The reporting requirements outlined above entail certain practical challenges, which are discussed below:
Cash Losses [Clause 3(xvii)]
Keeping in mind the above reporting requirements, the following are some of the practical challenges that could arise in reporting under this Clause:
a) No clarity on the definition of Cash Losses: The term ?cash losses’ is neither defined under the Companies Act, 2013 nor in the Accounting Standards / Indian Accounting Standards. However, the ICAI, in its Guidance Note on Terms Used in the Financial Statements issued in 1983, has defined the term ?Cash Profit’ as ?the net profit as increased by non-cash costs, such as depreciation, amortisation, etc. When the result of the computation is negative, it is termed as cash loss’. This definition is too inclusive and needs to be updated to keep pace with the changing trends and developments on the accounting front in the past couple of decades, like accounting for Deferred Tax, Unrealised Forex gains or losses, fair value adjustments, actuarial gains and losses for employee benefits etc. While the ICAI Guidance Note has touched upon some of these aspects, there is no authentic guidance/clarity, making it open to differing interpretations and difficulty in comparing and analysing different entities. It would be desirable to disclose the mode of arriving at the cash loss in the financial statements. Necessary changes could be considered by the ICAI and / or the regulators.
b) Companies adopting Ind AS: For such entities, the profit/loss after tax excludes items considered under Other Comprehensive Income (OCI) and hence it is imperative that proper care is taken to identify and give effect to only the cash components of items recognised in OCI like realised fair value/revaluation changes and forex gains and losses. For this purpose the cash component recognised under OCI should be considered for the period under report. Further, for computation of the cash profit/loss for the immediately preceding financial year, the restatements, if any, as per Ind AS-8 – Accounting Policies, Changes in Accounting Estimates and Errors, especially for prior period errors relating to periods earlier than the corresponding previous year. This should be clearly disclosed whilst reporting under this clause.
Financial Position including Financial Ratios [Clause 3(xix)]:
Before proceeding further it would be pertinent to note the following statutory requirements:
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:
The following ratios need to be disclosed:
a) Current Ratio
b) Debt Equity Ratio
c) Debt Service Coverage Ratio
d) Return on Equity Ratio
e) Inventory Turnover Ratio
f) Trade Receivables Turnover Ratio
g) Trade Payables Turnover Ratio
h) Net Capital Turnover Ratio
i) Net Profit Ratio
j) Return on Capital Employed
k) Return on Investment
Explanation to be provided for any changes by more than 25% compared to the preceding year.
Whilst reporting, the auditor should refer to the above disclosures for the relevant ratios such as current ratio, inventory turnover ratio, trade receivables turnover ratio, trade payables turnover ratio and capital turnover ratio, amongst others, made in the financial statements to ensure that there are no inconsistencies.
Before proceeding further, it is important to analyse the definition of Financial Assets and Financial Liabilities under Ind AS-32 since these terms are neither defined under the Companies Act, 2013 nor under Indian GAAP, since the reporting is with respect to these items as opposed to the other items in the financial statements.
Accordingly, companies to whom Ind AS is not applicable should also consider the said definitions for identifying financial assets and liabilities.
Definition of Financial Assets and Financial Liabilities under Ind AS-32
A financial asset is any asset that is:
(a) cash;
(b) an equity instrument of another entity;
(c) a contractual right:
(i) to receive cash or another financial asset from another entity; or
(ii) to exchange financial assets or financial liabilities with another entity under conditions that are potentially favourable to the entity; or
(d) a contract that will or may be settled in the entity’s own equity instruments and is:
(i) a non-derivative for which the entity is or may be obliged to receive a variable number of the entity’s own equity instruments; or
(ii) a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments. For this purpose the entity’s own equity instruments do not include puttable financial instruments classified as equity instruments in accordance with paragraphs 16A and 16B, instruments that impose on the entity an obligation to deliver to another party a pro rata share of the net assets of the entity only on liquidation and are classified as equity instruments in accordance with paragraphs 16C and 16D, or instruments that are contracts for the future receipt or delivery of the entity’s own equity instruments.
A financial liability is any liability that is:
(a) a contractual obligation :
(i) to deliver cash or another financial asset to another entity; or
(ii) to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity; or
(b) a contract that will or may be settled in the entity’s own equity instruments and is:
(i) a non-derivative for which the entity is or may be obliged to deliver a variable number of the entity’s own equity instruments; or
(ii) a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments. For this purpose, rights, options or warrants to acquire a fixed number of the entity’s own equity instruments for a fixed amount of any currency are equity instruments if the entity offers the rights, options or warrants pro rata to all of its existing owners of the same class of its own non-derivative equity instruments. Apart from the aforesaid, the equity conversion option embedded in a convertible bond denominated in foreign currency to acquire a fixed number of the entity’s own equity instruments is an equity instrument if the exercise price is fixed in any currency. Also for these purposes the entity’s own equity instruments do not include puttable financial instruments that are classified as equity instruments in accordance with paragraphs 16A and 16B, instruments that impose on the entity an obligation to deliver to another party a pro rata share of the net assets of the entity only on liquidation and are classified as equity instruments in accordance with paragraphs 16C and 16D, or instruments that are contracts for the future receipt or delivery of the entity’s own equity instruments. As an exception, an instrument that meets the definition of a financial liability is classified as an equity instrument if it has all the features and meets the conditions in paragraphs 16A and 16B or paragraphs 16C and 16D.
Keeping in mind the above reporting requirements, the following are some of the practical challenges that could arise in reporting under this Clause:
a) Inclusive nature of various parameters/data points: This clause requires the auditors to comment based on the following parameters/data points:
• Financial Ratios
• Ageing and expected dates of realisation of financial assets and repayment of financial liabilities
• Other information accompanying the financial statements in the Annual Report e.g. Directors Report, MD&A etc.
