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Indusind Bank – Strict Action Required To Eliminate Trust Deficit

Homo sapiens were neither the strongest species nor capable of flight, yet they outnumbered and outlasted many others. How, you ask? Consider chimpanzees—physically far stronger than humans—whose population remains below 300,000, while humans dominate the planet with 8.2 billion individuals. The key difference? Trust. Chimpanzee groups rarely exceed 200 members because, beyond that number, trust collapses and cooperation ends.

Humans, on the other hand, rely on trust in almost every aspect of life. We trust doctors with our health, auditors with financial integrity, management of the companies we are invested in, and banks, with our hard-earned money. But what happens when that trust is broken, and Jugaad becomes Jugaar? The impact can be catastrophic.

As Warren Buffett famously said, “It takes 20 years to build a reputation and five minutes to ruin it.” When crooks cheat with impunity, without fear of the law, their numbers only grow. If our laws remain weak and forgiving, they risk enabling more criminals to operate without consequences. Without strict action, trust in the system will be permanently eroded, threatening the very foundation on which businesses operate.

INDUSIND BANK – A CASE IN POINT

On 10th March, 2025, the bank made the following disclosure:

“During internal review of processes relating to Other Asset and Other Liability accounts of the derivative portfolio, post implementation of RBI Master Direction – Classification, Valuation and Operation of Investment Portfolio of Commercial Banks (Directions), 2023 issued in September 2023, including accounting of Derivatives, applicable from 1st April, 2024, Bank noted some discrepancies in these account balances. Bank’s detailed internal review has estimated an adverse impact of approximately 2.35 per cent of Bank’s Net worth as of December 2024. The Bank has also, in parallel, appointed a reputed external agency to independently review and validate the internal findings. A final report of the external agency is awaited and basis which the Bank will appropriately consider any resultant impact in its financial statements. The Bank’s profitability and capital adequacy remains healthy to absorb this one-time impact.”

IndusInd Bank’s share price crashed 27 per cent on March 11, hitting the new 52-week low mark, erasing ₹19,000 crore of market capitalisation. The stock hit three lower circuits, one after another, before 10 am on the National Stock Exchange. Imagine, how betrayed investors must have felt. Many questions emerged.

  • Is this just a tip of the iceberg? Are there more problems yet to be discovered?
  •  What led to this discovery?
  • Who committed the crime?
  • Will the perpetrators of the crime, be allowed to continue running the bank?
  • Is the depositor’s money safe, and could the bank collapse?
  • Is this an aberration and limited only to IndusInd?

The investor call held by the Bank, clarified a few things:

  •  The difference was accumulated over a period of time
  • The issue was identified by the Bank (Not clear, who in the Bank flagged it?).
  • The bank remains financially stable.
  • An Independent firm has been appointed to ascertain the full impact.
  • The CFO had resigned a couple of months ago.

Management’s response on the call with regard to the audit, was as follows: “So there are 4 types of audits which happened. So first of all, understand the structure of treasury. They have a front office, a mid-office and a back office and a concurrent audit, which continues to happen. Second, there is an internal audit, which happens. And also, they take support of external agencies before everything to do the audit. Then there is a statutory audit, which happens on these and then a compliance audit and then the RBI audit. All these audits continue to happen on treasury on a regular basis.”

Yet, a crucial question lingers: How was this discrepancy picked up only in the last three months despite multiple layers of audit over the years?

The Management’s response, “Those are questions which we will answer in detail once our review is complete by the external agency because it’s important. Based on this new circular, we did our own internal review. I would say that those questions, we are also, in process of finding out as to where was this missed from. So I’m sorry, I really can’t answer it right now. But once we have those answers, we’ll be absolutely transparent in getting back to you.”

The RBI quickly stepped in assuring depositors that their money is safe. RBI allowed the CEO to continue for another year (rather than 3 years, the board had sought), ensuring that the banks activity is not abruptly disrupted.

A CRISIS OF CONFIDENCE

This shocking revelation led to a flurry of analyst downgrades, exacerbating other concerns as well, such as stress in IndusInd Bank’s microfinance books. Curiously, one analyst still maintains
an outperform rating, which raises eyebrows and warrants an investigation—though that’s a story for another day.

There is significant regulatory overlap in this case. While the RBI is the primary banking regulator, SEBI governs market disclosures and insider trades, NFRA oversees auditors, and SFIO handles financial fraud investigations of a serious nature. They should all come together, though NFRA should spearhead this, as they have the appropriate accounting knowledge and investigative skills. Ultimately, each of these regulators will then have to consider stringent and punitive action, basis their jurisdiction, for e.g., NFRA can take action against the auditors, SEBI on the management for fraudulent practices as well as insider trading. SEBI should also look at the role of the independent directors and take stringent action on them. RBI too will need to coordinate with SEBI and NFRA.

It would be naive to dismiss this as a mere accounting error or attribute it to senior management succumbing to reporting pressures, especially when subsequent media reports highlighted substantial insider trades.

A CALL FOR ACTION

A full-scale and swift investigation is imperative. Not only should senior management be held accountable, but the role of auditors and independent directors must also be thoroughly scrutinized. If those responsible are not severely punished, it will embolden cheaters and criminals. As Mahatma Gandhi once said, “The moment there is suspicion about a person’s motives, everything he does becomes tainted.” The regulators must act decisively to restore faith in the financial system.

Trust is the bedrock of human connections and the very essence of our survival. When trust is violated—especially in financial integrity—it shakes the foundation of coexistence. Each breach is a perilous step toward the potential destruction of our shared economy and society. Upholding trust is not just a moral imperative; it’s a fundamental necessity for the well-being and continuity of our interconnected existence.

In conclusion, regulators must fire on all cylinders to make Indian stock markets safe for all. White-collar crimes should not be treated any differently than physical thefts. Some criminal who smuggles in a couple of gold biscuits, they are imprisoned, and life is made absolutely miserable for them. On the other hand, SEBI allows these white-collar crimes to go literally scot-free. At best there is disgorgement, some penalty, and some ban from the capital market. This is hardly any relief for investors who have lost tons of money, and the loss of trust in capital markets, which is a more serious thing. Moreover, for habitual wrong doers, the disgorgement and penalty is a cost of doing business!!

A system that fails to punish financial wrongdoers swiftly is a society destined for collapse, like the chimpanzees!! As Thomas Jefferson wisely said, “Honesty is the first chapter in the book of wisdom.” It’s time we enforce this principle in action, not just in words.

Implications Arising Out of New Format of Financial Statements for Non-Corporate Entities

The Institute of Chartered Accountants of India (ICAI), through its Accounting Standards Board, issued the revised “Format of Financial Statements for Non-Corporate Entities” (Revised 2022), effective from financial year 2024-25 onwards. This move aims to align the reporting practices of Non-Corporate Entities (NCEs) — including sole proprietorships, partnerships, LLPs, trusts, and others to facilitate better presentation, greater and more transparent disclosures, and enhance comparability. This article analyses the implications of the revised format and outlines the challenges and opportunities together with the way forward, both for the NCEs as well as the regulators arising out of its implementation.

INTRODUCTION

India’s financial reporting landscape has significantly evolved in the past decade. While corporate entities governed by the Companies Act, 2013 (“the Act”) have long followed standardised formats for financial reporting in the form of Schedule III (erstwhile Schedule VI), NCEs were governed largely by inconsistent legacy practices or were following formats prescribed by the tax authorities or other regulators like the Charity Commissioner. Considering the large number of such entities and their contribution to the GDP and tax base, a standardised financial reporting framework is desirable.

The Institute of Chartered Accountants of India have prescribed Accounting Standards for different type of entities. These Accounting Standards apply with respect to any entity engaged in commercial, industrial or business activities. For the applicability of Accounting Standards (AS) on entities other than companies, these entities are classified into four categories viz., Level I, Level II, Level III and Level IV non-company entities. Level I, being large size non-company entities, are required to comply fully with all the AS. Level IV, Level III and Level II non-company entities are considered Micro, Small and Medium Sized Entities (MSMEs) that have been granted certain exemptions/relaxations by the ICAI.

Recognising this, the ICAI had earlier released the Technical Guide on “Revised Format of Financial Statements for Non-Corporate Entities (2022)” followed by a Guidance Note on Financial Statements of Non-Corporate Entities in August 2023 (“Guidance Note”), which is applicable to all financial statements from 1st April, 2024 (i.e. for financial statements from financial year 2024-25 onwards)1. Since NCEs will have to start preparing financial statements, they must be aware of the implications and challenges and other related matters arising from the adoption of the revised formats.


1   The Technical Guide on Financial Statements of Non-Corporate Entities 
stands superseded by the Guidance Note issued by the ICAI.

SCOPE AND APPLICABILITY

The Guidance Note specifies that all Business or Professional Entities, other than Companies incorporated under the Companies Act and Limited Liability Partnerships incorporated under the Limited Liability Partnership Act, are considered to be Non-Corporate entities. Accordingly, the revised format applies to:

  •  Sole proprietorships
  • Partnerships
  • Hindu Undivided Families (HUFs)
  • Trusts
  • Association of Persons (AOPs)
  • Societies (not covered under the Companies Act)

It goes on to state that any formats/principles which are specifically prescribed under a particular statute or by any regulator/authority, e.g. trusts under the Maharashtra Public Trusts Act, 1956 or other autonomous bodies established by the Government can follow the said formats and also specific Guidance Notes / Technical Material issued earlier for educational institutions, political parties, NGOs etc. Accordingly, in the case of Trusts, AOPs and Societies to which there is no regulatory format prescribed, it appears that they have to follow the revised format, which, as indicated later, is almost aligned on the lines of Schedule III of the Act and hence may present challenges. The ICAI can consider issuing a clarification that the formats would apply only to commercial non-corporate entities.

The revised formats are applicable to financial statements prepared for periods beginning on or after 1st April, 2024. As per the ICAI announcement on ‘Clarification Regarding Authority Attached to Documents Issued by the Institute’ amended in August 2023, a member of the ICAI, while discharging his/her attest function, should examine whether the recommendations in a Guidance Note relating to an accounting matter have been followed or not. If the same has not been followed, the member should consider whether, keeping in view the circumstances of the case, a disclosure in his report is necessary in accordance with Engagement Standards. Further, though not expressly mentioned, it is presumed that the formats are applicable to general-purpose financial statements for which the audit needs to be conducted and reports to be issued as per the Standards of Auditing issued by the ICAI.

SALIENT FEATURES OF THE REVISED FORMAT

The revised format is almost entirely aligned with the formats prescribed under Schedule III of the Act, except for minor changes taking into account the operations of NCEs. However, they do not address specific operational features applicable to non-commercial / non-profit NCEs.

The following are certain salient features of the revised format:

Uniform Presentation

The revised format introduces a standardised structure for the Balance Sheet and the Profit & Loss Account, similar to those used by corporate entities under the Act. This ensures a consistent and familiar layout for stakeholders, improving readability, comparison, and analytical evaluation.

Classification of Assets and Liabilities

Entities are now required to distinguish between current and non-current assets and liabilities based on a 12-month operating cycle. This aligns with common accounting standards and helps in better liquidity and solvency assessments. It enhances the understanding of an entity’s short-term vs long-term financial obligations.

Disclosure-Oriented Approach

The revised format includes detailed disclosure requirements, extending beyond basic numerical data to cover related party transactions, contingent liabilities, and significant judgments or assumptions made, amongst other matters.

Notes to Accounts

Narrative and tabular notes are now emphasised. These provide clarity on the accounting policies adopted, detailed breakdowns of figures in the financial statements, and explanations of items such as provisions, asset valuations, and legal contingencies.

Alignment with AS Framework

The financial statements are to be prepared in line with the Accounting Standards issued by ICAI (not Ind AS) whilst maintaining relevance and feasibility for small and medium-sized non-corporate entities not governed by the Companies Act. This makes the standards accessible without being overly complex.

Transparency

Uniform formats encourage fuller and more accurate disclosures, thereby enhancing stakeholder confidence.

Creditworthiness Assessment

With standardised presentation, lenders and financial institutions can more reliably assess the risk profile and repayment capability of non-corporate borrowers, leading to improved access to finance.

Compliance Culture

The revised format will enable non-corporate entities to be ready for more structured and regulatory-compliant operations, facilitating easier transitions to corporate structures or public disclosures if needed in the future.

MAJOR CHANGES AND THEIR IMPACT

The revised format contains some major changes which will have far-reaching impact on non-corporate entities. These are briefly analysed hereunder:

Presentation of Shareholders’ / Owners / Partners Funds

There is a clear distinction between capital contributions, current account balances, and retained earnings which will help in understanding partner interests and fund movements.

Borrowings and Loan Disclosures

All borrowings must be classified as current or non-current and disclosed with details of security, terms of repayment, interest rates and nature (secured/unsecured). This will provide visibility on future commitments and repayment obligations and allow users to evaluate the entity’s leverage and funding structure.

Trade Payables Ageing Schedule

A detailed ageing analysis discloses the time-wise breakup of outstanding payables, specifically distinguishing amounts due to MSMEs. This would provide insights into the payment culture and vendor management practices, as well as working capital management policies. This also promotes compliance with MSME payment timelines and helps assess liquidity pressure.

Trade Receivables Ageing Schedule

Entities are required to present receivables based on due dates (e.g., less than 6 months, over 6 months). This identifies potential bad debts and inefficiencies in collection cycles, aiding in credit risk management.

Revenue and Other Income

Entities are required to provide a clear demarcation between operational revenue and other income streams such as interest, rent, and dividend income. This helps in assessing the core vs ancillary sources of income and facilitates better performance analysis.

Expenses Classification

Expenses must be grouped under predefined heads as per their nature. Further, any major items (exceeding 1% of turnover or ₹1 lakh, whichever is higher) must be individually disclosed. This improves cost transparency and helps in better variance analysis.

Related Party Disclosures

Entities are now required to follow tabular disclosure formats for related party disclosures. Non-corporate entities must reassess their definition of related parties under AS 18, which includes:

  •  Individuals with control or significant influence (e.g., proprietors, partners)
  • Relatives of such individuals
  • Entities under common control (including group firms, HUFs, trusts, etc.)

This will formalise the presentation of disclosures, reducing subjectivity and increasing uniformity in reporting across entities and will enhance the depth, clarity, and consistency of related party disclosures and improve the credibility and transparency of financial reporting.

Disclosure of Contingent Liabilities

The new format formalises the disclosure of contingent liabilities via specific note formats, requiring entities to explicitly categorise and quantify such liabilities under the following broad heads, as against scattered and unstructured disclosures earlier.

  •  Claims against the entity not acknowledged as debts
  •  Guarantees provided to banks or third parties
  • Disputed tax and other statutory demands pending before authorities Entities must now assess the following in terms of AS-29:
  •  Probability of outflow of resources
  •  Reliability of estimation
  •  Legal and contractual basis of such obligations

This would lead to improved comparability across reporting entities and a more accurate representation of financial risk.

BENEFITS AND IMPLEMENTATION CHALLENGES

Benefits

Adopting the revised formats provides several benefits not only for the entities but also for stakeholders, some of which are highlighted below:

Enhanced Credit Access

A clear, standard format makes financial statements more understandable to bankers and investors, improving creditworthiness assessments and enabling faster loan processing.

Improved Tax Compliance

Accurate and detailed reporting reduces mismatches with tax filings and enhances credibility, lowering the chances of tax disputes or penalties during assessment proceedings.

