specific inquiry;
• Consider meeting the entity’s external legal counsel to discuss the likely outcome of the litigation or claims, for example, where the matter is a significant risk.

c) It is possible that the company may not have been declared as wilful defaulter as at the date of the balance sheet but has been so declared before the audit report is issued. As per paragraph 6 of SA 560 Subsequent Events, the auditor shall perform audit procedures designed to obtain sufficient appropriate audit evidence that all events occurring between the date of the financial statements and the date of the auditor’s report that require adjustment of, or disclosure in, the financial statements have been identified. It is, therefore, clarified that the auditor should also consider whether the company has been declared as wilful defaulter as on the date of the audit report. The declaration of the company as a wilful defaulter will be published on the RBI website after the lender has followed the due process in terms of the above-referred RBI Circular.

Application of term loans for prescribed purposes [Clause 3 (ix)(c)]:
Additional disclosures under amended Schedule III:
While reporting under this Clause, the auditor will have to keep in mind the amended Schedule III disclosures which are as under:
Where the company has not used the borrowings from banks and financial institutions for the specific purpose for which these had been taken at the balance sheet date, the company shall disclose the details of where they have been used.

‘Utilisation of borrowed funds and share premium’
This Clause is applicable in case where the company has advanced or loaned or invested funds (either borrowed funds or share premium or from any other source) to any other person(s) or entity(ies) (Intermediaries) with the understanding that the Intermediary shall, inter alia, directly or indirectly lend or invest in the other persons or entities identified in any manner whatsoever by or on behalf of the company (Ultimate Beneficiaries). In such a case, the company shall provide in the financial statements certain details such as: date and amount of funds advanced or loaned or invested in Intermediaries with complete details of each Intermediary; date and amount of fund further advanced or loaned or invested by such Intermediaries to other Intermediaries or Ultimate Beneficiaries along with complete details of the Ultimate Beneficiaries; and, declaration that relevant provisions of the Foreign Exchange Management Act, 1999 and the Companies Act have been complied with for such transactions and the transactions are not violative of the Prevention of Money-Laundering Act, 2002.

Whilst reporting, the auditor should make a cross-reference to the above disclosures made in the financial statements to ensure that there are no inconsistencies.

Keeping in mind the above reporting requirements, the following are some of the practical challenges that could arise in reporting under this Clause:
a) In case of any loans / advances / payments to related parties or promoters / promoter group entities or any investments made in other companies, auditors need to exercise greater professional scepticism to ensure that the payments are genuine and for the purposes as per the sanctioned terms.

b) Reference should be made to the RBI Circular on wilful defaulters referred to earlier to identify possible instances of diversion of funds, since the purpose for which the funds are used / diverted are required to be reported / disclosed. Some instances of diversion of funds are:
• Payment to capital goods vendors from CC limits when there was shortfall in term loan sanctioned;
• Meeting company’s margin money from CC limits for expansion / modernisation / technical upgradation of existing project;
• Investment in subsidiary / Group companies;
• Investment in capital market or payment of long-term debt from the existing CC limits;
• Purchase of immovable properties / assets for personal use of the promoters / directors / KMPs;
• Current ratio of less than one may indicate that the company has diverted working capital loans for long-term purposes.

c) Under Ind AS, certain loans may be treated as compound financial instruments (part debt, part equity). The auditor shall cover the entire proceeds of the loans from the bank / FI for the purpose of reporting under the Clause.

Short-term funds utilised for long-term purposes [Clause 3 (ix)(d)]:
Additional disclosures under amended Schedule III:
Refer to Clause 3(ix)(c) earlier.