• Auditors knowledge of the plans of the Board of Directors and other management plans.
Whilst the parameters described in this clause appear to be inclusive, the auditors would have to go on the basis of the data and information which is available, except for the financial ratios, which are now mandatory as per Schedule III requirements. Certain specific challenges, especially for non-NBFC entities and MSMEs, are highlighted subsequently since they may not have all the information stated above, or the same may be sketchy or incomplete.
b) 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 financial liabilities need to be considered based on the legal form rather than the substance of the arrangements as is required in terms of Ind AS-32 and 109. Accordingly, redeemable preference shares though considered 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 compound financial instruments or equity under Ind AS will not be considered for reporting.
• 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 Ind AS disclosures.
c) Challenges for non NBFCs and Small and Medium Enterprises: Non NBFCs, may not have a formalised Asset Liability Management (ALM) system, which is required to be maintained in terms of the RBI guidelines to identify liquidity and maturity mismatches. Accordingly, the auditors of such entities would need to take greater care to review the data and come to appropriate conclusions to report under this clause. It would not be a bad idea to impress upon the Management of such entities to adopt the RBI guidelines and build up an appropriate ALM framework to the extent possible and based on cost-benefit analysis. In the case of MSMEs, whilst it may not be possible to have formalised ALM reporting systems, the auditors would have to ensure that data about the ageing of financial assets and liabilities is generated based on appropriate assumptions as per the conditions in which the entity is working. Further, in terms of capabilities, MSME entities may not be equipped enough to ensure the quality of the data and the controls governing the same. A greater degree of professional scepticism needs to be exercised in such cases, as discussed below.
d) Applying significant judgements and heightened level of professional scepticism: The auditors would have to use professional judgement and an increased level of professional scepticism in respect of the following matters whilst performing their audit procedures for reporting under this clause:
(i) Financial Ratios:
• Financial ratios may not always provide conclusive evidence, and hence auditors will have to also consider various other documents / information as discussed in the following bullets rather than relying only on the quantitative thresholds which they represent. An example is that of an ideal current ratio of 1.33:1 which is the benchmark to reflect strong liquidity. However, for a capital intensive industry even a lower current ratio may be acceptable due to higher level of funds blocked in long term capital intensive assets.
• These ratios cannot be standardised for all the entities, and the same needs to be tailored to the industries. A comparison would also be required with the peer group/competitors. It would be a good practice for auditors to obtain from the Management the basis of certain key ratios based on specific facts and circumstances.
• Each entity operates under different conditions hence ratios relevant to entities shall be considered whilst reviewing the data.
• While calculating ratios auditor should ensure that proper classification is done for current and non-current assets and liabilities. The same may not always be in line with the definition under Schedule III or under the Accounting Standards since certain items which may be current under these definitions may not necessarily be payable within the following year. An example could be the provision made for leave encashment which could be entirely classified as current as per the definitions under Schedule III or the accounting standards since legally the entity does not have an unconditional right to defer settlement beyond the next twelve months if all the employees decide to encash their leave though practically this is a remote possibility. Accordingly, for analysis and reporting under this clause, only the current portion as identified by the actuary would need to be considered since that is the most likely amount which would be settled within the next twelve months.
(ii) Expected date of realisation of financial assets and financial liabilities: In the case of NBFCs it will be easy to verify the expected date of realisation of assets and liabilities as those entities will have Asset Liabilities Management mechanism to analyse the due dates, as required in terms of the RBI guidelines. However, such a mechanism may not exist in case of other entities. Consequently, the auditor will have to put extra effort while reviewing the expected date of realisation of assets and repayment of liabilities in entities other than NBFCs, especially where the contractual terms are not specified. The auditors should prevail upon such entities to develop and strengthen their MIS and internal controls to capture the necessary data, and the same should be subject to proper verification in accordance with relevant auditing standards.
(iii) Other Information accompanying the Financial Statements: These documents generally comprise the Directors Reports and Management Discussion and Analysis Report, wherever required to be prepared. As per SA-720 – The Auditor’s Responsibility in Relation to Other Financial Information, the auditors are expected only to review the said information included as a part of the Annual Report accompanying the audited financial statement for any material factual inconsistencies and also include the same in the audit report. Further, in many cases there are practical challenges in getting this data before finalising the accounts and issuing the audit report. However the auditor should ensure that at least draft versions of these documents are made available by the Management. Finally, he should not only read the same for inconsistencies but also perform certain procedures as outlined below.
(iv) Review of the Board of Directors and Management Plans:
• Since the plans are forward-looking, the auditors would not be in a position to confirm the correctness thereof. However, while reviewing these plans, they will have to look into the historical performance and review various assumptions considered for the preparation of these plans and corroborate the same based on their understanding of the entity and the business in which it operates and other publicly available information.
• Auditors will also have to ensure that approved plans are in line with industries / peer group estimates.
(v) Audit Documentation: While taking the above judgements, auditors would have to ensure adequate documentation of the audit procedures performed as above to arrive at appropriate conclusion(s). In addition, they should also obtain Management Representation on specific aspects as deemed necessary. However, the Management Representation Letter shall not be a substitute for audit procedures to be performed but would serve as additional evidence.
CONCLUSION
The additional reporting responsibilities have placed very specific responsibilities on the auditors to provide early warning signals on the financial health of an entity. As is the case with most of the other clauses, where the auditors are expected to be playing varied and versatile roles, this clause is no exception since they are expected to play the role of a soothsayer!.