Professional Image

Entities with standardised, audited financials are more likely to attract partners, investors, and vendors, enhancing their brand perception and business prospects.

Better Internal Control

The need for enhanced disclosure and segregation coupled with more granular data collection
enforces tighter financial controls, better record-keeping, and informed decision-making. This would eventually translate into a better Compliance culture.

Challenges

In spite of the above benefits, there are several implementation challenges which can act as hurdles in the effective transition to the new financial reporting regime for such entities, some of which are briefly discussed below:

System and Template Overhaul

Many of these entities operate on basic or customised accounting systems that may not support the new classification and disclosure requirements. Significant effort may be required to update
software or manual reporting templates, the benefits of which may not be commensurate with the cost involved.

Data Availability

Entities may not maintain the level of detail required by the new format. For example, ageing analysis or related party disclosures might require significant historical data reconstruction or adjustments.

Lack of Awareness

Owners and managerial staff may not fully understand the relevance or implications of the new reporting format, leading to resistance or poor adoption.

Audit and Review Complexity

Auditors will need to verify new disclosure items, such as the classification of debtors, related party balances, and security on borrowings, which may involve additional work efforts, audit procedures, and reconciliations. Further, the additional effort and documentation may not result in a commensurate increase in their fees. Finally, the auditors may be exposed to greater scrutiny by the regulators.

WAY FORWARD

For Stakeholders

The new formats will have far-reaching implications primarily for ICAI and other Regulators, Chartered Accountants, Tax authorities, banks and other lenders.

ICAI and Other Regulators

Additional Guidance Notes / Technical Material-

  • Since non corporate entities take diverse forms and structures, ICAI could consider issuing further guidance on sector-wise illustrative financial statements, especially for non-commercial/non-profit entities, FAQs and implementation guidance to assist preparers and auditors.

Phased Implementation

  • ICAI and/or the regulators may consider introducing a simplified version of the format or a phase-wise implementation to reduce the initial compliance burden while maintaining reporting integrity.

Capacity Building

  • ICAI and/or the regulators should undertake capacity-building measures by organising webinars, workshops, and training for small practitioners, especially in Tier 2 and Tier 3 cities, which will enhance the quality of the overall adoption ecosystem.

Regulatory Synchronisation

  • Efforts should be made to harmonise financial statement formats with those used in tax return forms (ITRs) and other statutory filings like GST, charity commissioner, etc., thereby reducing duplication and reconciling mismatches. Finally, steps should be taken to harmonise the format with the filing under Tax Audit, especially for related party disclosures and contingent liabilities.

Chartered Accountants

CAs will have to play a greater and more proactive attest or advisory role than what is currently done, covering the following aspects:

  • Helping entities to restructure financial data, align ledgers, understand classification norms, adhere to structured accounting policies and maintain detailed financial and accounting records and MIS, as relevant.
  • Audit and review procedures will become more detailed and disclosure-focused, and greater emphasis will have to be placed on compliance with accounting and auditing standards and maintaining more robust documentation.

Tax Authorities

Tax officials and banks will benefit from structured and detailed financial statements, enabling quicker assessments and due diligence, reducing the scope for disputes, and promoting transparency in compliance and lending.

Banks and Other Lenders

Banks and others will benefit from structured and detailed financial statements, enabling proper and focused due diligence, reducing the scope for disputes, and promoting transparency in compliance and lending and monitoring the usage of funds

For Non-Corporate Entities

Entities will need to take several far reaching measures to align themselves with and gear up to the new financial reporting regime. The key matters in connection therewith are briefly discussed hereunder:

Transition Planning

Entities should map their existing reporting systems to the new format and create a migration plan, identifying gaps in account groupings and disclosures. Special efforts will be required to compile a master-related party register and revisit inter-firm and family group structures to identify indirect relationships. Similarly, entities would have to create a contingent liability register updated at each balance sheet date and obtain legal or expert opinions where outcome probability is uncertain.

Staff Training

Finance personnel and bookkeepers must be trained in the classification of accounts as per the formats, drafting of notes to accounts and accounting policies as per the Accounting Standards. Similarly, they need to be trained to maintain proper records and to improve the documentation, thereby ensuring accuracy and consistency in reporting. This will assist them in complying with the increased audit requirements.

Use of Technology

Entities will be required to use compliant accounting software or ERP systems to streamline compliance, reduce manual errors, and simplify periodic reporting and audit preparation. In certain cases, this may involve significant one-time implementation costs as well as additional recurring costs for employing persons with relevant skills who understand such systems.

CONCLUSION

The new format for financial statements for non-corporate entities will mark a significant step in the formalisation of India’s financial reporting ecosystem. While the journey to full adoption may be gradual and initially meet with some resistance, the long-term gains in credibility, compliance, and consistency will be substantial. Chartered Accountants, as custodians of financial integrity, have a vital role in driving this transition through proactive engagement, hand-holding of clients, and embedding best practices in the profession. To conclude, any short-term pain always paves the way for long-term gain!

Unravelling The Forensic Accounting And Investigation Standards

1. INTRODUCTION:

Investigations in the corporate landscape are referred to by a multitude of typologies, such as workplace, fraud, forensic or ethics investigations, to name a few and these typologies are representative of the myriad methods, techniques and processes deployed to achieve a singular objective i.e. discovery and determination of facts relating to an alleged violation. Given this context, the Forensic Accounting and Investigation Standards (“FAIS” or “Standards”)1 issued by the Institute of Chartered Accountants of India (“ICAI”) is a salient endeavor as it seeks to amalgamate a multitude of complex and divergent topics to provide a simple and unified framework for practitioners. However, applying a reductive approach to a complex matter can sometimes introduce unforeseen challenges. This note explores issues which stakeholders ought to consider apropos the services which fall within the ambit of FAIS.


1 Paragraph 1.2 of the Framework governing Forensic Accounting & Investigation 
(“FAIS Framework”) read with Paragraph 1.2 of FAIS 110 – Nature of Engagement

2. SCOPE:

The FAIS which took effect on 1st July, 2023, comprise of 20 standards addressing core topics such as fraud risk and fraud hypothesis, engagement acceptance, planning, and reporting and apply when a Professional renders services falling within the definition of Forensic Accounting, Investigation or Litigation Support services (“FAIS Services”). The definition of “Professional”2 encompasses not only members of ICAI but also other professionally qualified accountants engaged in forensic accounting and investigation. However, while compliance with the FAIS is mandatory for Chartered Accountants (“CA”), whether in practice or employment, it remains voluntary3 for qualified professionals who are not members of the ICAI.


2  Paragraph 3.1 of FAIS Framework
3  Paragraph 3.1.2. of the Implementation Guide on FAIS No 000


3. DEFINING & DISTINGUISHING FAI SERVICES: OVERLAPPING BOUNDARIES AND CONSEQUENCES

Formulating a precise definition can be especially challenging when a term aims to cover a wide range of scenarios or straddles multiple domains. This difficulty is apparent in the FAIS, which seeks to capture all possible subject matter and objectives of investigations, including investigations into financial, operational matters or in connection with litigation. As discussed further, while striving to remain sufficiently broad, these definitions run the risk of being so expansive that they become unwieldy.

3.1. FAIS DEFINITIONS

  •  Forensic Accounting4 :This term is defined as “gathering and evaluation of evidence by a professional to interpret and report findings before a Competent Authority5” and is further explained as “The overriding objective of Forensic Accounting is to gather facts and evidence, especially in the area of financial transactions and operational arrangements, to help the Professional6 report findings, to reach a conclusion (but not to express an opinion) and support legal proceedings”.

    4 Paragraph 3.2.1 of FAIS Framework read with Paragraph 3.3.1 of FAIS 
    Framework
    5 Competent Authority is defined as “Competent Authority refers to a court of law 
    (or their designated persons), an adjudicating authority or any other judicial 
    or quasi-judicial regulatory body empowered under law to act as such” - 
    Refer Page 155 of FAIS - Glossary of Terms
    6 Professional is defined as a professionally qualified accountant, 
    carrying membership of a professional body, such as the ICAI, 
    who undertakes forensic accounting and investigation assignments using accounting, 
    auditing and investigative skills. Refer Paragraph 3.1 of the FAIS Framework.
    
  •  Investigation7: Investigation is defined as “the systematic and critical examination of facts, records and documents for a specific purpose” and is explained as “a critical examination of evidences, documents, facts and witness statements with respect to an alleged legal, ethical or contractual violation. The examination would involve an evaluation of the facts for alleged violation with an expectation that the matter might be brought before a Competent Authority or a Regulatory Body8”.

    7 Paragraph 3.2.2 of FAIS Framework read with Paragraph 3.3.2 of FAIS Framework.
    
    8 Regulatory Body is defined as “Regulatory Bodies are established to govern 
    and enforce rules and regulations for the benefit of public at large”.- 
    Refer Page 160 of FAIS – Glossary of Terms
  •  Litigation Support9: While this term is undefined, it has been explained as “may include mediation, alternative dispute resolution mechanisms or the provision of testimony”10. Litigation is defined as “a process of handling or settling a dispute before a Competent Authority or before a Regulatory Body. Litigation could include mediation and alternative dispute resolution mechanism11”. Examples of Litigation Support include scenarios where a CA is asked to provide evidence in support of the observations made in a forensic report to an Investigation Agency or Competent Authority or a valuation exercise which may be used in settlement negotiations in context of a dispute12.

    9 Paragraph 3.2.3 of FAIS Framework – Page 17

    10  Paragraph 1.2.(c) of FAIS 110 – Nature of Engagement

    11  Paragraph 3.2.3 of FAIS Framework

    12 Paragraph 5.4 of the Implementation Guide on FAIS 110 –
      Nature of Engagement

While at first blush, Forensic Accounting and Investigation appear to be similar in coverage as they envisage evaluation of evidence in connection with reporting to a Competent Authority. However based on a conjunct reading of FAIS 11013 – Nature of Engagement read with the Implementation Guide on FAIS 11014 it appears that matters involving review of transactions and accounts with a definitive objective to report to a Competent Authority would be classified as Forensic Accounting. The clear implication here is that this exercise should be taken to gather evidence which is admissible in front of a Competent Authority. On the other hand, considering that Forensic Accounting presupposes reporting to a Competent Authority, it appears that any internally initiated exercise including review of financial transactions, would be classified as an Investigation, even though the underlying issue may be subject to the jurisdiction of a Competent Authority or Regulatory Body.


13  Paragraph 3.2, 3,3,4.2 & 4.3 of FAIS 110 – Nature of Engagement.

14  Paragraph 3.2, 3.3 and 3.4 of the Implementation Guide on FAIS 110 – 
Nature of Engagement

However, the examples cited in the FAIS15 do not appear to support the aforesaid reasoning. For instance, the estimation of loss of assets or profits for an insurance claim or the assessment of pilferage of inventory, which would not necessarily entail reporting to a Competent Authority are classified as Forensic Accounting, whereas alleged manipulation of stock prices or an exercise to identify misutilisation of funds consequent to loan defaults, are placed under the umbrella of Investigations. Furthermore, although the term Litigation Support suggests services where a CA represents a client in legal proceedings, its broad scope and varied applications, as can be inferred from the inclusive meaning and examples, can blur the lines between Litigation Support and Investigation.


15 Paragraph 5.2 and 5.3 of the Implementation Guide on FAIS 110 –
 Nature of Engagement

In conclusion, the imprecision and overlap in the definitions of Forensic Accounting, Investigation, and Litigation Support create an interpretational haze that is difficult to resolve.. Without more precise and harmonized guidelines, these definitions risk being stretched to a point where they offer little functional clarity, thereby leaving CA uncertain about the exact nature of their engagements and the requirements to be met before a Competent Authority or a Regulatory Body.

3.2. BROADENING THE SCOPE: BEYOND FRAUDULENT ACTS

Although fraud16 has been defined in the FAIS, the definitions of Forensic Accounting and Investigation (“Forensic Investigation”) do not explicitly reference it. The Implementation Guide on FAIS 110 – Nature of Engagement, which is advisory, notes that an Investigation aims to “uncover potential fraud…” and “check for fraudulent intent…”17, yet the definition of Investigation, which refers to “legal, ethical or contractual violation”, strongly suggests that fraud is not a predicate element. Collectively this implies that even matters where fraud, misrepresentation, or misappropriation (collectively “Fraudulent Acts”) is not suspected might fall under the FAIS.


16  Paragraph 3.2.4 of FAIS Framework

17  Paragraph 3.3 of Implementation Guide on FAIS 110 – Nature of Engagement

The Cambridge dictionary describes the term Forensic as “related to scientific methods of solving crimes”18. The American Institute of Certified Public Accountant’s Statement on Standards for Forensic Services (“AICPA FS”) specifies wrong doing 19 as predicate element of an investigation. On a similar note, SEBI’s LODR which mandate reporting of Forensic Audits by listed companies reference an element of wrongdoing by referring to “mis-statement in financials, mis-appropriation / siphoning or diversion of funds” as a prerequisite element20. Collectively, this implies that wrongdoing or misconduct ought to be an essential aspect of a Forensic Investigation.


18 Cambridge Dictionary, https://dictionary.cambridge.org/dictionary/english/forensic?q=Forensic, 
Last accessed on March 25, 2025.

19  Para 1 of AICPA FS

20 “Frequently Asked Questions (FAQ) On Disclosure of Information Related 
to Forensic Audit of Listed Entities”, SEBI, https://www.sebi.gov.in/sebi_data/faqfiles/nov-2020/1606474249513.pdf, 
Last Accessed on March 25, 2025.

As such, it appears that FAIS diverges from the norm. To cite an example, the AICPA FS stipulate that valuation exercises not rendered in context of a litigation or investigation, would not be considered as a forensic service21. However, the examples cited in the FAIS22 suggest that exercises in nature of valuations and loss estimations are classified as Forensic Accounting, including even where litigation is not anticipated or wrongdoing is not suspected.


21 Para 2 of AICPA FS

22 Annexure 1 of FAIS 210 – Engagement Objectives read with Paragraph 5.2

 and 5.3 of the Implementation Guide on FAIS 110 – Nature of Engagement

By not requiring Fraudulent Acts as a starting point and by using undefined terms like “operational arrangements” or broad phrases such as “legal, ethical or contractual violations,” the FAIS potentially and may be inadvertently extend their scope to a wide array of fact-finding engagements. Even routine engagements can fall under the FAIS definition of an Investigation. For instance, if GST authorities flag discrepancies in sales data, hiring a CA to verify these discrepancies, even without any suspicion of wrongdoing could fall within the ambit of FAIS, as it involves a critical examination of records for a potential legal violation. Similarly, if a buyer alleges discrepancies in supply of goods, any assistance provided in evaluating the claims, may qualify as an Investigation, given the alleged breach of contract.

The decision not to explicitly require an allegation or indication of fraudulent activity in the definitions of Forensic Accounting and Investigation under the FAIS has significant practical implications. Although this breadth appears designed to accommodate a wide range of factual inquiries, it can lead to confusion and dissonance among both CAs and stakeholders as to whether a particular engagement would fall within the ambit of FAIS.