Keeping in mind the above reporting requirements, the following are some of the practical challenges that could arise in reporting under this Clause:
a) The auditor is required to state the nature of application of funds if the company has financed long-term assets out of short-term funds. The auditor can determine the nature of application of funds only if there is a direct linkage between the funds raised and the asset. The determination of direct relationship between the particular funds and an asset from the balance sheet may not always be feasible. The auditor shall obtain adequate audit evidence supporting the movement in funds. If the quantum of long-term funds raised is less than the funds used for long-term assets, this may imply that some of the long-term assets have been financed through short-term funds.

b) Often, it may not be possible to establish a direct link between the funds and the assets / utilisation, since money is fungible. The auditor shall determine the overall deployment of the source and application of funds of the company. The auditor may also review the cash flow statement to determine whether short-term funds have been used for long-term purposes. Instances where short-term funds would have been utilised for long-term purposes would include, for example, where the company has utilised funds from bank overdraft facilities in long-term investments or long-term projects or fixed assets. Similarly, there may be cases where the company raises monies from public deposits due for repayment within two to three years for the purpose of acquiring long-term investments, unless the company is able to demonstrate that a bulk of these deposits are renewed.

c) In case of NBFCs and Ind AS companies the ALM / Maturity Analysis disclosures need to be referred to for the purposes of identifying any maturity mismatches. Further, in such cases the auditor should also check whether the company’s treasury / finance department uses any liquidity / working capital management tools and if so to check the design and operating effectiveness of the internal controls around the same. If the quantum of long-term funds raised is less than the funds used for long-term assets, this may imply that some of the long-term assets have been financed through short-term funds. These considerations would equally apply to all entities where the volume of borrowings is significant.

Funds borrowed for meeting obligations of group companies [Clause 3 (ix)(e)]:
Additional disclosures under amended Schedule III:
Refer to Clause 3(ix)(c) earlier.

Keeping in mind the above reporting requirements, the following are some of the practical challenges that could arise in reporting under this Clause:
a) Identifying subsidiaries and associates: Since this Clause requires to separately report on funds borrowed for meeting the obligations of subsidiaries, joint ventures and associates, the identification thereof is of paramount importance. The Guidance Note has clarified that these terms should be interpreted in accordance with the provisions of the Act which could be different, in certain cases, from what is defined in the Accounting Standards in the case of subsidiaries which is examined as under:
Section 2(87) of the Act defines ‘subsidiary company’ or ‘subsidiary’ in relation to any other company, means a company in which the holding company – (i) controls the composition of the Board of Directors; or (ii) exercises or controls more than one-half of the total voting power either at its own or together with one or more of its subsidiary companies. Thus, the Act emphasises on legal control which is similar to what is considered for the purpose of Accounting Standard 21 (AS 21) – Consolidated Financial Statements for companies adopting Indian GAAP. The concept of control and, therefore, subsidiary relationship under Ind AS 110 is much broader. Existence of factors such as, de facto control, potential voting rights, control through de facto agents, power to enforce certain decisions, etc., have to be considered, which are not considered for the purpose of section 2(87). Hence, for companies adopting Ind AS there could be differences between what is disclosed in the accounts and what is required for reporting under this Clause, which would need to be reconciled to ensure completeness of reporting. The auditors of Ind AS companies will need to take utmost care about this distinction while dealing with this Clause.

The definition of ‘associate’ under the Act extends to an entity that is significantly influenced by the investor company. Significant influence may be achieved in cases where the company is accustomed to act as per the directions of the investor company. Such a significant influence may be as a result of shareholders’ agreements, too. Therefore, the definition of ‘associate’ can be quite broad vis-a-vis the Accounting Standards.

b) Determining the reporting boundaries: This presents several challenges and raises certain issues which are discussed below:
• The Clause refers to any funds taken from any entity. However, both these terms have not been defined;
• Whilst the Guidance Note has specified that the word entity would include banks, FIs, companies, LLPs, Trusts, Government or others irrespective of the legal form, normally in case of trusts and others the purpose for which the funds have been given may not be clearly specified in the absence of any statutory requirements and lack of proper documentation. This would make it difficult for the auditor to establish a proper audit trail for the utilisation of funds, and hence he needs to exercise a heightened degree of professional scepticism. He should also consider obtaining a suitable management representation in this regard;
• Further, whilst the funds would include both short-term and long-term funds as clarified in the Guidance Note, there is no clarity as to whether it would cover both borrowed funds and share capital. A plain reading seems to suggest that even funds raised by issue of shares should be considered. In such cases, the auditor should refer to the Offer Letter / Prospectus to identify whether the funds are to be utilised for granting loans and advances to or making investments in or meeting other obligations of group companies. The same should also be corroborated with the reporting under Clause 3(x)(a) and (b).
• Finally, the auditor should consider the procedures performed for reporting under Clause 3(ix)(c) earlier wherein he would have identified diversion of funds, and if required he should cross-reference the same for reporting purposes.

