(This is the sixth article in the CARO 2020 series that started in June, 2021)
BACKGROUND
Non-Banking Financial Companies (NBFCs) are entities where generally public money is involved and therefore they have always been subject to greater scrutiny and attention by the regulators (primarily, the Reserve Bank of India [RBI] and the National Housing Bank [NHB]). There are several classes of NBFCs each of which has a separate set of criteria / conditions to fulfil to continue carrying on their business. Core Investment Companies (CICs) are also a separate class of NBFCs which could be used as a tool to camouflage transactions amongst group companies.In the past there have been instances where the general public has lost money in such companies. Hence, to protect the interest of society, responsibilities have been cast on auditors to report some aspects of these companies so that regulators can take necessary action based on the red flags (if any) raised by the auditors.
SCOPE OF REPORTING
The scope of reporting can be analysed under the following clauses:
| Clause No. |
Particulars |
Nature of change, if any |
| Clause 3(xvi)(a) |
RBI Registration: |
No change* |
Whether the company is
required to be registered u/s 45-IA of the Reserve Bank of India Act, 1934 (2
of 1934) and, if so,
whether the registration has
been obtained |
| Clause 3(xvi)(b) |
Conduct of Business: |
New Clause |
Whether the company has
conducted any Non-Banking Financial or Housing Finance activities without a
valid Certificate of Registration (CoR) from the Reserve Bank of India as per
the Reserve Bank of India Act, 1934 |
| Clause 3(xvi)(c)
3(xvi)(d) |
CICs: |
New Clause |
Whether the company is a
Core Investment Company (CIC) as defined in the regulations made by the
Reserve Bank of India and, if so, whether it continues to fulfil the criteria
of a CIC, and in case the company is an exempted or unregistered CIC, whether
it continues to fulfil such criteria |
Whether the Group has more
than one CIC as part of the Group; if yes, indicate the number of CICs which
are part of the Group |
*No change and hence not discussed
PRACTICAL CHALLENGES IN REPORTING
The reporting requirements outlined above entail certain practical challenges in respect of the new clauses which are discussed below:
RBI Registration [Clause 3(xvi)(b)]:
Before proceeding further, it would be pertinent to note the following statutory requirements:
NBFCs
As per section 45-I(f) of the RBI Act, 1934, an NBFC is a company incorporated under the Companies Act, 2013 or 1956 which carries on the business of a financial institution or carries on the principal business of receiving deposits or lending in any manner.
As per section 45-I(c) of the RBI Act, the business of a financial institution means the business of financing by way of loans and advances, hire-purchase finance, acquisition of stocks, equities, debentures, any other marketable securities, etc., insurance business, etc.
Exclusions from definition
The NBFC business does not include entities whose principal business is the following:
• Agricultural activity
• Industrial activity
• Purchase or sale of any goods excluding securities
• Sale / Purchase / Construction of any immovable property – Providing of any services.
The following NBFCs are not required to obtain any registration with the RBI, as these are already registered and regulated by other regulators:
• Merchant Banking Companies
• Stock broking companies registered with SEBI
• Venture capital funds
• Insurance companies holding a certificate of registration issued by IRDA
• Chit Fund Companies as defined in section 2, Clause (b) of the Chit Fund Act, 1982
• Nidhi Companies as notified u/s 620(A) of the Companies Act, 1956.
Meaning of principal business
The RBI has defined1 financial activity as principal business to bring clarity to the entities that will be monitored and regulated as NBFCs under the RBI Act. The criteria are called the 50-50 test and are as under:
• The company’s financial assets must constitute 50% of the total assets AND
• The income from financial assets must constitute 50% of the total income.