CAs are bound to assess whether an engagement falls within the FAIS and report compliance in their reports23. However, clients would be wary of labelling ordinary fact-finding exercises as a “forensic” exercise as this characterisation may lead to an inference of suspected misconduct triggering governance and reporting obligations as well as potential reputational risks. This approach may translate into more extensive documentation, enhanced reporting standards, and greater administrative overhead, placing a disproportionate burden on clients for lower-risk assignments. The same poses practical challenges which the CAs and client will have to proactively work together to address appropriately.


23  Paragraph 4.3 of FAIS 510 – Reporting Results

Furthermore, if Fraudulent Acts are not a predicate element, then the application of topical standards relating to fraud (such FAIS 120 – Fraud Risk) would be irrelevant. And since fraud is the predicate theme which binds the various FAIS, this incongruity may lead to potential complexities in the application of the FAIS leading to deficient outcomes.

3.3. DETERMINING FAIS APPLICABILITY

The FAIS ties its applicability to the purpose for which a service is rendered, yet its broad definitions may make it difficult to classify engagements. In particular, the terms “alleged legal, ethical or contractual violations” and “expectation” of litigation remain undefined, allowing multiple interpretations of whether an engagement qualifies as an Investigation or a general fact-finding exercise.

For instance, examining financial records for improper payments can serve markedly different objectives; from a straightforward risk assessment to probing suspected impropriety. If the client’s stated goal is merely to assess risk, the FAIS may not apply. However, if concerns of wrongdoing trigger the exercise, then FAIS could be applicable. In practice, determining which scenario applies can be challenging and, while dependent on the Client’s stated objectives, would also require a CA to assess the potential outcomes which would arise thereon.

Making a consistent and defensible classification often calls for legal expertise to interpret complex facts and predict potential outcomes; tasks that may extend beyond the CA’s traditional skill set. In high-stakes situations with uncertain or evolving circumstances, this lack of clarity poses a significant risk of non-compliance, underlying the need for more precise guidance in the FAIS.

4. INDEPENDENCE – UNREALISTIC PRESCRIPTIONS

The Basic Principles of FAIS (“Principles”) mandate that a CA should be “independent” and should “be free from any undue influence which forces deviation from the truth or influences the outcome of the engagement24 and that the CA “needs to resist any pressure or interference in establishing the scope of the engagement or the manner in which the work is conducted and reported”25. A CA who is unable to establish the scope or the way the work is conducted would be violating the principle of independence26, which in turn would necessitate a qualification in the CA’s report27 or withdrawal by the CA from the engagement. At the same time ‘FAIS 210 – Engagement Objectives’ indicates that scope should be agreed upon with the client. Based on a conjunct reading, it appears that a CA should primarily determine the scope but with the consent of the client.

This strict independence requirement would be reasonable where the mandate to investigate is derived under law, such as an investigation initiated by regulators like SEBI but would appear to be excessive in case of client-initiated mandates, such as internal investigations, where a CA is rendering a contractual service at the client’s request. It may be noted that he AICPA FS do not prescribe independence as a requisite standard for forensic service28.


24 Paragraph 3.1 of Basic Principles of Forensic Accounting
 and Investigation (“Basic Principles”)

25  Paragraph 3.1 of Basic Principles

26  Paragraph 3.1 of the Basic Principles

27Paragraph 5.3 of the Preface to the Forensic Accounting 
and Investigation Standards (“Preface”)

28  Paragraph 6 of AICPA FS

5. ADHERENCE TO FAIS BY IN-HOUSE CAs

As explained above, the Basic Principles of FAIS (“Principles”) mandate that a CA should be “independent” and “needs to resist any pressure or interference in establishing the scope of the engagement or the manner in which the work is conducted and reported”29. FAIS appear to be mandated for CAs in employment (“CA-E”) and it is obvious demonstrating this extent of independence in an employer-employee relationship is infeasible given the nature of the relationship.


29  Paragraph 3.1 of Basic Principles

CA-Es operate in a different work construct when compared to CAs in practice. In fact, independence standards stipulated in the Code of Ethics issued by the ICAI apply to CAs in practice only. If FAIS are considered to be applicable to CA-Es, the potential conflicts and issues which would arise, may discourage CA-Es in undertaking any task in the nature of a FAIS Service. To illustrate, FAIS presupposes that the lifecycle of a FAIS engagement would be structured starting with engagement acceptance and culminating with a report, a structure which may not be practical or realistic in certain respects in the context of Forensic Investigations performed by a CA-E. As such, FAIS Services rendered by CA-E may be challenged as being non-compliant with FAIS and this deficiency may be used to discredit the outcome or findings of FAIS Services.

6. ATTORNEY CLIENT PRIVILEGE – DISHARMONIOUS CONSTRUCTION

Attorney-client privilege, in the context of investigations, is a legal doctrine that protects communications, including the work product, between a client and their legal counsel from disclosure to third parties including regulators, ensuring that sensitive information exchanged for obtaining legal advice remains confidential. In many Forensic Investigations, a CA may be retained under the direction of legal counsel specifically to maintain this protective umbrella, thus preserving privileged communications and related work products from forced disclosure.

However, the FAIS presupposes that the CA independently determines the scope and procedures of the engagement, without explicitly acknowledging the role of legal counsel over the investigatory process. This oversight can create tension: on one hand, the CA must comply with the FAIS; on the other, she is expected to operate under legal counsel’s instructions to maintain privilege. The resulting ambiguity raises serious questions about whether adherence to FAIS could inadvertently undermine attorney-client privilege, potentially compelling a CA to disclose information that would otherwise remain protected.

While the FAIS provides that CAs should consider the applicability of privilege while sharing evidence, the application of independence standards prescribed under FAIS may mean that umbrella of privilege may not be available, even if the CA is working under the directions of legal counsel. It is suggested that the ICAI should provide clarification that in relation to all work products protected by privilege, CA engaged through legal counsel may heed to the advice of the legal counsel, especially considering the applicable law which confers privilege on persons engaged by advocates under Section 132 (3) of Bhartiya Sakshya Adhiniyam, 2023.

7. SHARING INFORMATION WITH GOVERNMENT AGENCIES: BALANCING OBLIGATIONS AND CONFIDENTIALITY

“FAIS 240 – Engaging with Agencies” (“FAIS 240”) prescribes the standards in connection with interactions with Law Enforcement Agencies30 and Regulatory Bodies31 (collectively referred to as “Agencies”) in connection with FAIS Services. FAIS 240 clarifies that testimony32 is a statement provided to a Competent Authority33 such as a court, and is not included in the scope of FAIS 240. As such, it appears that any interaction with Agencies such as CBI or the ED, which are distinct from a Competent Authority, would fall under the scope of FAIS 240.

FAIS 24034, when read with Implementation Guide on FAIS 24035, appears to stipulate that a CA should provide information and / or clarifications to Agencies in connection with FAIS Services when called upon do so. FAIS 240 also stipulates that CAs should, in their engagement letters36, include clauses relating to sharing of information with Agencies without prescribing any guardrails on the nature or extent of information which is to be shared or any due processes to be followed, such as approval of or communication to the client, before sharing such information.


30 Defined in Paragraph 1.3 of FAIS 240 – Engaging with Agencies as 

“typically Central or State agencies mandated to enforce a particular law with the power to prevent,

 detect and investigate non-compliances with those laws. Their powers may be restricted

 by jurisdiction or by the law they are entrusted to enforce.”
31 Defined in Paragraph 1.3 of FAIS 240 -- Engaging with Agencies as

 “established to govern and enforce rules, laws and regulations for the benefit of public at large”

32 Defined in Paragraph 1.3(b) of FAIS 360 – Testifying before a Competent Authority - 

 as “A statement of the Professional whether oral, written or contained in electronic form,

 testifying before the Competent Authority on the facts in relation to a subject matter.”

33 Defined in Paragraph 1.3(d) of FAIS 360 – Testifying before a Competent Authority as 

“Competent Authority refers to a court of law (or their designated persons), an adjudicating 

authority or any other judicial or quasi-judicial regulatory body empowered under law to act as such.”

34 Paragraph 1.4(b) FAIS 240-Engaging with Agencies

35 Paragraph 3.2 of Implementation Guide on FAIS 240

36 Paragraph 4.4 FAIS 240-Engaging with Agencies

It also appears that FAIS 240 conflicts with the Basic Principles which prohibit the sharing of confidential information without the approval of the client, unless there is a legal or professional responsibility to do so and it can be argued that FAIS 240, which is specific, would take precedence over the Basic Principles, which are generic. Agencies can potentially use this argument to seek information from CAs, including that protected by attorney-client privilege, as refusal to share may be construed as non-compliance with FAIS which would in turn may lead to grounds for initiating disciplinary action against the CA.

It would be beneficial for the FAIS to explicitly provide exemptions for CAs from disciplinary action in situations where they refrain from sharing information to uphold attorney-client privilege, as outlined in FAIS 240. This clarification would further reinforce the principle of client primacy established in the Basic Principles.

8. CONCLUSION

While the FAIS are a laudable initiative to standardize and elevate forensic engagements, certain ambiguities and unrealistic requirements risk creating confusion and compliance challenges. The likely outcome and forum of a FAIS Service is litigation where it would be subject to extensive rigor and scrutiny. However, as discussed, the inherent ambiguities and sometimes, incompatible standards may impact the defensibility of a FAIS Service in a legal setting. Greater precision in defining key terms, a more realistic approach to independence in client-engaged scenarios, explicit accommodation for attorney-client privilege, and clearer guidance for in-house CAs are needed. By addressing these issues, the ICAI can ensure that the FAIS supports effective and credible investigative work.

Evolution of Audit: From Paper to Pixels

In this article, the evolution of audit practices from paper-based documentation to digital platforms is illuminated, highlighting how technology has revolutionized the approach towards Audit. This Article further explains how this transition to electronic documentation (“E-Documentation”) has helped significantly in improving efficiency, accuracy and transparency in audits. It allows for secure storage, easy retrieval and structured organization of audit files, which enhances internal and external review processes. Digital tools like automated resource management, cost management and certain electronic tools streamline the operations, while advanced data analytics techniques for sampling and journal entry testing bolster audit effectiveness by detecting errors and anomalies with greater precision. Embracing these innovations enables audit firms to elevate their practices, moving from routine tasks to insightful analyses, ensuring consistent and efficient audit procedures in the digital age.

“Change is the only constant”, as rightly quoted by Heraclitus, a Greek philosopher. The field of audit has embraced this notion of believing that change has always been by its side.

From handwritten documentation to digital algorithms, the evolution of audit has been a journey “from paper to pixels”. In this article, we explore the advancements that have shaped the audit scope, exploring how technology has upgraded the way audits are conducted and how professionals navigate to understand the audit processes adopted in the digital age.

As industries adapt to the rapid pace of technological advancement, the audit profession has been at the forefront of innovation, embracing digitalisation to revolutionise its practices. From the rigorous scrutiny of paper documents to the swift analysis of digital data, the evolution of audit has been nothing short of extraordinary.

In this article, we will delve into the importance of the article by discussing the following aspects:

  •  The shift from paper-based to digital audit practices.
  •  Evaluating the risk of the client before accepting a new client or an existing client.
  • Facilitating communication between the client and the engagement team.
  •  Advanced tools like data analytics which enhance transparency, accuracy and efficiency.

In the field of auditing, the transition from paper-based processes to digital platforms has resulted in exceptional efficiency, accuracy and transparency.

DIGITALISATION OF AUDIT DOCUMENTATION – “E-DOCUMENTATION”

Before digitalisation, audit documentation was primarily done using physical / paper-based methods. This involved extensive manual processes like paperwork, handwritten notes, printed financial statements and physical files for audit engagement. Auditors would manually document their findings, observations and procedures. The process of compiling and organising audit documentation was labour-intensive and time-consuming. Storage and retrieval of paper-based audit files posed significant challenges in terms of  space, security, confidentiality and maintaining documents in a systematic way. Overall, the pre-digitalisation era of audit documentation relied heavily on manual processes, paper-based records and physical documentation, which were susceptible to inefficiencies, errors and limitations in terms of accessibility and flexibility.

The era of digitalization paved the way for ‘E- documentation’. E- Documentation stands for Electronic Documentation and refers to securing, maintaining confidentiality and storing the documents electronically. This revolutionary change has proved to be significant for all the professionals pursuing the practice of audit.

The introduction of electronic documentation with various accounting and auditing tools, such as Suvit, facilitates the process of audit documentation. This has various built-in features, such as risk evaluation forms, auto-populated workpapers / questionaries, and communications within the audit team and between the audit team and the management. The auditor can analyze the level of risk for a particular audit engagement as well as it shall also help the auditor to design effective audit procedures to be undertaken for the audit engagement. Moreover, the work performed, findings and reports of an auditor right from the audit planning phase to the conclusion phase can be stored for a prolonged period of seven years as per SA 230 and can be retrieved whenever required. This features robust functionality for maintaining compliance with the maker-checker policy. Additionally, it incorporates a mechanism to imprint immutable timestamps, ensuring the integrity and non-editable nature of the records. E-Documentation serves as a trail for all the actions performed by the auditor during an audit.

Some of the merits of E-Documentation are mentioned below:

  •  Internal review

The cloud-based tool can be accessed by the audit team at any point in time. This facilitates smooth review within the audit team and between the audit team and the Subject Matter Experts (‘SMEs).

  •  External review

Due to the storage of documentation in a structured manner, it helps in efficient reviews by the external person as well (such as a peer reviewer, or any other regulatory body). All the relevant information and data related to the entity being audited is stored in a centralised manner. E- Documentation also ensures retrieval for a prolonged period, which enables any person to review the work done at any point in time.

  •  Roll forward

Apart from the merits mentioned above, the documentation stored in the audit file for a particular year can be utilised in subsequent years by rolling it forward. This process involves transferring audit documentation such as audit memos, workpapers, checklists, auditor’s assessment and conclusion from the previous year to subsequent years. This feature facilitates in planning procedures for subsequent year’s audits.

  •  Standard checklists

E-Documentation tool includes checklists designed to facilitate and support auditors’ work. These checklists feature questions related to audit procedures conducted related to various critical areas such as Going concern, impairment of investments / assets, etc. Audit firms can embed/customize standard checklists on Accounting Standards (AS), Auditing Standards, Company Auditor’s Report Order (CARO), 2020, Internal Financial Control, Companies Act, etc., in the software to ensure uniformity across all the engagements / clients. The audit team uses these checklists to document their actual work performed in the respective areas under examination. Further, these checklists also help in ensuring that any important thing in relation to the audit is not missed out.

  •  Restricted access

Further, access to the E-Documentation tool can be restricted to the audit team until and unless access is granted to the extended team members with prior approvals. This ensures privacy, confidentiality and security of sensitive client information and data. Further, since working papers are the property of the auditor, utmost care should be taken so that the independence of the audit is maintained before access is granted to any external member.

EVALUATING RISKS AT THE FIRM LEVEL — CLIENT ONBOARDING

The client acceptance procedures shall be focused on ensuring that the clients who are chosen to serve should represent an appropriate balance of risk and reward. The firm minimises the exposure to high-risk clients by identifying each before accepting any engagement and then determining whether the firm is willing to manage the exposure. Additionally, internal risk evaluations, annual inspections, practice risk assessment and continuous monitoring are all integral for ensuring that when a firm chooses to serve a client, the firm follows the policies and procedures and meets the industry standards. The client acceptance process shall be workflow-driven and shall be dependent on the type of services warranted by the client and the size of the engagement. It must require more than one level of approval (in terms of maker and checker), each of which shall be generated electronically to avoid any bias.

