CARO 2020 SERIES: NEW CLAUSES AND MODIFICATIONS LOANS & ADVANCES, GUARANTEES & INVESTMENTS

BACKGROUND

SCOPE OF REPORTING

CLAUSE-WISE ANALYSIS OF ENHANCED REPORTING REQUIREMENTS

Applicable Transactions [Clause 3(iii) and Clause 3(iii)(a)]:
• The scope has been enhanced to cover investments made, guarantee or security provided and advances granted in the nature of loans in addition to loans granted (‘specified investments and loan transactions’).

• The reporting is extended to all parties and not just those covered in the register maintained u/s 189 of the Act.

• The reporting is required only if the above transactions have been entered into ‘during the year’.

Transactions not Prejudicial [Clause 3(iii)(b)]:
• The scope has been enhanced to cover investments made, guarantees provided, security given and also advances in the nature of loans and guarantee provided, in addition to loans.

• Replacement of the word ‘such’ by ‘all’ means that this clause applies to all loans / advances granted during the year.

Servicing of Loans [Clause 3(iii)(c)]:
The scope has been enhanced to cover advances in the nature of loans in addition to loans.

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

Applicable Transactions [Clause 3(iii)]:
a. There is significant widening in the scope of reporting of financial transactions undertaken with all classes of entities. Further, the reporting is applicable to all companies, except for the exemption provided to companies whose principal business is to give loans.
b. Clauses 3(iii)(a) and (e) dealing with aggregation of specified investments and loans transactions and evergreening of loans would not apply to companies which are primarily engaged in lending activities.

Aggregation of Specified Transactions [Clause 3(iii)(a)]:
a. Identifying subsidiaries: Since this Clause requires separately aggregating and reporting loans and advances in the nature of loans to 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, and 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 on 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 to be reported 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.

b. Tracking of transactions entered into and settled in the same year: This Clause requires reporting the aggregate of specific transactions entered during the year even if the same are settled during the year. This may provide challenges to ensure completeness of the transactions where the volumes are substantial and the auditor would in such cases have to test the design as well as operating effectiveness of the internal controls and undertake test-checking of the transactions. A specific representation should also be obtained that all such transactions which have been squared off / settled during the year have been considered in the details provided by the management.

c. Identifying advances in the nature of loans: This is by far the most far-reaching change since what constitutes ‘advance is in the nature of a loan’ would depend upon the facts and circumstances of each case and involve significant judgements which would need to be exercised by the auditors based on their past experience and the understanding of the business. The following guiding principles may be kept in mind; however, these are not to be considered as exhaustive:

•  An advance against a purchase order, in accordance with the normal trade practice, would not be an advance in the nature of a loan.

•  An advance given for an amount which 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.

•  When a trade practice does not exist, a useful guide would be to consider the period of time required by the supplier for the execution of the order, based on the time between the purchase of the raw material and the delivery of the finished product. Any advance which exceeds this period would normally be an advance in the nature of a loan unless there is evidence to the contrary.

•  A stipulation regarding interest may normally be an indication that the advance is in the nature of a loan but this by itself is not conclusive and there may also be advances which are not in the nature of a loan and which carry interest.

It is imperative that the auditor not only scrutinises all advances given but also old outstanding advances where further amounts are given during the year to ensure their propriety and reasonableness for the purposes of reporting under this Clause as well as under Clause 3(iii)(c) discussed later.

Specified investments and loans transactions are not prejudicial [Clause 3(iii)(b)]:
a. The auditor will have to evaluate design and test the operating effectiveness of controls over specified transactions as these could be highly subjective. For example, valuation based on which investments in unlisted securities are made specifically into equity. Also, the auditor will have to comment upon commitments made in the earlier years but the transaction is entered into during the reporting period.

b. Whether investments are prejudicial: The auditors will have to use their judgement judiciously while reporting under this Clause. They will have to evaluate adherence to the processes and controls discussed above at the time of making the investment and not evaluate based on hindsight, specifically for investments in unlisted securities. The auditor will consider the company’s financial position, its leverage, purpose of making the investment, valuation based on which the investment is made, if the valuation is based on third party valuation report, whether the investee is a related party and specifically if it is controlled by promoters, related party / employee of promoter, compliance with SA 620 Using the Work of Auditor’s Expert, compliance with regulations, etc., to determine whether investments are prejudicial to the company’s interest.