The RBI, vide its Circular Ref: RBI/2011-12/446 DNBS (PD) CC. No. 259/03.02.59/2011-12 dated 15th March, 2012 has clarified that parking of funds in bank deposits without commencing NBFI activities within a period of six months after registration cannot be treated as financial assets and receipt of interest income on fixed deposits with banks cannot be treated as income from financial assets as these are not covered under the activities mentioned in the definition of ‘financial Institution’ in section 45-I(c) of the RBI Act, 1934. This is because bank deposits constitute near money and can be used only for temporary parking of idle funds, and till the commencement of the NBFI business for the initial six months after registration.
1 Vide Circular DNBS (PD) C.C. No. 81 / 03.05.002 / 2006-07
Housing Finance Activities
Housing Finance Activities are carried on by Housing Finance Institutions. The term ‘Housing Finance Institution’ is not defined in the RBI Act. However, reference can be made to the National Housing Bank Act, 1987 which defines such institutions and the definition is as follows: ‘housing finance institution’ includes every institution, whether incorporated or not, which primarily transacts or has as one of its principal objects the transacting of the business of providing finance for housing, whether directly or indirectly; Housing finance companies are defined under the Housing Finance Companies (National Housing Bank) Directions, 2010 as follows:
‘housing finance company’ means a company incorporated under the Companies Act, 1956 (1 of 1956) which primarily transacts or has as one of its principal objects the transacting of the business of providing finance for housing, whether directly or indirectly.Earlier, Housing finance companies were supposed to be registered with the National Housing Bank. However, based on the amendments made to the National Housing Bank Act, 1987 through the Finance (No. 2) Act, 2019 now registrations of HFC’s are within the ambit of RBI. All earlier HFCs having obtained registrations under the National Housing Bank Act, 1987 shall be deemed to be registered with the RBI and such HFCs shall comply with the prescribed conditions. Specific Responsibilities of Auditors (Master Direction – Non-Banking Financial Companies Auditor’s Report (Reserve Bank) Directions, 2016):
Conducting Non-Banking Financial Activity without a valid Certificate of Registration (CoR) granted by the Bank is an offence under chapter V of the RBI Act, 1934. Therefore, if the company is engaged in the business of a non-banking financial institution as defined in section 45-I(a) of the RBI Act and meeting the Principal Business Criteria (Financial asset / income pattern) as laid down vide the Bank’s press release dated 8th April, 1999, and directions1 issued by DNBR, the auditor shall examine whether the company has obtained a Certificate of Registration (CoR) from the Bank.
Categorisation of NBFCs
NBFCs have been categorised as under based on whether they accept public deposits as well as based on their assets size and type of activities.
Systemically Important Non-Deposit-taking NBFC (NBFC-ND-SI):
The following are the key conditions which are required to be complied with by such companies as per the relevant RBI directions:
a) A minimum asset size of Rs. 500 crores is required to be maintained.
b) If the asset size post registration falls below Rs. 500 crores in a given month due to temporary fluctuations and not due to actual downsizing, the NBFCs shall continue to meet the reporting requirements and shall comply with the extant directions as applicable to NBFC-NDSI till the submission of its next audited balance sheet to the RBI. A specific dispensation letter from the RBI should be obtained in this regard.
c) It has net owned funds of Rs. 200 lakhs as per the latest audited balance sheet unless it undertakes specific business activities as indicated subsequently.
Non-Systemically Important Non-Deposit-taking NBFC (NBFC-ND-NSI)
The following are the key conditions which are required to be complied with by such companies as per the relevant RBI directions:
A) Asset size should be below Rs. 500 crores.
B) It has net owned funds of Rs. 200 lakhs as per the latest audited balance sheet unless it undertakes specific business activities as indicated subsequently.
Deposit-taking NBFC (NBFC-D):
A) It has net owned funds of Rs. 200 lakhs as per the latest audited balance sheet unless it undertakes specific business activities as indicated subsequently.
B) It complies with the various operational provisions for acceptance, renewal, repayment of public deposits and other related matters in terms of the NBFC Acceptance of Public Deposits (RBI) Directions, 2016.