  •  Apart from assessing a new client, it is equally important to assess the existing client relationships / engagements as well. Hence, evaluating client continuance should be a periodic process due to which the risk parameters of an existing client are revalued/reassessed. Further, the client assessment should also be carried out if there is a significant change in the composition of Those Charged with Governance (TCWG).
  •  Engagement acceptance is required to be performed prior to initiating a new engagement, irrespective of whether the firm has continuously performed the engagement for an existing client or will be performed for a new client. The EAF shall be completed and approved prior to the commencement of an engagement.

Hence, the firm should have these kinds of electronic forms which help in assessing the acceptance of a client or an engagement, and if there is any risk on account of any fraud, litigation, etc., against the TCWG / management, then the tool will populate the risk to the engagement team to evaluate the matter in detail.

EFFICIENT ELECTRONIC DATA EXCHANGE BETWEEN THE CLIENTS AND AUDIT TEAM

As mentioned above, in the pre-digitalisation era, exchanging data within the audit team and between the audit team and the client used to be chaos. Various difficulties were faced with respect to its storage and collation; to a certain extent, this might have hampered the overall quality of the audit. However, the digitalisation of the audit processes has led to better work management.

These tools automate the preparation of detailed requirement lists and facilitate secure file sharing, which enables auditors to manage audits effectively. These tools facilitate a collaborative environment for auditors and the client, ensuring real-time progress tracking and simplifying data management. These tools function as centralized digital platforms that manage and organize documents, making it easier for users to locate and access necessary information by arranging documentation within a unified digital repository. It also facilitates the retention of data and information for a prolonged period.

Due to such pioneering change, since the storage of data is now centralized, it has become easier to streamline the audit.

DIGITAL TOOLS

Let us delve into the use of various digital tools and their purpose, which can be used in the audit processes. Maximising audit effectiveness entails harnessing the power of data analytics to transform traditional auditing practices. By integrating sophisticated data analytical tools and techniques, auditors can revolutionize: Resource and cost management; communicating initial audit requirements to the client; selection of samples & vouching and testing of journal entries (JE).

A. RESOURCE MANAGEMENT

Resource management involves planning, allocation and optimisation of resources efficiently to achieve the goals of the firm. Keeping meticulous track of time spent on engagements is pivotal for preserving the trust and transparency vital to professional relationships. The time spent by the audit team and keeping a record of this is of utmost importance. This helps in demonstration of the time spent by partner and manager on engagements which is paramount in ensuring the success and credibility/quality of the overall audit.

This brings a wealth of experience and expertise to the table, which is essential for maintaining high-quality standards throughout the audit process. Their involvement is crucial in overseeing audit procedures meticulously, analyzing financial statements accurately and drawing well-supported audit conclusions.

Moreover, partners and managers play a pivotal role in managing audit risks effectively by identifying potential issues early on and implementing appropriate responses. Their technical knowledge allows them to address complex accounting matters with precision, ensuring compliance with auditing standards and regulatory requirements. Beyond technical aspects, their interaction with clients fosters clear communication, manages expectations and strengthens client relationships.

Additionally, partners and managers provide rigorous review and oversight of audit work performed by junior staff, ensuring thoroughness and accuracy in audit findings. Ultimately, the time invested by partners and managers in audit engagements not only enhances the quality of audits but also upholds the firm’s commitment to integrity, independence and ethical practices in auditing. By aligning costs with the services provided, clients are assured of fair invoicing, reinforcing confidence in the partnership. Moreover, this practice facilitates efficient resource allocation and project management, empowering firms to evaluate process effectiveness, pinpoint areas for enhancement and refine future resource distribution strategies.

B. EFFECTIVE COST MANAGEMENT

The documentation of work conducted during engagements serves multifaceted purposes. It not only provides a detailed record of audit procedures but also furnishes invaluable support for quality control evaluations. Assigning unique job codes to each engagement streamlines this process, simplifying cost analysis and bolstering accountability by correlating time expenditures with specific client projects or internal endeavours. This systematic methodology not only optimises billing procedures but also fortifies project management structures, culminating in an overall improvement of operational efficacy across the organisation.

C. COMMUNICATING INITIAL AUDIT REQUIREMENTS “PREPARED BY THE CLIENT (PBC)”:

“PBC” stands for “Prepared by Client.” This term refers to the documents and schedules that the client prepares and provides to the auditors as part of the audit process. These documents facilitate the auditors’ examination of the Company’s records and support the information presented in the financial statements. This typically includes reports, schedules, listings, vouchers and reconciliations.

Numerous interactions between clients and auditors make it challenging to track all the requirements and communications. To address this, an electronic PBC tool can be adopted to streamline the process. This tool allows the insertion of agreed timelines for data sharing and ensuring deadlines are met. It provides a robust review mechanism and enables task assignment to team members on both the auditor and the client sides. It also helps in improving collaboration and accountability. Importantly, it allows critical issues to be highlighted for partners or managers efficiently.

Adopting an electronic PBC tool enhances transparency and efficiency in the audit process. It ensures all communications and document submissions are tracked accurately, which reduces the risk of oversight.

This technology fosters a more organized and effective audit, leading to better outcomes and smoother operations for both auditors and the client.

D. SAMPLING AND VOUCHING

Diverse sampling methods in auditing, such as statistical, random, systematic, stratified, block, judgmental and haphazard sampling, offer tailored approaches to the auditor. Each method presents distinctive benefits, ensuring comprehensive, effective and efficient audit.

A FEW OF THE SAMPLING METHODS ARE EXPLAINED BELOW:

Statistical sampling: A method of selecting a subset of items from a population using statistical techniques to ensure that the selected subset is representative of the entire population.

Random sampling: A technique where each item in the population has an equal chance of being selected, eliminating bias and ensuring that the sample is representative of the entire population.

Systematic sampling: A method where items are selected at regular intervals from the entire population, starting from a randomly chosen number and then every 10th item of the entire population.

Stratified sampling: A technique where the population is divided into distinctive sub-groups (strata) based on specific characteristics, and samples are extracted from each sub-group to ensure that the selected sub-group is representative of the entire population.

Block sampling: A method where the population is divided into blocks or clusters, and entire blocks / clusters are selected randomly to form the  sample, often used when items within blocks / clusters are more like each other than items in the other blocks / clusters.

Judgmental sampling: A non-random method where the auditor selects items based on professional judgment, often used when specific items are believed to be significant, and the selection will be representative of the entire population.

Haphazard sampling: A non-random method where items are selected without any specific plan or pattern.

Further, for vouching, the audit team can also deploy data analytics, which enhances transaction verification, automates tasks and improves accuracy, thus streamlining processes and conserving resources. Advanced data analytical tools enable efficient cross-referencing of transactions with source documents which further helps in minimising errors.

E. JOURNAL ENTRY (JE) TESTING

JE Testing involves reviewing and verifying the accuracy and validity of financial transactions recorded in the Company’s books of account. Through data-driven approaches, auditors can identify patterns, anomalies and trends within large datasets, allowing for more targeted and efficient sampling methodologies (to a certain extent mentioned in the earlier sections).

Advanced data analytics enable auditors to scrutinise transactions with greater precision, enhance the detection of errors and irregularities, and ensure a more thorough examination of financial transactions, thus providing the outcome efficiently. Further, these data analytical tools help in scrutinising journal entries for accuracy and legitimacy, which facilitates the auditor to flag suspicious entries and provide deeper insights into financial transactions.

VARIOUS TESTS IN JE TESTING ENCOMPASS:

  •  Keyword analysis: Search for specific words or phrases like “bribe” or “charity” within worksheets.
  •  Year-End entries: Analyse journal entries made nearer to year-end dates.
  •  Public holiday entries: Review entries on holidays to detect unusual or large transactions and assess their reasonability.
  •  Weekend entries:Scrutinise entries, especially passed on weekends and evaluate their nature.
  •  Materiality assessment: Review entries above the materiality to identify unusual transactions.
  •  Single entry verification: This means that basic accounting method where each transaction is recorded once rather than using a double-entry system. It is important to ensure that no single entries are mistakenly passed into the books of account.

Incorporating digital tools and data analytics enhances audit effectiveness by optimising resource management, improving cost efficiency and facilitating clear communication of audit requirements. Advanced sampling techniques and JE testing with data analytics further strengthen accuracy and reliability, ensuring thorough scrutiny of financial transactions. These innovations not only streamline processes but also uphold integrity, independence and compliance with auditing standards, ultimately fostering robust audit outcomes and client & regulatory satisfaction.

CONCLUSION

Hence, the suggested tools for audit digitalization and optimization are merely a starting point and not an exhaustive list. These tools exemplify how technology can significantly enhance the audit process, from manual documentation to resource management to risk assessment; effective communication between the client and the engagement team and using Digital tools truly harnesses the benefits of these advancements.

Audit firms and their quality control departments must mandate the use of these digital tools, ensuring consistent, accurate and efficient audit practices.

By embracing these innovations, audit firms can transform their practices from routine tasks to insightful analyses, unlocking new levels of precision and efficiency. The future of auditing is bright and with these tools, firms will be well-equipped to lead the charge into this exciting new era

Key Year End Audit Considerations

Statutory Audit of financial statements is mandatory for all companies under the Companies Act, 2013. Whilst audit process commences well before the close of the financial year, for issuing the audit report attention needs to be paid to certain key matters as at the financial year end. Regulators like SEBI, NFRA, ROC, etc. are also keeping a close watch on the information contained the financial statements and the audit report through inspection of the audit work papers and other documents. The focus areas for the regulators generally cover matters regarding modified audit report, reliance on estimates, fraud risk factors, related party transactions, communication to those charged with governance and compliance with laws and regulations keeping in mind the overarching principle of materiality. Any slippages in these critical areas can make or break the reputation of the audit firms and their personal.

1. INTRODUCTION

Presentation and disclosure in financial statements play an important role in providing transparency to stakeholders. They help users to understand the financial health and performance of a company. Regulators are putting more emphasis on presentation and disclosures in financial statements due to increased stakeholder expectations, higher focus on public interest, and ongoing efforts to enhance global harmonization and prevent financial irregularities and frauds.

In today’s volatile market, every company is grappling with multiple challenges. Uncertainty in laws and regulations and economic volatility have put immense pressure on companies. Whereas earlier the annual reports were a thin booklet, currently, their size has increased manifold, which includes the financial statements and statutory auditors report issued to the members of a company under the Indian Companies Act, 2013 “(the Act”). Further, even though the audit report is addressed to the members since the annual report is mandatorily required to be hosted on the company’s website by listed companies under SEBI guidelines, there is no limit on the public accessibility thereof, making companies more accountable.

Finally, regulators like the Securities and Exchange Board of India (SEBI), Registrar of Companies (RoC), National Financial Reporting Authority (NFRA), etc., are keeping a close watch on the information, especially the audited financial statements and the report thereon which are available in public domain.. These regulators have regulatory powers to conduct inspections to delve into the working papers and documents of an audit firm to check if there is any lacuna in the audit procedures followed by the auditor and whether the auditor has complied with relevant Standards on Auditing (“SAs”).

With the end of the financial year (FY) 2024-25 around the corner, the hustle and bustle of audit have already commenced. This article presents some of the key year-end considerations for the auditors that they should keep in mind while performing the audit.

KEY CONSIDERATIONS PERTAINING TO AUDITOR’S REPORT

On completion of the audit, the auditor is required to issue an audit report to express the audit opinion. The following Standards on Auditing deals with respect to audit conclusions and reporting:

  •  SA 700 (Revised), Forming an Opinion and Reporting on Financial Statements
  •  SA 701, Communicating Key Audit Matters in the Independent Auditor’s Report
  •  SA 705 (Revised), Modifications to the Opinion in the Independent Auditor’s Report
  •  SA 706 (Revised), Emphasis of Matter Paragraphs and Other Matter Paragraphs in the Independent Auditor’s Report
  • SA 720 (Revised), The Auditor’s Responsibilities Relating to Other Information

SA 700 (Revised) prescribes the content of an audit report, which should, at a minimum, be forming part of the audit report. The following are certain issues requiring careful consideration:

A. QUANTIFICATION IN QUALIFICATIONS

It is pertinent to note that pursuant to paragraph 21 of SA 705 (Revised) if there is a material misstatement of the financial statements that relate to specific amounts in the financial statements (including quantitative disclosures in the notes to the financial statements), the auditor is required to include in the Basis for Opinion paragraph a description and quantification of the financial effects of the misstatement, unless impracticable. If it is not practicable to quantify the financial effects, the auditor is required to state that fact in this section. Where an accurate quantification is not possible, but a management estimate is available, the auditor performs such audit tests on those management estimates as are possible and clearly indicates that the amount quantified is based on management’s estimate. If it is impracticable for the auditor to quantify or estimate the effect of the misstatement, this fact needs to be included in the Basis for Modified Opinion paragraph.

Therefore, the auditor needs to quantify the financial effects of the misstatement, and only if it is impracticable, the auditor can include the qualification without quantification. The word ‘impracticable’ is not defined in Standards on Auditing but is commonly understood as ‘after making every reasonable effort’ to do so.

B. OTHER MATTER

As per paragraph 10 of SA 706 (Revised), if the auditor considers it necessary to communicate a matter other than those that are presented or disclosed in the financial statements that, in the auditor’s judgment, is relevant to users’ understanding of the audit, the auditor’s responsibilities or the auditor’s report, the auditor is required to include an “other matter” paragraph in the auditor’s report, provided:

  •  That is not prohibited by law or regulation; and
  •  When SA 701 applies, the matter has not been determined to be a key audit matter to be communicated in the auditor’s report.

An auditor should not include other matter paragraph for matters adequately disclosed in the financial statements. It can be included, for example, to highlight that in case the audit of some of the components of a company has been audited by other auditors, then this fact is required to be presented in the audit report to the consolidated financial statements under the “Other Matters” paragraph. However, in view of the recommendation by NFRA for revision of SA-600 on the lines of ISA 600, it needs to be seen whether the reference to the work of other auditors will be permissible.

C. EMPHASIS OF MATTER VS. QUALIFIED OPINION

Another important area is the use of the ‘Emphasis of matter’ (EOM) paragraph in the auditor’s report.
As per paragraph 8 of SA 706 (Revised), if the  auditor considers it necessary to draw users’ attention to a matter presented or disclosed in the financial statements that, in the auditor’s judgment, is of such importance that it is fundamental to users’ understanding of the financial statements, the auditor should include an Emphasis of Matter paragraph in the auditor’s report provided:

  •  The auditor would not be required to modify the opinion in accordance with SA 705 (Revised) as a result of the matter; and
  •  When SA 701 applies, the matter has not been determined to be a key audit matter to be communicated in the auditor’s report.

EOM paragraph should not be included as a substitute for modification. For example, if the company has not provided adequate requisite disclosures in its financial statements, the auditor should evaluate the requirement to express a qualified opinion on the basis of the requirement of SA 705 (Revised) and should not include an EOM paragraph.

Examples of circumstances where the auditor may consider it necessary to include an Emphasis of Matter paragraph are:

  •  Uncertainty relating to the future outcome of exceptional litigation or regulatory action.
  •  A significant subsequent event that occurs between the date of the financial statements and the date of the auditor’s report.
  •  Early application (where permitted) of a new accounting standard that has a material effect on the financial statements.
  •  A major catastrophe that has had, or continues to have, a significant effect on the entity’s financial position.