c) Challenges for NBFCs, highly leveraged companies and companies with a large number of group companies: Such companies are likely to face certain specific challenges which need to be kept in mind whilst considering the various reporting requirements which are as under:
• The auditor shall review the company’s internal control systems and test the design and operating effectiveness to identify whether there is proper monitoring of the usage of funds as per the sanctioned terms or approved purposes;
• The auditor shall review the company’s internal control systems and test the design and operating effectiveness to identify whether related parties and the transactions with them are identified and appropriately recorded. He should also perform adequate and appropriate procedures under SA 500 on Related Parties. In particular, the auditor shall inspect or inquire about the following for indications of the existence of related party transactions or transactions that the management has not previously identified or disclosed to the auditor:
a) Bank, legal and third-party confirmations obtained as part of the auditor’s procedures;
b) Minutes of meetings of shareholders and of those charged with governance;
c) Such other records or documents as the auditor considers necessary in the circumstances of the entity;
d) The entity’s ownership and governance structures;
e) The types of investments that the entity is making and plans to make; and
f) The way the entity is structured and how it is financed.

Loans raised against pledge of securities of group companies [Clause 3 (ix)(f)]:
Additional disclosures under amended Schedule III:
Registration of charges or satisfaction with Registrar of Companies
Where any charges or satisfaction are yet to be registered with the Registrar of Companies beyond the statutory period, details and reasons thereof shall be disclosed.
Whilst reporting, the auditor should make a cross-reference to the above disclosures made in the financial statements to ensure that there are no inconsistencies.

Keeping in mind the above reporting requirements, the following are some of the practical challenges that could arise in reporting under this Clause:

a) Identifying subsidiaries and associates: Similar considerations as discussed under Clause 3(ix)(e) earlier would apply.

b) Negative lien / residual / floating charge: There may be cases where the company has a negative lien on its investments in subsidiaries, joint ventures and associate companies. It may be noted that such negative lien is not a pledge. Sometimes, loan agreements have a general or residual or floating charge on all securities without specific pledge of any security. Reporting under this Clause will be applicable only when the securities held in the subsidiaries, etc., are pledged for obtaining such loan by the company.

c) Validity / legality of pledge: In case of any doubts on the validity or legality of the pledge, the auditor may consider obtaining confirmation from the company’s lawyers by performing the procedures as per SA 501 referred to earlier. For this purpose the auditor should be aware of the requirements as under:
• Section 77 of the Companies Act, 2013 dealing with registration of charges;
• Section 12 of the Depositories Act, 1996 read with Regulation 58, SEBI (Depositories and Participants) Regulations, 1996.
In case the auditor based on his inquiries and / or discussion with the legal personnel observes any non-compliance with respect to the above, he should consider inviting attention to the same in his report so that the lender / pledgee is aware of the same.

d) The auditor may consider giving a reference to the reporting of defaults under Clause 3(ix)(a) earlier in case of any defaults without specifying the extent of default.

Impact on the audit opinion:
Whilst reporting on these Clauses, the auditors may come across several situations wherein they may need to report exceptions / deviations. In each of these cases, they would need to carefully evaluate the impact of the same on the audit opinion by exercising their professional judgement to determine the materiality and relevance of the same to the users of the financial statements. These are broadly examined hereunder:

In such cases, it is imperative that the Board’s Report contains explanations / comments on every reservation / adverse comment in the audit report as per section 134(3)(f) of the Companies Act, 2013 and that there is no factual inconsistency between the two.

CONCLUSION
The above changes have cast onerous reporting responsibilities on the auditor, especially towards the lenders for various critical aspects as under:
• Identifying defaults on timely basis.
• Monitoring the end use of funds.
• Providing red flags towards Going Concern and fraud-related issues.

Accordingly, the auditors would need to exercise greater degree of professional scepticism during the course of their audits.