Investment and Credit Company:
It is an NBFC which satisfies the following criteria:
a) Any company which is a financial institution carrying on as its principal business – asset finance, the providing of finance whether by making loans or advances or otherwise for any activity other than its own; and
b) Any company which is a financial institution carrying on as its principal business the acquisition of securities and is not in any other category of NBFC as defined by the RBI in any of its Master Directions.
Factoring Companies:
a) They should be registered with the RBI u/s 3 of the Factoring Regulation Act, 2011.
b) The financial assets in the factoring business should constitute at least 50% of the total assets and the income derived from the factoring business is not less than 50% of the total income.
‘Factoring business’ means the business of acquisition of receivables of assignor by accepting assignment of such receivables or financing, whether by way of making loans or advances or otherwise against the security interest over any receivables but does not include –
(i) credit facilities provided by a bank in its ordinary course of business against security of receivables;
(ii) any activity as commission agent or otherwise for sale of agricultural produce or goods of any kind whatsoever or any activity relating to the production, storage, supply, distribution, acquisition or control of such produce or goods or provision of any services (as defined in the Factoring Regulation Act, 2011).
Infrastructure Debt Fund NBFC (IDF-NBFC):
a) The sponsor entity should be registered as an Infrastructure Finance Company [IFC] (see below).
b) The sponsor entity should comply with the following conditions:
(i) It has obtained the prior approval of the RBI to sponsor an IDF-NBFC.
(ii) It shall be allowed to contribute a maximum of 49% to the equity of the IDF-NBFCs with a minimum equity holding of 30% of the equity of the IDF-NBFC.
(iii) Post investment in the IDF-NBFC, the sponsor must maintain minimum Capital to Risk Assets Ratio (CRAR) and Net Owned Funds (NOF) prescribed for IFCs.
c) The IDF-NBFC shall comply with the following conditions:
(i) It has Net Owned Funds of Rs. 300 crores or more.
(ii) It invests only in Public Private Partnerships (PPP) and post commencement operations date (COD) infrastructure projects which have completed at least one year of satisfactory commercial operations.
(iii) It has entered into a Tripartite Agreement (involving the IDF-NBFC, the concessionaire and relevant project authority) in accordance with the prescribed guidelines.
(iv) It shall have at the minimum a credit rating grade of ‘A’ of CRISIL or equivalent rating issued by other accredited rating agencies such as FITCH, CARE and ICRA.
(v) It shall have at the minimum CRAR of 15% and Tier II Capital shall not exceed Tier I Capital.
NBFC – Micro Finance Institutions (NBFC-MFIs):
a) It has net owned funds of Rs. 500 lakhs (except if it is registered in the North Eastern Region, in which case the requirement is Rs. 200 lakhs).
b) It has a capital adequacy ratio consisting of Tier I and Tier II Capital which shall not be less than 15%. The total of Tier II Capital at any point of time shall not exceed 100% of Tier I Capital.
c) It needs to ensure that not less than 85% of the net assets (total assets other than cash and bank balances and money market instruments) are in the nature of qualifying assets. [As defined in the RBI Guidelines.]
NBFC – Infrastructure Finance Company (NBFC-IFC):
a) It does not accept deposits.
b) A minimum of 75% of its total assets are deployed in ‘infrastructure lending’. [See note below]
c) It has Net Owned Funds of Rs. 300 crores or more.
d) It shall have at the minimum a credit rating grade of ‘A’ of CRISIL or equivalent rating issued by other accredited rating agencies such as FITCH, CARE and ICRA.
e) It shall have at the minimum CRAR of 15% (with a minimum Tier I capital of 10%).
‘Infrastructure lending’ means a credit facility extended by an NBFC to a borrower by way of term loan, project loan subscription to bonds / debentures / preference shares / equity shares in a project company acquired as a part of the project finance package such that subscription amount to be ‘in the nature of advance’ or any other form of long-term funded facility for exposure in the infrastructure sub-sectors as notified by the Department of Economic Affairs, Ministry of Finance, Government of India, from time to time.