KEY CONSIDERATIONS PERTAINING TO ESTIMATES (INCLUDING USING THE WORK OF MANAGEMENT EXPERTS)

The auditor is required to perform adequate procedures to obtain sufficient appropriate audit evidence for estimates and complex transactions. The auditor should maintain documentation in sufficient detail to demonstrate the following:

  •  Competence, capabilities and objectivity of management experts have been determined (the auditor should consider the self-interest threat of the management expert when numerous valuation assignments from other group companies were being performed by the same valuer);
  •  Evaluating for management bias;
  •  Procedures performed in order to determine the reasonableness of the assumptions/methods used by management experts;
  •  Procedures performed by the auditor over management assessment;
  •  Professional judgements made by the auditor in concluding on high-estimate areas;
  •  In case of critical estimates/balances, involve internal experts for determining the appropriateness of the assumptions/methods used for valuation;
  •  In case there are caveats in the valuation report, legal opinions, etc., documentation on how the auditor has dealt with those

KEY CONSIDERATIONS PERTAINING TO COMMUNICATION WITH THOSE CHARGED WITH GOVERNANCE (TCWG)

SA 260 (Revised), Communication with TCWG requires the auditor to communicate significant findings from the audit with those charged with governance. This is another key focus area for the regulators. Some of the key considerations are as follows:

  •  TCWG comprises a Board of Directors, Audit Committee and Management. Communication with the Audit Committee is not sufficient.
  •  Auditors should maintain documented evidence for:

– Communication of the planned scope and timing of the audit with TCWG.

– Minutes (“what and when”) of meeting with the TCGW/Audit Committee, including the team’s conclusion on the matters discussed.

– Accounting/auditing matters discussed with TCWG during the initial planning meeting and their final resolution

  •  Critical matters should be communicated to TCWG, and regular discussions with the management should be documented.
  •  Audit committee presentation contains only management’s estimate/representation, does not include audit procedures performed and auditor’s conclusion
  •  Minimum communication with TCWG to ensure compliance with SA 260

– Auditor Independence

– The Auditor’s Responsibilities in Relation to the Financial Statement Audit

– Planned Scope and Timing of the Audit

– Significant Findings from the Audit, including the auditor’s assessment

– Inquiries with TCWG and response thereto

NFRA recently issued “The Auditor-Audit Committee Interactions Series 1”, which draws the attention of the auditors to the potential questions the Audit Committee / Board of Directors (BoD) may ask them in respect of accounting estimates and judgements. The first in the series in this regard includes aspects pertaining to the audit of Expected Credit Losses (ECL) for financial assets and other items as required by Ind AS 109, Financial Instruments.

SA 260 also requires the auditor to communicate with TCWG about qualitative aspects of the accounting practices, policies and disclosures. The reason behind such a communication is that the views of the auditor would be particularly relevant to TCWG in discharging their responsibilities for oversight of the financial reporting process.

This series put forwards some key questions relating to the following topics which the BoD / Audit Committee may ask the auditor regarding the audit of ECL:

  •  Audit of ECL computation
  •  Test of design and operating effectiveness of control mechanism over recognition and measurement of ECL
  •  Audit of methodology used for ECL computation

KEY CONSIDERATIONS RELATED TO INTERNAL CONTROLS OVER FINANCIAL REPORTING (ICFR)

The auditor has to report under section 143(3) of the Act as to whether the company has adequate internal financial controls in place and the operating effectiveness of such controls. As per the Act, the term ‘internal financial controls’ means the policies and procedures adopted by the company for ensuring the orderly and efficient conduct of its business, including adherence to the company’s policies, the safeguarding of its assets, the prevention and detection of frauds and errors, the accuracy and completeness of the accounting records, and the timely preparation of reliable financial information. The Guidance Note on Audit of Internal Financial Controls Over Financial Reporting states that the auditor’s objective in an audit of internal financial controls over financial reporting is to express an opinion on the effectiveness of the company’s internal financial controls over financial reporting and the procedures in respect thereof are carried out along with an audit of the financial statements. Because a company’s internal controls cannot be considered effective if one or more material weakness exists, to form a basis for expressing an opinion, the auditor must plan and perform the audit to obtain sufficient appropriate evidence to obtain reasonable assurance about whether material weakness exists as of the date specified in management’s assessment.

Some of the key areas which require careful consideration are as follows:

  •  Evaluation of controls over management override as part of entity-level controls; the auditor should maintain adequate documentation and procedures for controls around management override (remain cautious that deviation to the process might be a red flag for management override).
  •  Evaluation of management testing of ICFR is critical, and its impact on ICFR conclusion should be documented. Inquiries with the internal auditor and evaluation of the role of the internal auditor, and a review of internal audit reports and the auditor’s conclusion should also be documented.
  •  Adequate testing/focus even on non-critical areas (e.g. PPE)

KEY CONSIDERATIONS RELATING TO SIGNIFICANT UNUSUAL OR HIGHLY COMPLEX TRANSACTIONS

Material misstatement of financial statements, including fraudulent financial reporting, can arise from significant unusual or highly complex transactions, including situations that pose difficult “substance over form” questions, such as transactions not in the ordinary course of business undertaken with related parties. The Standards on Auditing give particular attention to the accounting for and disclosure of such transactions in the context of the auditor’s identification and assessment of risks of material misstatement, whether due to error or fraud and the auditor’s responses thereto.

The auditors are required to exercise professional judgment and maintain professional skepticism throughout the planning and performance of an audit and, among other things, identify, assess and respond to risks of material misstatement, whether due to fraud or error. Accordingly, the auditor plans and performs an audit with professional skepticism, recognising that circumstances may exist that cause the financial statements to be materially misstated. Maintaining professional skepticism throughout the audit is necessary if the auditor is, for example, to reduce the risks of overlooking unusual circumstances. The auditor is required to:

  •  Evaluate whether information obtained about the entity indicates that one or more fraud risk factors are present; for example:

♦ Significant related party transactions not in the ordinary course of business or with related entities not audited or audited by another firm; and

♦ Significant, unusual, or highly complex transactions, especially those close to period end that pose difficult “substance over form” questions

♦ Inquire of management and others within the entity as appropriate about the existence or suspicion of fraud, including, for example, employees involved in initiating, processing or recording complex or unusual transactions and those who supervise or monitor such employees;

♦ Inquire of management and others within the entity, and perform other risk assessment procedures considered appropriate to obtain an understanding of the controls, if any, that management has established to:

♦ authorise and approve significant transactions and arrangements with related parties; and

♦ authorise and approve significant transactions and arrangements outside the normal course of business;

If the auditor identifies significant transactions outside the normal course of business, inquire management about the nature of these transactions and whether related parties could be involved.

Fraudulent financial reporting often involves management override of controls that otherwise may appear to be operating effectively. Management override of controls or other inappropriate involvement by management in the financial reporting process may involve such techniques as omitting, advancing or delaying recognition in the financial statements of events and transactions that have occurred during the reporting period or engaging in complex transactions that are structured to misrepresent the financial position or financial performance of the entity. The auditor is required to treat the risk of management override of controls as a risk of material misstatement due to fraud and, thus a significant risk.

COMPLIANCE WITH LAWS AND REGULATIONS

Compliance with laws and regulations is a crucial aspect which engages the attention of auditors for which they need to keep in mind the requirements laid down in SA-250. Auditors are primarily concerned with the non-compliance with Laws and Regulations that materially affect financial statements, which includes the following, amongst others:

  •  Form and content of financial statements, including amounts to be reflected and disclosures to be made (Schedule III, Banking Regulation Act, Insurance Act, SEBI Mutual Fund guidelines, etc.)
  •  Conducting of business including licensing and registration (Banks, Mutual Funds, NBFCs, Pharmaceutical companies, fertilizer companies, etc.), which could have potential going concern issues
  •  Operating aspects of the business (Provisioning, valuation, taxation, safety aspects etc.) with possible financial consequences like fines, penalties, etc.

Adequate and appropriate procedures need to be performed to identify instances of non-compliance:

  •  Inquiries with the Management.
  •  Inspecting correspondence with relevant statutory authorities.
  •  Reading the minutes.
  •  Appropriate Control and Substantive procedures for industry-specific requirements like provisioning, valuation, accrual of expenses for retirement benefits, computation of incentives and subsidies etc.

Following are some of the instances of non-compliance which need to be considered in the context of year-end financial reporting:

  •  Non-payment / delayed payment of statutory dues (CARO reporting).
  •  Non-compliance with certain statutory and procedural requirements under various laws in respect of certain transactions or investigations by government departments resulting in fines and penalties or other demands and consequential disclosure of contingent liabilities or making provisions.
  •  Unsupported transactions, especially with related parties.

KEY CONSIDERATIONS PERTAINING TO MATERIALITY

The concept of materiality is the final test which determines the nature and extent of reporting and the issuance of the final opinion in the audit report as to whether the financial statements present a fair view. It helps to determine the material misstatements. As per SA 320, misstatements are material if they, individually or in aggregate, could reasonably be expected to influence the economic decisions of the users taken on the basis of financial statements. Whilst generally materiality is determined on a quantitative basis, in certain situations, misstatements may be qualitatively material, which needs to be kept in mind during year-end reporting as follows:

  •  Transactions resulting in changing loss into profit and vice versa.
  •  Transactions having an impact on compliance with debt covenants (e.g. current ratio, DSCR, etc.)
  •  Transaction has an impact on contractual agreements.
  •  Transaction has an impact on compliance with regulatory provisions.
  •  Transaction has an effect on variable compensation payable to Key Managerial Person.
  •  Transaction resulting in fraud or omission or commission.

The following are the different stages in the calculation of materiality.

  •  Planning Materiality: It is computed as the overall materiality representing a threshold above which the financial statements could be misstated and would affect the economic decision of the user of the financial statements. It depends on the size of the organization, types of transactions, character of management and auditor’s judgement and is set as a percentage of the profit, assets or net worth depending upon the nature of the entity.
  •  Performance Materiality: It is an amount less than overall materiality and acts as a safety buffer to lower the risk of aggregate uncorrected and undetected misstatements, which could be material for overall financial statements.
  •  Specific Materiality: It is established for a class of transactions, account balances and disclosures.

The materiality must be appropriately calculated since that has a bearing on the aggregate uncorrected and undetected misstatements and the consequential impact on the overall audit opinion.

CONCLUSION

Audit of financial statements is no longer about simply issuing an audit report but demonstrating and documenting the conclusions reached in respect of all auditing standards, as applicable to a particular company, especially in respect of matters requiring modification, reliance on estimates, fraud risk factors and related party transactions, amongst others whilst at the same time ensuring compliance of all relevant laws and regulations keeping in mind the overarching principle of materiality. With the constant inspections to which the auditors are exposed, any material deviations, especially in the aforesaid critical areas, can make or break the reputation and hard work built by the audit firms and the individual partners/proprietors and senior audit team members with severe consequences like fines and penalties and debarring the firm from undertaking audits.

Forensic Accounting & Investigation In Healthcare Industry – Challenges & Opportunities

Forensic Accounting – The word forensic accounting makes you think about frauds, misappropriation, manipulation, embezzlement, illegal activities that can be detected from the examination of financial statements, books of accounts and other such documents with the intention to detect, investigate, or prevent any fraud.
Healthcare activities covers every section of the society. Due to wide spread and complex nature of activities, fraud may occur at any given point in the cycle, starting from patient registration at a healthcare centre or a hospital to the final prescription given to the patient.

INTRODUCTION

Forensic Accounting – The name itself causes you, the reader to promptly think about frauds, misappropriation, manipulation, embezzlement, illegal activities related to finance, etc. Yes, forensic accounting is related to the examination of financial statements, books of accounts and other such documents with the intention to investigate, detect or prevent any fraud. Unlike other audits, statutory or otherwise, the forensic accounting is not mandated under any statute. However, The Institute of Chartered Accountants of India has issued the Forensic Accounting and Investigation Standards on 1st July, 2023. Also, these standards are mandatorily applicable to all the Forensic Accounting engagements conducted on or after 1st July, 2023. Hence, mostly, forensic accounting is seen as an audit similar to a statutory audit or a tax audit since it also involves the examination of financial statements and books of accounts. However, it has more facets to it.

Forensic accounting is conducted with the main aim of gathering information and acquiring minute details about the financial matters of an entity or an individual, which can be put forth as admissible evidence in a court of law. As the judicial aspect is involved, forensic accounting goes beyond the step of regular audit, towards investigation. Forensic accounting requires a comprehensive set of skills and investigative techniques to corroborate the evidence of any fraud that has been committed or instances where an entity is prone to fraud. Generally, it is said that an auditor is a ‘watchdog’ and not a ‘bloodhound’. However, it can be said that a forensic accountant is a ‘bloodhound’.

Forensic Accounting covers various areas and industries where different investigative approaches have to be curated that suit the type of industry. The approach decides the investigative techniques to be used while conducting a forensic accounting engagement. Every sector is prone to frauds. In this article I take up the Healthcare industry.

HEALTHCARE INDUSTRY & FRAUDS

Healthcare Industry has several cycles and interactions which are two way — where both provider and recipient interact. Its spread and need is pervasive. One reason for susceptibility for fraud is the cyclical nature of activities. The following may be the normal structure of the cycle:

  1.  Patient Registration
  2.  Appointments
  3.  Patient diagnosis
  4.  Utilisation of services
  5.  Billing & Coding
  6. Payment
  7. Prescription
  8.  Medical Follow-up
  9.  Insurance Claim (Reimbursement or Cashless) and back to Step 1

A fraud may occur at any given point in the cycle mentioned above, starting from patient registration at a healthcare centre to the final prescription given to the patient. It is important to note that, unlike cyber frauds where the victim is mostly the consumer, in the case of the healthcare industry, apart from the patient, fraud can be perpetrated on the healthcare provider, health insurance provider, etc., by a frivolous lawsuit, fake claim of insurance, deliberate targeting of a healthcare centre or a hospital with the intention of harming its reputation, etc. Furthermore, healthcare centres or large hospitals are also prone to organisational frauds, leading to reputational embarrassment and loss of credibility.

A number of frauds are being detected in the healthcare industry at various levels, which underlines a worrying truth, i.e., “Wealth is Health”. Frauds are committed with the sole purpose of acquiring money illegally, immorally and at the cost of human health. Frauds are committed over intricate issues which are difficult to detect or prevent without the help of forensic accounting. Even though fraud might have a negative financial impact, it is not the only issue at hand. Major consequences regarding human health are being faced by numerous patients, their relatives, etc. due to frauds perpetrated on them and the dire fact is that the healthcare system in India is under heavy risk of fraud and manipulation. Frauds in the healthcare industry may be characterized into 2 categories:

  •  Deliberate Offences
  •  Offences occurring due to ignorance / over-tolerance / lack of vigilance

Deliberate offences include fraudulent activities carried out in order to defraud an individual or an entity carrying out its operations in the healthcare industry. Fraudulent activities may include providing false information about patients and their diagnosis, mishandling of critical information about patients, false and incorrect claims lodged with insurance companies, fake prescriptions for medicines which are not at all required but made only to claim reimbursement for the same, etc.

Offences occurring due to ignorance are mostly due to the casual approach. It includes cases where medical ethics are not followed, and overbilling is tolerated just because the patient was critical, upcoding of services which were not even prescribed but have been added to the billings, and illegal supply of drugs, medicines, and other medical equipment without proper entries at the medical stores, etc.