c. Transactions with entities which are consolidated: In many cases, companies infuse additional funds in subsidiaries / joint ventures / associates or other entities which are their strategic investments and which have financial difficulties, or to meet their financial commitments. Such infusion per se would not be construed as prejudicial to their interest, unless it is proved that it is not for genuine business purposes or not in accordance with the company’s policies or with the applicable legal and regulatory guidelines. Hence, each specified investment and loan transaction would need careful assessment by the auditor.

d. Transactions undertaken by NBFCs: Since NBFCs are also covered for reporting under this Clause, this would present a specific challenge since it is their business to undertake specified investments and loans transactions and hence such transactions are likely to be voluminous. In such instances, the auditor would need to ensure that all applicable and reportable transactions are undertaken in accordance with the guidelines issued by the RBI which would inter alia include the Board-approved policies for loans and investments as well as for risk assessment and other processes relating thereto laid down by the company since any material and significant deviation could result in transactions which are prejudicial to the company’s interest.

Hence, for reporting under this Clause apart from deviations in any specific significant transaction, any general non-compliance which is material would also need to be reported.

e. Salary and other similar advances to employees: In case of companies which have a policy of granting salary, festival, medical and similar advances, the same would be construed as advances and not advances in the nature of loans. However, the auditor should review the policy in respect thereof and in case of any material transaction, specifically with related parties who are employees or key managerial persons, which are not in accordance with the policy, or which may be considered as advances in the nature of loans, as the same may be required to be reported.

Servicing of Loans [Clause 3(iii)(c)]:
a. Transaction in the form of advances in the nature of loans: Due to the reasons discussed under Clause 3(iii)(a) earlier, the auditors would have to use their judgement to identify whether servicing thereof is regular, or else they would need to indicate separately the names of such parties individually together with the amounts and the extent of delay. Further, in case no repayment term is specified, the auditor will have to report such fact.

b. Restructuring transactions undertaken by NBFCs: NBFCs undertake restructuring of loans and advances due to various reasons in accordance with RBI guidelines, including in terms of the Covid-19 Regulatory Package. This may result in a moratorium on repayments or conversion of overdue interest into funded interest term loans. In such cases, since the originally stipulated terms are not adhered to, it would need to be reported under this Clause.

As per the Guidance Note, the name of each entity which is not regular in repayment of principal and payment of interest needs to be disclosed separately. This may be a challenge to NBFCs in view of large number of delays and / or restructuring, specifically during Covid times. The better option in such cases would be to consolidate such entities into various logical buckets for the purpose of reporting under this Clause.

Evergreening of Loans and Advances [Clause 3(iii)(e)]:
Amendment of Disclosures in the Auditors Report
Before proceeding further, it is relevant to note that whilst reporting under this Clause the auditor would have to keep in mind the amendment in the Companies (Audit and Auditors) Amendment Rules, 2021 whereby the following additional matters need to be covered in their main audit report with effect from the financial year 2021-22:

(i) ‘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 kind of funds) by the company to or in any other person(s) or entity(ies), including foreign entities (“Intermediaries”), with the understanding, whether recorded in writing or otherwise, that the Intermediary shall, whether directly or indirectly, lend or invest in other persons or entities identified in any manner whatsoever by or on behalf of the company (“Ultimate Beneficiaries”) or provide any guarantee, security or the like on behalf of the Ultimate Beneficiaries’;

(ii) ‘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 received by the company from any person(s) or entity(ies), including foreign entities (“Funding Parties”), with the understanding, whether recorded in writing or otherwise, that the company shall, whether directly or indirectly, lend or invest in other persons or entities identified in any manner whatsoever by or on behalf of the Funding Party (“Ultimate Beneficiaries”) or provide any guarantee, security or the like on behalf of the Ultimate Beneficiaries’;

(iii) ‘Based on such audit procedures that the auditors have considered reasonable and appropriate in the circumstances, nothing has come to their notice that has caused them to believe that the representations under (i) and (ii) above contain any material misstatement’.