NBFC Account Aggregator:
a) The entity has net owned funds of Rs. 200 lakhs and above.
b) The entity does not have a leverage ratio [ratio of outside liabilities excluding borrowings / loans from group companies to owned funds] of more than seven.
c) There is a Board-Approved Policy for undertaking the business as an Account Aggregator, including the pricing thereof which at least provides the matters as laid down in the guidelines.
‘Business of an Account Aggregator’ means the business of providing under a contract, service in the following matters:
(i) retrieving or collecting such specified financial information [as prescribed by the RBI] pertaining to its customers, as may be specified by the RBI from time to time; and
(ii) consolidating, organising and presenting such information to the customer or any other financial information user [an entity registered with and regulated by any financial sector regulator{RBI, SEBI, IRDA and PFRDA}] as may be specified by the RBI provided that the financial information pertaining to the customer shall not be the property of the Account Aggregator, and not be used in any other manner.
NBFC Peer-to-Peer Lending Platform (NBFC P2P):
a) The entity has net owned funds of Rs. 200 lakhs and above.
b) There is a Board-Approved Policy for undertaking the business on the Peer-to-Peer Lending platform, including the pricing thereof which at least provides the matters as laid down in the guidelines.
‘Peer-to-Peer Lending Platform’ means an intermediary providing the services of loan facilitation via online medium or otherwise, except as indicated hereunder, to the participants who have entered into an arrangement with an NBFC P2P to lend on it or to avail of loan facilitation services provided by it.
(i) Not to raise deposits as defined by or u/s 45-I(bb) of the Act or the Companies Act, 2013;
(ii) Not to lend on its own;
(iii) Not to provide or arrange any credit enhancement or credit guarantee;
(iv) Not to facilitate or permit any secured lending linked to its platform; i.e., only clean loans will be permitted;
(v) Not to hold, on its own balance sheet, funds received from lenders for lending, or funds received from borrowers for servicing loans; or such funds as stipulated below;
(vi) Not cross-sell any product except for loan-specific insurance products.
Securitisation and Reconstruction Companies
a) The entity has net owned funds of Rs. 200 lakhs and above.
b) It should undertake the business of securitisation and asset reconstruction in accordance with the prescribed guidelines for which there is a proper Board-Approved policy, covering the following matters, amongst others:
(i) Acquisition of financial assets.
(ii) Rescheduling of debts.
(iii) Enforcement of security interest.
(iv) Settlement of dues payable by the borrower.
(v) Conversion of debt into equity.
(vi) Realisation plan. Change / takeover of management.
(vii) Issue of security receipts and related matters.
Keeping in mind the above reporting requirements, the following are some of the practical challenges that could arise in reporting under this Clause:
a) Entities engaged in other than NBFI activities: The auditor may come across situations in which a company engaged in other than NBFI activities holds funds in financial assets which may be in excess of 50%, pending deployment in the business, or due to other business / commercial reasons. In such cases the auditor needs to examine the objects of the company in the Memorandum of Association, minutes of the Board / other committee meetings, business plans, etc., and also whether the company has corresponded with the RBI and accordingly make a factual mention under this Clause. He should use his judgement based on the facts and circumstances and apply professional scepticism. If required, he should obtain management representation only as additional evidence and not as a substitute for other audit procedures.
b) NBFCs not requiring registration under the RBI Act: For such entities as identified above, the auditor should check whether they have obtained registration from SEBI or other applicable regulators since strictly they are also regarded as NBFCs in terms of the RBI guidelines and accordingly appropriate factual reporting is recommended. This aspect is not covered in the Guidance Note and a clarification from the MCA and / or the ICAI on the same is desirable.