These are just some examples which are known and have been discussed later in this article. However, the list is not exhaustive since perpetrators find various ways to commit frauds when it comes to the healthcare industry, and the lack of a strong monitoring and safeguarding system helps them get away with it.

Following are various types of frauds in the healthcare industry that have made it vulnerable and how the number of frauds is growing day by day due to a lack of a standardized and structured forensic accounting procedure, which is adding fuel to the fire.

PATIENT INFORMATION MANAGEMENT

Whenever a person registers as a patient at a healthcare centre or a hospital, his/her critical and personal information is gathered in order to make proper and accurate records. These records not only contain the health issues of the particular person but also contain the medical history of his / her family. The doctor is assisted by this information while prescribing medicines or further medical procedures or tests. Such critical information has to be stored with proper safeguards, and it has to be ensured that there is no unauthorized access to the same. However, perpetrators hack into the system, use fake user IDs to enter the system, attempt to control the system from an undisclosed location, etc., only to gain access to patient records. Once the information is accessed, the same is sold to various companies or parties for hefty prices. Another way to perpetrate the fraud is through an insider. An employee of the healthcare centre or hospital acts in an unethical way in exchange for bribes, a guarantee of promotion, or any other enticement or incentives, etc., when he/she provides access to the records without tampering with the system. In this age of digitization and advanced information technology, one of the most important aspects of human life is data privacy. Hence, data has become more valuable than money and the healthcare industry is an avenue where fraudsters can have a plethora of personal information at their hands. Forensic accounting and investigation provide a comprehensive approach where investigative techniques are used in order to find lacunas with the system or any other technological aspect of the entity which may make it prone to fraud. At the same time, it shall be conducted in a way where the findings shall be admissible as evidence in the court of law.

Furthermore, such information, which is gained unlawfully, is also utilized to make false insurance claims, leading to insurance fraud. Mostly, this is done in order to dupe the insurance companies and acquire funds in an illegal way. Insurance fraud is an area where forensic accounting and investigation can assist companies in verifying whether the claims launched are legitimate and true. A forensic accountant can apply a string of audit and investigative procedures to ensure the legitimacy of a claim, which shall protect the insurance company from falling prey to a fraudulent claim.

PRESCRIPTIONS & MEDICATIONS

In India, chemists and medical shops are allowed to sell both prescribed as well as non-prescribed drugs, medicines, etc. This is another grey area where multiple levels of frauds are perpetrated, and these are difficult to detect since the amounts involved in these frauds are negligible, but overall, they have a huge impact. Fake prescriptions are prepared in order to claim reimbursements; multiple prescriptions are collected from various doctors and medical practitioners in order to gain access to certain prescribed medicines. Once these medicines are purchased on the basis of a fake prescription, the medicines are sold illegally at exorbitant prices without any proper billings. Otherwise, there have been cases where such medicines are used for substance abuse with prescription drugs not being used for their intended medical objective.

Have you ever wondered when you visit a certain doctor / medical practitioner or a hospital, and they provide you with a prescription for medicines, those medicines are available only at the medical stores affiliated with the hospital or which are set up within the hospital premises or only in selected medical shops? One might ponder upon the thought that since these are prescription drugs, they should be available at almost every medical shop. However, this is not the case. The patient has no choice but to purchase medicines from selected medical shops or the ones within the hospital premises. What could be the logic behind this? Why is there a compulsion on the patient to purchase medicines from certain medical shops only? Why are they not provided with an option to purchase medicines from a medical shop of their own choice? It seems that the doctors / medical practitioners or the hospitals have a nexus with the medical shops where the medical shops keep such medicines in their stock in huge quantities, which the doctor/medical practitioner shall prescribe. It is pre-decided as to what brand of the medicine shall be prescribed and only that brand of medicine is ordered in wholesale by the medical shop. Due to this pre-arrangement, a patient is unable to acquire medicines from a medical shop of his/her own choice since that medical shop does not have the stock of the prescribed medicine. This stems to a whole new level of fraud since an illegal nexus has been formed where the patients are being tricked and are given no choice but to buy medicines and other medical items from selected stores only. Forensic accounting function at this level may assist in investigating the types of medicines being prescribed. It may provide a structure to prepare a database which shall duly prompt the auditor to report where a particular brand of medicine is being prescribed frequently. The reasons for the same shall be sought from the management.

Furthermore, a forensic accounting function may provide insights related to the pricing of the medicines where it can be investigated that a doctor / medical practitioner or a healthcare center or a hospital is prescribing expensive medicines in most cases, whereas medicines with similar ingredients for a same diagnosis are available in the market which are priced at lower rates. Another point of malpractice could be the rates of the medicines where certain medical shops provide medicines at their Maximum Retail Prices whereas certain medical shops apply huge discounts for the same medicines. If the patient is not given the option to purchase the medicines from the medical shop of his own choice, he / she might end up paying more since the discount scheme may not be available at the affiliated medical shop or the medical shop within the hospital premises. Yes, there is a National Pharmaceutical Pricing Authority (NPPA), a government agency responsible for setting prices of drugs and ensuring medicines are available across the country. It published an Analysis Report in 2018, which included facts that private hospitals procure medicines and other medical equipment at very low prices and sell them to patients at much higher prices, with profit margins going beyond 500 per cent for some items. However, not everything falls under the ambit of the NPPA. Items such as diagnostic services and devices do not come within the purview of NPPA and, hence, have been found to be overpriced.

In most cases, it was noted that nearly 15% of the total bill was for diagnostic services with the prices being at a higher side. The NPPA reported that profit margins for “Non-Scheduled Devices” such as syringes and catheters were “exorbitant and clearly a case of unethical profiteering in a failed market system”. In the case of a reputed private hospital, as reported by the Economic Times in December 2017 and the report of the NPPA, it was found that certain devices and medical equipment were charged to the patients at a very high price, whereas it was procured by the hospital at a very low price. For example, a bed wet wipe used to clean the patient was procured by the hospital at ₹33 per unit; however, it was charged to the patient at ₹350 per unit with a profit margin of a whopping 960 per cent. Apart from that, disposable syringes without needles used for the treatment was procured by the hospital at ₹13.60 apiece yet it was charged to the patient at ₹200 a piece, an increased markup of 1370 per cent. A thorough forensic accounting and investigation function may help curb such practices and bring to light such instances where patients are required to pay more just because it is the hospital policy to purchase medicines from selected stores only and at the prices stated by the hospitals.

OVERCHARGING FOR MEDICAL PRODUCTS & SERVICES

Generally, treatments provided in private healthcare centres or hospitals or clinics are expensive, and they charge the patients for every single service provided, including accommodation. As per the Analysis Report of the NPPA, it was found that the largest items on the hospital bills were drugs, devices and diagnostics, which comprised nearly 56 per cent of the total bill, which was higher than the charges for medical procedures and room rent which comprised around 23 per cent of the total bill. As per the “Health in India” Report from the 71st Round of the National Sample Survey, around 58% of households in rural areas and around 68 per cent of households in urban areas prefer private hospitals for in-patient treatments. Hence, the reliance of the public on private hospitals is key for such hospitals to rake up the prices for better services. There is a need for a regulator to keep a check on these issues.

As far as the law is concerned, the NPPA classifies medical items, including medicines and drugs, into 3 categories:

  •  Medicines under Price Control
  •  Medicines not under Price Control
  •  Consumables that are neither under Price Control nor under the country’s list of essential medicines

Here is the interesting part. Scheduled Medicines come under essential medicines, which ultimately are covered under the price control mechanism whereas Non-Scheduled branded medicines are not covered under the price control mechanism. Hence, the drug-making companies often bring into the market new variants of scheduled drugs as “new drugs” or “fixed drugs combinations” in order to escape the price control mechanism. The healthcare centres or the hospitals taking advantage of the same and to earn higher profits, often prescribe Non-Scheduled branded medicines instead of Scheduled Medicines. Hence, this could be another area where an effective Forensic Accounting function can investigate such matters and provide various counter-measures to ensure that instances of overcharging are avoided in the future.

KICKBACK SCHEMES

To start with, kickback in the healthcare industry is defined as an arrangement where a doctor / medical practitioner is paid for patient referrals. This payment may be in cash or kind. Cases have been found where kickbacks include payments in the form of bookings of international flights, overseas vacations, expensive appliances, five-star hoteling, etc. It can be seen in normal cases where an ENT (Ear-Nose-Throat) specialist recommends his/her patient to get certain tests done by a radiologist, a pathologist, or a doctor who recommends each of his/her patients to get their hearts checked out by a heart specialist surgeon for no concrete reason, etc. In most cases, the patients do not ignore such advice being a matter of health. Obviously, in the cases mentioned above, the doctors referring the patients to the latter receive the kickback. These are simple examples of kickback schemes that are being applied mostly in Tier 2 and Tier 3 cities of India on a large scale. Tier 1 cities are no exception either.

However, in spite of such activities, there is no law to regulate and curb such practices. In the state of Maharashtra, a recent case involved a reputed hospital, where its 11 Heads of Departments were found to be operating unauthorized bank accounts. The same was reported by the Times of India in April 2023. The amount involved ran up to ₹6 Crores, and the majority of it was spent on foreign trips, flight bookings and hotels. The inquiry was initiated in 2018 by the then Medical Education Secretary. As per the Times of India report, questionable actions were in departments such as ophthalmology, radiology and surgery. In that, the surgery department was the major recipient of “kickbacks”, with deposits being found which were made by various pharmaceutical companies.

In this background, the Maharashtra State Government had nearly finalised the draft of an Act to curb such practices of kickbacks in the healthcare industry. It was known as “The Prevention of Cut Practices Act, 2017”. However, it never passed the draft stage due to protests from the medical fraternity over the provision of harsh punishments and administrative difficulties over its implementation. Apart from the punishment for kickbacks, the draft Act also contained provisions for punishing fake complainants and those trying to deliberately malign the image of a doctor/medical practitioner. Even then, the draft has not been implemented to date.

Challenges involved in the implementation of Forensic Accounting and Investigation in the healthcare industry:

LACK OF A PROPER STATUTE

Currently, no statute requires a healthcare centre, a hospital or an individual doctor / medical practitioner to get its transactions audited by a Forensic Accountant. Hence, most of the institutions shall resist appointing such an auditor unless there is a statutory requirement to do so. Since forensic accounting is still considered to be a niche sector in India, there is no law governing the implementation of forensic accounting functions. It is recommended in various industries, however, there is no mandatory provision regarding the same.

We have various laws in place for dealing with issues of fraud, such as Section 143(12) of the Companies Act, 2013 requires the auditor to report frauds against the company being committed by the officers or employees of the company to the Central Government within the prescribed time. Apart from that, the Companies (Auditor Report) Order 2020 requires the auditor to report on the events of frauds noticed during the audit period.

Regulation 11C of the SEBI Act, 1992 empowers the SEBI to direct any person to investigate the affairs of Intermediaries or Brokers associated with the securities market whose transactions in securities are being dealt with in a manner detrimental to the investors or the securities market.

Section 43 and Section 44 of the Information Technology Act, 2000 have prescribed penalties for 6 types of offences.

Section 33 of the Insurance Act of 1938 empowers the Insurance Regulatory and Development Authority of India to direct any person (investigating authority) to investigate the affairs of any insurer.

LACK OF PUBLIC AWARENESS

There is a great need to raise public awareness about frauds in the healthcare industry and the impact of forensic accounting functions in such an environment. For that, various finance institutions may conduct public awareness programs where the public is given first-hand information about various types of frauds, their impacts and the tools of forensic accounting to detect and prevent such frauds. The Central Government could also take initiative in this matter. It can establish specialised task forces for regular mentoring of the public throughout the country.

ROLE OF HEALTHCARE PROVIDERS

The healthcare providers of the country should be willing to conduct forensic accounting functions of their medical activities. They should consider preparing a set of robust internal controls which will assist in the prevention of fraudulent activities and the same time, facilitate the conducting of forensic accounting engagement.

DATA PRIVACY CONCERNS

As mentioned earlier, data and information are vital aspects in the age of the digitised healthcare industry. Forensic accounting requires access to critical data related to patients in order to investigate. However, healthcare centres or hospitals might be hesitant to provide access to patient details. Further, the consent from a patient could also be an issue in the effective implementation of forensic accounting procedures.

COMPLEX BILLING STRUCTURE

It is a complex structure since the fees being charged are not for reaching a pre-decided conclusion. A forensic accounting engagement starts with a suspicion or doubt and ends with that suspicion or doubt being proven or otherwise. Hence, it takes a while to negotiate with the management regarding the appropriate fees for conducting the forensic accounting engagement.

TRAINING & EDUCATION

In most of healthcare centres or hospitals, the medical staff is not aware of the frauds happening in the healthcare industry, or they are simply unaware of the facts as to what is a malpractice, or a healthcare fraud is. Healthcare centres or hospitals need to train their staff in the operation of various types of fraudulent activities and urge them to avoid the same and to come forward if they witness certain fraudulent activities. An effective whistleblowing policy is recommended so that employees do not resist from reporting issues related to frauds and fraudulent activities. Simultaneously, they also need to be made aware of forensic accounting functions along with their impact on the business of the healthcare centre or hospital.

A standardized structure or an audit plan may assist in lowering certain challenges for a successful implementation of forensic accounting functions.

Opportunities for conducting forensic accounting engagement in the healthcare industry:

SUPPLIERS’ FRAUD

Healthcare centres or hospitals deal with various suppliers for medical devices, equipment, and other related services. Forensic accounting can examine contracts with suppliers, invoices, payment terms and other conditions to detect kickbacks, instances of inflated prices, excess supply or conflicts of interest arising due to the business transactions.

MEDICAL DEVICE FRAUD

With the increasing use of medical devices, there is a risk of fraud related to their procurement, usage and maintenance. Forensic accounting functions can assess the procurement process, inspect the actual usage of the device along with the price charged to the patients, and verify the ratio of stock turnover in order to get a clear idea of whether excess supply is being procured by the management.

PATIENT RECORDS MANIPULATION

Healthcare providers or hackers may alter patient records to justify unnecessary and complicated medical procedures. Forensic accounting function can assist in the analysis of electronic health records of patients for unauthorised access, tampering, or inconsistencies in documentation or prescribed medication.

DATA SECURITY BREACHES

With the digitisation of healthcare data, there is an increased risk of data breaches and unauthorised access to sensitive patient information. The auditor could provide various insights related to the maintenance of critical data of patients via data analytics, the use of Artificial Intelligence to detect and prevent frauds and to enhance the reliability of the internal controls installed by the management.

FRAUDULENT PRACTICES IN CLINICAL TRIALS

Clinical research is integral to the healthcare industry; however, fraudulent practices such as data fabrication or manipulation can compromise the integrity of clinical trials. A forensic accounting function can assist in examining trial protocols, data collection methods and participant recruitment processes to ensure compliance with ethical standards and regulatory requirements.

GOVERNMENT HEALTHCARE PROGRAMS

Government-funded healthcare programs like Ayushman Bharat face challenges related to fraud, waste and abuse. Forensic accounting can evaluate program implementation, eligibility criteria, actual existence of the patient with actual requirement for a treatment and claims processing to prevent misuse of public funds. Recently, a multi-speciality hospital1 in Ahmedabad allegedly misused Ayushman Bharat Pradhan Mantri Jan ArogyaYojana (PM-JAY) and performed unnecessary surgeries to get benefits under this scheme.