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

a. Identification of Ultimate Beneficiaries: Consequent to the above disclosures made in the financial statements, auditors need to check the details of those disclosures and check all such transactions with the respective documents and other correspondence to identify whether any such transaction gets covered for reporting under this Clause. In this regard, the auditors should also take a representation from the management.
b. Transactions within group entities / related parties: In case of complex group structures, it would be difficult to establish a clear audit trail for the transactions, thus making it difficult to identify any such transaction.
c. Determining the Total Loans and Advances in the nature of loans (‘the denominator’): This Clause requires reporting of the percentage of such transactions to the aggregate value of loans and advances in the nature of loans. However, determining the denominator could pose challenges especially for advances in the nature of loans for the reasons discussed earlier. Accordingly, it is imperative for the auditors to reconcile the denominator, especially for advances in the nature of loans with the financial statements to ensure completeness.
d. The auditor will also need to track loans which have fallen due for repayment up to the balance sheet date and which have been renewed / extended / settled post-balance sheet date but before the date of the audit report, as the same is required to be reported under this Clause during the year as well as the following year.
e. Finally, the RBI in the Master Circular dated 1st July, 2014 on Prudential Norms on Income Recognition, Asset Classification and Provisioning Pertaining to Advances, has reiterated that the basic objective of restructuring of loans by banks was to preserve the economic value of the borrower units and not evergreening of problem accounts. Borrower Accounts should be taken up for restructuring by the banks if the financial viability is established and there is a reasonable certainty of repayment from the borrower, as per the terms of the restructuring package and looking into their cash flows of and assessing the viability of the projects / activity financed. Accordingly, the auditors should be vigilant with regard to all restructuring proposals requested for by the borrowers.

Demand Loans [Clause 3(iii)(f)]:
Additional Disclosures under amended Schedule III:
While reporting under this Clause, the auditor will have to keep in the mind the amended Schedule III disclosures which are as under:

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

a. Identification of Promoters: Promoter has not been defined under the Order. However, the amended Schedule III states that ‘Promoter’ will be as defined under the Companies Act, 2013. Although a few promoters could be traced to those named in the prospectus or identified in the annual return, the auditor will have to rely on secretarial and other records and / or management representation to determine those who have control over the affairs of the company directly or indirectly, whether as director or shareholder or otherwise or in accordance with whose advice, directions, or instructions the Board is accustomed to act upon, to be considered as promoters. In case there are no such persons, then also a specific representation should be obtained.

b. Identification of Related Parties (subsidiaries): Similar considerations as discussed earlier for reporting under Clause 3(iii)(a) would be relevant for reporting under this Clause. In this context, the auditor would need to reconcile the disclosures under this Clause with what is disclosed in the financial statements (for companies adopting Ind AS) as well as in terms of the disclosures under Schedule III as specified above, to ensure completeness.

c. Transactions undertaken by NBFCs: Since there is no specific exemption granted to NBFCs, the auditor should consider the specific guidelines issued by the RBI for granting of demand and call loans, which are summarised hereunder:
• The Board of Directors of every applicable NBFC granting / intending to grant demand / call loans shall frame a policy for the same.
• Such policy shall stipulate the following:

(i) A cut-off date within which the repayment of demand or call loan shall be demanded or called up;
(ii) The sanctioning authority shall record specific reasons in writing at the time of sanctioning demand or call loan, if the cut-off date for demanding or calling up such loan is stipulated beyond a period of one year from the date of sanction;
(iii) The rate of interest which shall be payable on such loans;
(iv) Interest on such loans, as stipulated, shall be payable either at monthly or quarterly rests;
(v) The sanctioning authority shall record specific reasons in writing at the time of sanctioning demand or call loan, if no interest is stipulated or a moratorium is granted for any period;
(vi) A cut-off date, for review of performance of the loan, not exceeding six months commencing from the date of sanction;
(vii) Such demand or call loans shall not be renewed unless the periodical review has shown satisfactory compliance with the terms of the sanction.

In case the auditor has identified any deviation, he may consider reporting the same under this Clause or cross-reference the same to the disclosures made in the financial statements depending upon the materiality of the transaction.

d. Determining the Total Loans and Advances in the nature of loans (‘the denominator’): This Clause requires reporting of the percentage of such transactions to the aggregate value of loans and advances in the nature of loans. However, determining advances in the nature of loans could pose a challenge, for the reasons discussed earlier.

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