c) Withdrawal / revocation / suspension / surrender of Certificate of Registration: The auditor should check whether the certificate of registration is withdrawn, revoked, suspended or surrendered and ascertain the reasons for the same and whether the same could affect the going concern assumption and accordingly ensure consistency in reporting. This is particularly relevant for specific classes of NBFCs as indicated earlier and whether they are undertaking only the prescribed activities and complying with the specific conditions as laid down. He should use his judgement based on the facts and circumstances and apply professional scepticism and ensure factual reporting, as deemed necessary. If required he should obtain management representation only as additional evidence and not as a substitute for other audit procedures. Finally, he should also seek guidance as per SA 250 dealing with reporting responsibilities due to non-compliance with laws and regulations.
d) Reporting under the RBI guidelines: The auditor should keep in mind the specific certification and reporting responsibilities under the NBFC Auditors Report (Reserve Bank) Directions, 2016 to report any non-compliances or exceptions, as prescribed (which includes carrying on business on the basis of a registration certificate), as well as any other deviations, especially those impacting specific classes of companies as indicated above. In such cases there should be consistency in reporting both under the Directions as well as under this Clause with appropriate cross-referencing and linking.
CICs [Clause 3(xvi)(c) and (d)]:
Before proceeding further, it would be pertinent to note the following statutory requirements:
Definition of Core Investment Companies – CIC’s
Core Investment Companies are defined as companies which comply with the following conditions as on the date of the last audited balance sheet:
i. it holds not less than 90% of its net assets in the form of investment in equity shares, preference shares, bonds, debentures, debt or loans in group companies;
ii. its investments in the equity shares (including instruments compulsorily convertible into equity shares within a period not exceeding ten years from the date of issue) in group companies and units of Infrastructure Investment Trust only as sponsor constitute not less than 60% of its net assets as mentioned in Clause (i) above…
provided that the exposure of such CICs towards InvITs shall be limited to their holdings as sponsors and shall not, at any point in time, exceed the minimum holding of units and tenor prescribed in this regard by SEBI (Infrastructure Investment Trusts) Regulations, 2014 as amended from time to time.
iii. it does not trade in its investments in shares, bonds, debentures, debt or loans in group companies except through block sale for the purpose of dilution or disinvestment;
iv. it does not carry on any other financial activity referred to in sections 45-I(c) and 45-I(f) of the Reserve Bank of India Act, 1934 except
a. investment in
(i) bank deposits,
(ii) money market instruments, including money market mutual funds and liquid mutual funds,
(iii) government securities, and
(iv) bonds or debentures issued by group companies
b. granting of loans to group companies and
c. issuing guarantees on behalf of group companies.
Definition of Group Companies
‘Companies in the Group’ means an arrangement involving two or more entities related to each other through any of the following relationships:
a) Subsidiary-parent (defined in terms of AS 21),
b) Joint venture (defined in terms of AS 27),
c) Associate (defined in terms of AS 23),
d) Promoter – promotee [as provided in the SEBI (Acquisition of Shares and Takeover) Regulations, 1997] for listed companies,
e) a related party (defined in terms of AS 18),
f) Common brand name, and
g) investment in equity shares of 20% and above.
Note: Even in case of entities which adopt Ind AS, it appears that the group companies would have to be identified as per the criteria prescribed in the respective local Accounting Standards.
Definition of Net Assets:
Net Assets means total assets as appearing on the assets side of the balance sheet but excluding
* cash and bank balances;
* investment in money market instruments;
* advance payments of taxes; and
* deferred tax asset.