1.http://www.hindustantimes.com/cities/others/ahmedabad-crime-branch-busts-ayushman-card-fraud-linked-to-khyati-hospital-101734452205203.html

GHOST PATIENTS AND PHANTOM BILLING

Some healthcare providers may engage in phantom billing by charging for services not rendered or billing for fictitious patients. Forensic accounting function can identify discrepancies between patient records, appointment schedules, actual treatment with medicines or further procedures prescribed and billing invoices to detect such fraudulent activities.

ANTI-MONEY LAUNDERING (AML) COMPLIANCE

Healthcare centres or hospitals are susceptible to money laundering schemes, wherein illicit funds are disguised as legitimate healthcare transactions. Forensic accounting can prove to be a game changer since it can investigate and assess transactional data, monitor financial activities, and implement AML controls to prevent money laundering and terror financing.

FRAUDULENT RESEARCH GRANTS

Academic institutions and research organisations receive grants for conducting medical research and to provide valuable insights on various issues in the healthcare industry; however, there is a possibility of misuse of funds or they may engage in research misconduct. Forensic accounting functions can thoroughly examine grant expenditures, rigorous implementation of research protocols and publication records to verify the integrity and reliability of research activities and ensure proper accountability for research grant funds.

WHISTLEBLOWER ALLEGATIONS

Whistleblowers within healthcare centres or hospitals may report concerns about fraud, corruption, illegal activities or regulatory violations. Forensic accounting function can investigate whistleblower allegations, protect whistleblower confidentiality and provide evidence for legal proceedings or regulatory enforcement actions, which shall be considered as admissible in a court of law. In various whistleblower cases, it is noted that the findings are not admissible in the court since the employment provisions of the employee prevent him/her from disclosing information about the employer, or it is deemed as a conflict of interest. In some cases, a non-disclosure clause is also added to the contract of employment to prevent the employee from whistleblowing. In such cases, a forensic accounting function can go leaps and bounds to protect the rights of whistleblower employees and bring to light any fraudulent activities being carried out at healthcare centres or hospitals.

CONCLUSION

After getting through with various implications of the forensic accounting function in the healthcare industry, it can be concluded that current practices and policies are increasingly putting Wealth over Health, and that is a serious concern for the industry since almost the entire populace is integrated with the healthcare industry.

However, it may also be noted that black ships are in every profession. For a few such scrupulous people, the entire profession gets a bad name. Forensic Accounting function, in a way, helps to protect the reputation of the profession by exposing malpractices and wrong people. Lastly, forensic accounting engagement should not be visualised as a tool or a measure which has limited utility. It has the ability to go beyond the strides of frauds and ensure a healthcare industry so effective and transparent that it sets a global benchmark.

Climate Change and Its Impact on Financial Statement

This article explores the critical intersection of climate change and corporate finance. As the world grapples with the urgent need to address climate change, driven by the UN Sustainable Development Goals (SDGs) and the growing emphasis on Environmental, Social, and Governance (ESG) factors, companies are increasingly recognising the financial implications of their environmental impact. From rising operational costs and disrupted supply chains to changing consumer preferences and increased regulatory scrutiny, climate change poses significant risks and opportunities for businesses. This article will delve into how these climate-related factors can impact a company’s financial statements, highlighting the crucial role of ESG reporting frameworks like the Business Responsibility and Sustainability Reporting (BRSR) in navigating this evolving landscape.

WHAT IS CLIMATE CHANGE?

Our planet is experiencing a dramatic shift in its climate, largely due to human activities over the past couple of centuries. By burning fossil fuels like coal, oil, and gas, we’ve released a massive amount of greenhouse gases into the atmosphere. These gases act like a blanket, trapping heat and causing our planet to warm up. This warming trend isn’t just about rising temperatures. It’s disrupting our weather patterns, leading to more intense heatwaves, stronger storms, and a significant rise in sea levels as glaciers and ice caps melt. These changes threaten our ecosystems and have devastating consequences for people and economies around the world.

India, unfortunately, is particularly vulnerable to these impacts. We’re already seeing a surge in extreme weather events like floods, droughts, and scorching heatwaves. These events disrupt lives, damage infrastructure, and threaten our agricultural productivity. To tackle this crisis, we need a two-pronged approach:

  •  Mitigation: We must drastically reduce our greenhouse gas emissions to prevent further warming.
  • Adaptation: We must also adapt to the changing climate by implementing measures to protect our communities and infrastructure from the inevitable impacts.

The effects of climate change are not confined to the environment. They are deeply intertwined with our financial systems. Extreme weather events can devastate businesses, damaging assets, disrupting supply chains, and increasing operational costs. The transition to a low-carbon economy also presents challenges, such as the need for significant investments in renewable energy and the risk of stranded assets. Recognising these risks, financial regulators and standards-setting bodies are now demanding greater transparency around climate-related issues. The International Accounting Standards Board (IASB), for example, recently issued an exposure draft addressing the disclosure of climate risks in financial statements underscoring their relevance to financial stability.

By understanding and disclosing these risks, companies can better manage them and make more informed decisions. It’s time for businesses to acknowledge their role in addressing climate change and to embrace sustainable practices that safeguard their long-term viability.

CLIMATE-RELATED RISKS AND OPPORTUNITIES

Climate related financial information has an increased demand for decision making by the investors, lenders, insurance underwriters and other stakeholders. However, the improved disclosures of the climate-related information would assist the investors, lenders, insurance underwriters and other stakeholders to analyse the potential financial impacts due to climate change. These improved disclosures would include climate-related risks and opportunities which will be the handbook to evaluate such disclosures.

The TCFD (Task Force on Climate-Related Financial Disclosures) has identified that there are several frameworks for climate-related disclosures in different jurisdictions to favour the growing demand of such information disclosure, however, it is significant to have a standardised framework that will align all the jurisdictions including G20 and other existing regimes and look for an opportunity to provide the common framework for climate-related disclosures.

The important elements of such climate-related disclosure framework is the categorisation of the disclosures into climate-related risks and opportunities. Hence, the TCFD has defined their categories. These recommendations has resulted in encouraging the businesses to make such disclosures as a part of their annual reports highlighting issues that are more pertinent to their business activities.

The main climate-related risks and opportunities are given below followed by their brief descriptions:

1. Climate-related Risks

The TCFD has divided the Climate-related Risks in two sub-categories each having further divisions in its type of risk. The two major sub-categories of risks are: (a) risks related to the transition to a lower- carbon economy, and (b) risks related to the physical impacts of climate change. Further, the detailed sub-categories are as under:

(a) Transition Risks

Transition to a lower-carbon economy can have extensive policy & legal, technology, market and reputational changes to adopt the mitigation and adaptation requirements related to the climate changes. These transitional risks can result in varying levels of financial and reputations risk to the organisation depending on the nature, speed, and focus of these changes.

(i) Policy and Legal Risks:

The policy and legal risks refers to the challenges that are faced by the companies due to the changes in the policies, regulations, frameworks and other legal changes that are aimed at addressing the climatic challenges. These kind of risks arise from governmental and regulatory bodies as they are the ones who implement these new laws, standards and policies to transit towards a low-carbon economy and mitigate the impact of climate changes. In case of failure to comply and adopt these changes, it will lead to financial losses, legal liabilities, and reputational damages.

Policy Risks are the ones that are linked to changes in governmental policies and regulatory frameworks related to climate change mitigation and adaptation. Some of these examples include: Stricter Limitations on Emissions, Subsidy Reforms, Energy Efficiency Regulations, Carbon Pricing and Taxes, Ban on Certain Activities, etc.

Legal Risks are the fines / penalties imposed on the businesses due to non-compliance with evolving climate-related regulations or failure to meet disclosure and sustainability standards. Such legal risks includes litigation for non-compliance, increased disclosure requirements, contractual obligations, securities fraud or misrepresentation, liability for environmental harm, etc.

(ii) Technology Risk

Such risks refer to the potential disruptions and challenges due to shifts in technology aiming towards reduction in carbon emissions and enhancing sustainability. These risk arises when the companies transit towards low-carbon energy-efficient technologies to adhere to the regulatory changes, market demands, or several environmental objectives.

Technology Risks includes certain key aspects, such as: Use of outdated technology, investment cost for adopting greener technologies, and competitive market in terms of adapting climate-friendly technologies, temporary operational disruptions while introducing new technologies, changing regulatory requirements, etc.

Managing such risks requires strategic planning, investment in innovation, and staying aware of technological and regulatory developments.

(iii) Market Risk

Financial impact that arises from the shift in supply and demand due to the transition to low-carbon economy are identified as the Market Risks. Under this factor, the transitions to low-carbon economy are driven by the factors such as new climate policies,  technological advancements, or changes in consumer behaviour.

The key components of market risks includes: Demand shifts, changes in prices of commodities, devaluation of assets, fluctuation in investor behaviour, supply chain impacts, etc.

(iv) Reputation Risk

This risk has a potential harm to a Company in terms of damage to public image, brand value, or stakeholder trust due to its perceived or lack of response to climate change and sustainability expectations. This occurs when companies fail to address climate-related demands from customers, regulators, investors, or the general public, which can negatively affect Company’s reputation and market positioning.

The manifested reputation risks includes: Failure to adapt to regulatory changes, environmental negligence, changes in customer preferences, greenwashing accusations, investors’ pressure, etc.

(b) Physical Risks

Physical Risks are the potential harm or disruptions to the businesses, economies, and ecosystems caused by the physical impacts of climate change. There risks resulting from climate changes can either be event drive (acute) or longer-term shifts (chronic) in climate patterns. They can significantly affect the operations, assets, supply chains, and financial performance of the Company.

(i) Acute Physical Risk

These risks are the immediate or short-term consequences of the extreme weather events that are caused due to climate change. Such risks includes sudden and severe climate- related incidents, such as: Floods, Storms, Hurricanes, Heatwaves, Wildfire, etc.

Acute Risks can disrupt company operations, harm supply chains, damage assets, and affect the communities. To face and mitigate such risks, companies shall plan for resilience, disaster recovery, and other mitigation strategies to manage the potential impacts.

(ii) Chronic Physical Risk

Chronic Risk refers to the long-term changes in environmental and climatic conditions that could affect the businesses, its infrastructure, and societies. Unlike acute physical risks, that are associated with short-term, severe weather events, chronic physical risks are gradual and has persistency in climate patterns that can disrupt normal operations and productivity.

These risks include examples such as: Rising global temperatures, long-term droughts or shift in rainfall, sea-level rise, soil degradation, etc.

2. Climate-related Opportunities

Climate-related Opportunities refer to the potential benefits and positive impacts that the companies get which arise from the transition to a low-carbon economy and from proactive approaches to managing climate risks. Companies that recognise and leverage these opportunities can enhance their competitiveness, drive innovation, and contribute to sustainability.

Climate-related Opportunities are further classified as under:

(a) Resource Efficiency

Resource Efficiency under climate-related opportunities refers to effective utilisation of resources such as energy, water, material and land, in a way that it minimises waste generation and reduces negative environmental impact while maximising the productivity and profitability.

Embracing the resource efficiency could provide various benefits such as: Lower operation cost, gain competitive advantage, risk mitigation, adoption of innovative technologies, improved brand image, complying with environmental regulations, etc.

(b) Energy Source

Energy Source can be referred to the potential benefits that occurs from a transition to cleaner, renewable, and more efficient energy solutions to reduce the negative environmental impact and other greenhouse gas emissions.

The Companies that invest in the sustainable solutions can benefit from financial, operational, and reputational advantages. The transitional journey may include key aspects such as: Adoption of Renewable Energy Sources, Implementing Energy-efficient Technologies, Investing in Clean Energy Solutions, Offering Green Products in the Market, etc.

(c) Products & Services

Products & services refers to the creation, innovation, and adaptation of sustainable practices in the business offerings that helps the businesses and customers to transit to low-carbon sustainable economy. Such sustainable offerings benefits the businesses in generating new revenue streams by addressing the environmental risks and challenges.

The key examples here includes, development of low-carbon products, sustainable packaging, green financial products, adapting renewable energy services, energy efficiency solutions, carbon credits and reforestation programs, etc.

(d) Markets

The new or growing sectors, regions, and types of assets where businesses can gain a competitive advantage by adapting the practices to transit to low-carbon economy can be referred to as Markets. These markets offer potential growth and diversification by aligning with sustainability and decarbonisation goals.

The key aspects of these markets include: Sustainable Financing like investing in Green Bonds, Impact Investing; Low-Carbon Infrastructure, Renewable Energy Production, Collaborations with Governments & Development Banks, Carbon Trading & Offsetting Markets, etc.

(e) Resilience

It is a business’s ability to adapt and withstand to climate change challenges. This is merely focused on transitioning the climate-related risks to climate-related opportunities by minimising disruptions and enhancing adaptive capacity. Opportunities that are related to resilience includes, efficiency improvements, innovative products / processes, supply chain adaptation and investment in long-term sustainability projects, etc.

FINANCIAL IMPACTS OF POTENTIAL CLIMATE-RELATED RISKS

The financial impacts are basically the economic consequences faced by the companies due to both transition and physical risks posed by climate change. These impacts includes effects on the company’s operations, liabilities, assets and costs in several ways.

Below are the key areas where financial impacts may arise:

Type

 

Climate-Related Risks

 

Potential Financial Impacts

 

Transition Risks

 

Policy and Legal

Increased costs related to greenhouse gas (GHG) emissions pricing

• Increased obligations for emissions reporting

• Regulatory mandates on existing products and services

• Heightened risk of litigation

 

 

Higher operating expenses, including compliance costs and increased insurance premiums

• Asset write-offs, impairments, or early retirements due to policy shifts

• Elevated costs or reduced demand for products and services as a result of fines and legal judgments

 

Technology

 

Replacement of current products and services with lower-emission alternatives

• Unsuccessful investments in developing or adopting new technologies

• Expenses incurred in transitioning to low- emission technologies

 

 

 

• Asset write-offs and premature retirement of existing infrastructure

• Decline in demand for current products and services

• Increased research and development (R&D) expenses for new and alternative technologies

• Capital investments and cost required for developing new technologies and adopting & implementing new practices and processes

Market
• Shifts in customer preferences and behavior

• Uncertainty in market trends and signals

• Rising costs of raw materials

• Declining demand for products and services as consumer preferences shift

• Higher production costs due to fluctuating input prices (e.g., energy, water) and stricter output regulations (e.g., waste management)

• Sudden and unforeseen increases in energy costs

• Altered revenue streams and mix, potentially leading to lower overall revenues

• Revaluation of assets such as fossil fuel reserves, land, and securities

Reputation

 

• Changes in consumer preferences

• Negative perception or stigmatisation of the industry

• Heightened stakeholder concerns or adverse feedback from stakeholders

 

• Decline in revenue due to reduced demand for goods and services

• Loss of revenue from disruptions in production capacity (e.g., delays in planning approvals or supply chain interruptions)

• Decreased revenue from challenges in workforce management, such as difficulties in attracting and retaining employees

• Limited access to capital due to increased exposure to physical risks

Physical Risks

 

Acute

Heightened intensity of extreme weather events, including cyclones and floods.