2 ‘Public funds’ includes funds raised either directly or indirectly through public deposits, inter-corporate deposits, bank finance and all funds received from outside sources such as funds raised by issue of Commercial Papers, debentures, etc., but excludes funds raised by issue of instruments compulsorily convertible into equity shares within a period not exceeding ten years from the date of issue
Registration requirements
CICs having total assets of Rs. 100 crores or more either individually or in aggregate along with other CICs in the group and which raise or hold public funds2 are categorised as Systematically Important Core Investment Company (CIC-ND-SI). All CIC-ND-SI are required to apply to RBI for grant of certificate of registration. Every CIC shall apply to the RBI for grant of certificate of registration within a period of three months from the date of becoming a CIC-ND-SI.CIC-ND-SI who do not have asset size of more than Rs. 100 crores and Core Investment Companies that do not have access to public funds are exempted from the registration requirement with RBI. This exemption is not applicable to CICs who intend to make overseas investment in the financial sector. However, these CICs shall pass a Board Resolution that they will not, in the future, access public funds.CICs investing in Joint Venture / Subsidiary / Representative Offices overseas in the financial sector shall require prior approval from the RBI.
Raising of Tier II Capital by NBFCs
‘Tier II capital’ includes the following:
a) Preference shares other than those which are compulsorily convertible into equity;
b) Revaluation Reserves at discounted rate of 55%;
c) General provisions (including that for Standard Assets) and loss reserves to the extent these are not attributable to actual diminution in value or identifiable potential loss in any specific asset and are available to meet unexpected losses, to the extent of one and one fourth per cent of risk weighted assets;
d) Hybrid debt capital instruments [a capital instrument which possesses certain characteristics of equity as well as of debt];
e) Subordinated debt [see below]; and
f) Perpetual debt instruments issued by a non-deposit-taking NBFC which is in excess of what qualifies for Tier I Capital, to the extent the aggregate does not exceed Tier I capital.Subordinated Debt
It means an instrument which fulfils the following conditions:
a) It is fully paid-up;
b) It is unsecured;
c) It is subordinated to the claims of other creditors;
d) It is free from restrictive clauses; and
e) It is not redeemable at the instance of the holder or without the consent of the supervisory authority of the non-banking financial company.
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 identification of investments in group companies, viz., subsidiaries, joint ventures and associates under the respective Accounting Standards under Indian GAAP, there could be practical challenges for companies adopting Ind AS, since the definitions therein could be different.
There is emphasis on legal control under AS 21, 23 and 27 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 as group companies and what is required for identifying CICs 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) Companies adopting Ind AS: One of the criteria for exemption of CIC-ND-SI with asset size of less than Rs. 100 crores from registration is that it does not accept ‘Public Funds’ as defined above. Companies adopting Ind AS are likely to face certain practical challenges 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 from the public though considered as financial liabilities / borrowings under Ind AS, will not be considered in the definition of public funds since legally they are in the nature of share capital. Similarly, optionally convertible debentures raised from the public though considered as compound financial instruments or equity under Ind AS, will be considered in the definition of public funds since only funds raised by issue of instruments compulsorily convertible into equity shares within a period not exceeding ten years from the date of issue are exempted from the definition of public deposits.
* Such NBFCs raising Tier II capital (including any subordinated debt) from the public would need to carefully examine the terms and conditions and accordingly ensure that any instrument which is in the nature of equity in terms of Ind AS 32 and 109 is not considered ‘public funds’ as referred to earlier. In respect of hybrid instruments, the predominant legal characteristics would need to be considered even if certain portion is classified as equity in terms of Ind AS 32 and 109. The auditors of Ind AS companies will need to take utmost care about this distinction while dealing with this Clause.
c) Reporting under the RBI guidelines: Similar considerations as discussed under Clause 3(xvi)(b) earlier would apply.
CONCLUSION
The additional reporting responsibilities have placed specific responsibilities on the auditors in the light of several recent failures in the sector and the expectation bar has been substantially raised amongst the various stakeholders. Accordingly, they would need to be equally adept both at pole vaulting as well as long jump to cross the raised bar!
This saying perfectly applies to the audit profession, wherein all the actions taken by the auditors are essentially the result of a careful evaluation. For instance, before accepting the appointment, the auditor is required to ensure independence and client and engagement evaluation, before starting the audit he needs to complete the engagement formalities and audit planning, and before issuing the audit report he needs to ensure the performance and documentation of his audit procedures.