 

Chronic

 

• Alterations in precipitation patterns and increased variability in weather conditions

• Increasing average temperatures

• Rising sea levels

 

 

Reduced revenue from diminished production capacity (e.g., challenges in transportation and supply chain disruptions)

• Decreased revenue and elevated costs due to adverse workforce impacts (e.g., health risks, safety issues, and absenteeism)

• Asset write-offs and early retirement of existing assets resulting from damage in “high-risk” locations

• Increased operating costs due to insufficient water supply for hydroelectric plants or cooling systems for nuclear and fossil fuel plants

• Heightened capital expenditures driven by facility damage

• Lower revenues resulting from decreased sales and output

• Rising insurance premiums and potential restrictions on coverage for assets situated in “high-risk” areas

FINANCIAL IMPACTS OF POTENTIAL CLIMATE-RELATED OPPORTUNITIES

Though the companies navigate the challenges / risks posed by climate-change, it also identifies significant opportunities to drive growth and enhance resilience. These opportunities can lead to various positive financial impacts, such as:

Type Climate-related Opportunities Potential Financial Impacts
Resource Efficiency

 

Adoption of more energy-efficient transportation methods

• Implementation of streamlined production and distribution processes

• Increased focus on recycling and resource recovery

• Transition to energy-efficient and sustainable buildings

• Reduction in water consumption and improved water management practices

• Lower operating costs achieved through efficiency improvements and cost reductions

• Enhanced production capacity, leading to higher revenues

• Increased asset value, such as energy-efficient buildings with higher ratings

• Positive impact on workforce management, including improved health, safety, and employee satisfaction, resulting in reduced costs

Energy Source

 

• Adoption of low-emission energy sources

• Utilisation of supportive policy incentives

• Integration of innovative technologies

• Participation in carbon trading markets

• Transition to decentralised energy generation systems

• Lower operating cost through cost-effective emissions reduction measures

• Reduced vulnerability to future increases in fossil fuel prices

• Decreased exposure to GHG emissions, minimising sensitivity to carbon pricing changes

• Enhanced returns on investments in low- emission technologies

• Improved access to capital as investors increasingly prioritise low-emission businesses

• Reputational gains leading to higher demand for products and services

Products

& Services

• Expansion and innovation in low-emission products and services

• Creation of climate adaptation and insurance risk management solutions

• Development of new offerings through research, development, and innovation

• Opportunities to diversify business operations

• Capitalising on shifting consumer preferences toward sustainable products and services

• Increased revenue driven by growing demand for low-emission products and services

• Revenue growth from offering innovative solutions to climate adaptation needs (e.g., insurance and risk management products)

• Enhanced competitive advantage by aligning with evolving consumer preferences, leading to higher revenues

Markets

 

• Entry into               new markets and expansion opportunities

• Utilisation of regulatory incentives and support

• Access to new assets and locations requiring insurance coverage

• Increased revenue opportunities through entry into new and emerging markets (e.g., collaborations with governments and development banks)

• Enhanced diversification of financial assets (e.g., investments in green bonds and sustainable infrastructure)

Resilience

 

• Engagement in renewable energy initiatives and implementation of energy-efficiency strategies

• Diversification and substitution of resources

• Enhanced market valuation through strategic resilience planning (e.g., infrastructure, land, and buildings)

• Greater supply chain reliability and operational continuity under diverse conditions

• Increased revenue from new products and services designed to support resilience and adaptability

EFFECTS OF CLIMATE-RELATED MATTERS ON FINANCIAL STATEMENTS

Ind AS Standards Impact
Ind AS – 1

Presentation of Financial Statements

• Companies must disclose significant climate-related matters that could materially impact their financial performance. This includes uncertainties related to future cash flows, asset impairment, and decommissioning obligations. These disclosures should help investors understand the potential impact of climate change on the company’s financial health.

• Disclose key assumptions and judgments used in financial reporting, particularly those related to climate-related uncertainties. This includes how climate-related factors are considered in areas like impairment testing, the determination of cash-generating units, and the estimation of future cash flows.

• Disclose the sensitivity of financial results to different climate-related scenarios. This helps investors understand how changes in climate conditions or policy responses could impact the company’s financial performance.

• Assess and disclose the company’s ability to continue as a going concern, considering the potential impact of climate-related risks. This includes evaluating the potential impact of climate change on the company’s operations, market demand, and access to resources.

Ind AS – 2

Inventories

• Climate-related events can significantly impact the value of a company’s inventory. For example, extreme weather events can damage inventory, rendering it obsolete. Changes in consumer preferences due to climate change can also reduce the selling price of inventory or increase the costs associated with completing and selling it.

• When the cost of inventory is no longer recoverable, IAS 2 requires companies to write down the inventory to its net realisable value. Net realisable value represents the estimated selling price of the inventory in the current market, minus the estimated costs of completion and sale.

• Companies must use the most reliable evidence available to estimate the net realisable value of their inventory. This may include market prices, recent sales data, and expert opinions.

Ind AS – 12

Income Taxes

• Ind AS 12 allows companies to recognise deferred tax assets for tax losses and temporary differences that can be used to reduce future tax bills. However, these assets can only be recognised if it’s likely that the company will generate enough future taxable profits to utilise these tax benefits.

• Climate-related issues can significantly impact a company’s future taxable profits. For example, extreme weather events can disrupt operations, leading to lower profits and potentially preventing the company from utilising its deferred tax assets. Conversely, climate change mitigation efforts, such as investments in renewable energy, can impact future tax liabilities and therefore the value of deferred tax assets.

Ind AS – 16

Property, Plant and Equipment &

Ind AS – 38

Intangible Assets

• Climate change can significantly impact a company’s research and development (R&D) activities. This may lead to increased expenditures on developing new technologies, such as renewable energy solutions, or adapting existing products to mitigate climate risks. These R&D costs may be capitalised as assets under certain accounting standards, depending on their nature and expected future benefits.

• Companies must disclose the amount of R&D costs recognised as an expense during each reporting period. These expenses may be impacted by climate-related changes, such as increased spending on climate-related R&D projects or adjustments to existing R&D programs due to changing market conditions or regulatory requirements.

• Companies are required to regularly review and adjust the estimated useful lives and residual values of their assets. This includes considering the potential impact of climate change. For example, climate-related events like extreme weather can shorten the useful life of certain assets, while changing regulations related to greenhouse gas emissions can render some assets obsolete.

• Companies must disclose the expected useful lives of each class of asset and any changes to these estimates. These disclosures should include the impact of climate-related factors, such as asset obsolescence or changes in regulatory requirements, on the estimated useful lives and residual values of assets.

Ind AS – 36

Impairment of Assets

• Companies are required to regularly assess whether their assets, such as goodwill, property, plant and equipment, and intangible assets, have lost value. Climate-related factors, such as reduced demand for products that emit greenhouse gases or significant environmental changes, can signal potential impairment. For example, changes in environmental regulations or shifts in consumer preferences towards more sustainable products can lead to a decline in the value of certain assets.

• When assessing asset impairment, companies must estimate the future cash flows that the asset is expected to generate. These estimates should consider the potential impact of climate-related factors on the company’s future operations and market conditions. It’s crucial to base these projections on reasonable and supportable assumptions that reflect management’s best estimate of future economic conditions, taking into account potential climate-related risks.

• IAS 36 prohibits the inclusion of cash flows arising from future restructuring or performance enhancement activities in the impairment assessment. This ensures that the impairment test reflects the intrinsic value of the asset under normal operating conditions.

• Companies must disclose the events and circumstances that led to any impairment losses.
This includes disclosing the impact of new legislation on emission reductions, changes in consumer preferences, or other climate-related factors. Additionally, companies must disclose the key assumptions used in their impairment assessments and the potential impact of reasonably possible changes to these assumptions.

Ind AS – 37

Provisions, Contingent Liabilities and Contingent Assets and Appendix “C” Levies

 

• Climate change can significantly impact a company’s liabilities. This includes potential liabilities arising from government fines for failing to meet climate-related targets, costs associated with environmental remediation, and expenses related to restructuring efforts to adapt to a low-carbon economy. Additionally, existing contracts may become onerous due to changes in climate-related legislation or regulations.

• IAS 37 requires companies to disclose the nature of provisions and contingent liabilities. This includes any uncertainties related to the timing and amount of expected future cash outflows. Companies must also disclose the major assumptions made about future events when determining the amount of provisions, particularly when these assumptions are significantly influenced by climate-related factors.

Ind AS – 107

Financial Instruments

• Ind AS – 107 requires companies to disclose information about their financial instruments and the associated risks. Climate change can significantly impact these risks, such as by affecting the likelihood of borrowers defaulting on loans (credit risk) or by impacting the value of investments in sectors vulnerable to climate change. Companies must disclose how these climate-related factors may affect their financial instruments.

• For companies holding investments in other companies, Ind AS – 107 requires disclosure of investments by industry or sector. This helps investors understand the company’s exposure to industries that may be more vulnerable to the effects of climate change, such as those heavily reliant on fossil fuels or those operating in regions prone to extreme weather events.

Ind AS – 109

Financial Instruments

• Climate change can significantly impact the accounting for financial instruments. For example, loan agreements may include clauses that link interest rates or repayment schedules to a company’s progress in meeting climate-related targets. This can complicate the accounting for these loans, as lenders need to carefully assess whether the cash flows received are solely interest payments or include performance-based components.

• Climate-related factors can increase the risk of borrowers defaulting on loans. Extreme weather events like wildfires or floods can disrupt a borrower’s operations, impacting their ability to repay debt. Changes in climate regulations can also significantly impact a borrower’s financial performance, increasing the risk of default. Additionally, the value of collateral used to secure loans may be diminished due to climate change impacts, such as the inaccessibility or non-insurability of certain assets.

• When assessing the likelihood of borrowers defaulting on loans (credit risk), lenders must consider all relevant factors, including climate-related risks. Ind AS – 109 requires the use of all reasonable and supportable information in estimating expected credit losses. This means that lenders must incorporate potential climate-related impacts into their economic forecasts and credit risk assessments.

Ind AS – 113

Fair Value Measurement

• Climate change can significantly impact the fair value of a company’s assets and liabilities. For example, the introduction of new climate-related regulations can change how market participants perceive the value of certain assets or liabilities, potentially impacting their market price.

• Fair value measurements, particularly those based on less observable inputs (Level 3 of the fair value hierarchy), are highly sensitive to underlying assumptions. These assumptions must consider the potential impact of climate-related risks, such as the likelihood of extreme weather events, changes in consumer preferences, and shifts in regulatory landscapes.

• Ind AS – 113 mandates companies to disclose the key inputs used in their fair value measurements, especially for assets and liabilities classified within Level 3 of the fair value hierarchy. They must also explain how changes in these unobservable inputs, including those related to climate change, could significantly affect the fair value measurement.

IFRS 17

Insurance Contracts

(Ind AS 117 is yet to be issued)

• Climate change can significantly impact insurance companies. As climate change intensifies, we can expect to see more frequent and severe weather events, such as hurricanes, floods, and wildfires. This increases the likelihood and severity of insured events like property damage, business interruptions, and health claims, which in turn can impact the insurance company’s financial obligations.

• IFRS 17 requires insurance companies to accurately measure and disclose their insurance liabilities. Climate change introduces significant uncertainties into these calculations. Companies must carefully consider how climate change may impact the frequency and severity of insured events when determining their liabilities.

• Companies must disclose significant judgments made in applying IFRS 17. This includes how they account for the potential impact of climate change on the likelihood and severity of insured events. They must also disclose how they manage the risks associated with these climate-related events and how sensitive their insurance liabilities are to changes in these risks.

PROPOSED ILLUSTRATIVE EXAMPLES

The International Accounting Standards Board (IASB) has recently issued an Exposure Draft titled “Climate-related and Other Uncertainties in the Financial Statements.” This draft introduces eight illustrative examples to enhance the application and disclosure of climate-related and other uncertainties in financial statements. These examples aim to improve the quality and consistency of climate-related disclosures by providing practical guidance on how to apply existing International Financial Reporting Standards (IFRS) to various scenarios. Two of the examples are given below, for reference:

Example 1 – Materiality Judgements Leading to Additional Disclosures (IAS 1/IFRS 18)

Scenario: A manufacturer with a climate-related transition plan, including investments in energy-efficient technology and changes in manufacturing methods.

Disclosures: The entity discloses that its transition plan has no material effect on its current financial position and financial performance.

Basis for Disclosure

  •  The entity determined that the transition plan does not currently impact the recognition or measurement of assets, liabilities, income, and expenses.
  •  However, the entity recognises that the absence of this information could mislead users, as they might expect some financial impact from the planned changes.
  •  Considering the detailed disclosure of the transition plan outside the financial statements and the industry’s known exposure to climate-related transition risks, the entity concludes that this disclosure is necessary to provide a complete picture to financial statement users.

Example 2 – Disclosure of Assumptions: Specific Requirements (IAS 36)

Scenario: A company operates in an industry with significant greenhouse gas emissions and is subject to existing and anticipated future emissions regulations.

Disclosures: The entity discloses that future emission allowance costs are a key assumption in its impairment testing of a cash-generating unit.

Basis for Disclosure:

  •  IAS 36 requires disclosure of key assumptions used in impairment testing, particularly those with a significant impact on the recoverable amount.
  •  Future emission allowance costs are identified as a key assumption due to their potential impact on the cash flows of the cash-generating unit.

CONCLUSION

Climate change is no longer just an environmental issue; it’s a significant financial risk that companies cannot afford to ignore. The increasing frequency and severity of extreme weather events, growing pressure from regulators, and shifting consumer preferences are all impacting businesses. These factors directly affect a company’s bottom line, influencing revenues, costs, and the value of its assets.

As companies are increasingly required to disclose climate-related risks and opportunities in line with regulations like SEBI LODR and other frameworks, it’s crucial to connect this information to their financial performance. Simply put, companies need to understand how climate change impacts their finances. ESG reporting provides a structured way to do this, helping companies bridge the gap between their environmental and social impacts and their financial performance.

This approach aligns with the principles outlined in IFRS S2, which emphasises the importance of connecting financial and non-financial information. By understanding how climate risks and opportunities influence both their financial performance and broader sustainability objectives, companies can gain deeper insights into their overall business health. Embracing ESG principles allows companies to navigate this evolving landscape more effectively, building long-term resilience and positioning themselves for sustainable success.

REFERENCES

Auditor’s Report on Special Purpose Financial Statements

Special Purpose Financial Statements (SPFS) are prepared to meet the information needs of specified users. In February 2024, the Institute of Chartered Accountants of India (ICAI) issued the revised Standards on Auditing (SAs): SA 800 dealing with SPFS; SA 805 dealing with Audits of Single Financial Statements and Specific Elements, Accounts or Items of a Financial statement and SA 810 dealing with auditor’s report on summary financial statements. This article provides an overview of the requirements of SA 800 (revised) and explains the key aspects of special purpose financial statements.

An entity generally prepares general purpose financial statements as per the general purpose framework. A general purpose framework is designed to meet the common financial information needs of a wider range of users, e.g. financials prepared as per applicable Generally Accepted Accounting Principles for tax filing purposes; financial statements prepared under the Companies Act, 2013. The general purpose framework, i.e. Indian Accounting Standards and Accounting Standards, are used for the preparation and presentation of the financial statements and such financial statements are called statutory financial statements (i.e. prepared pursuant to a regulation or statute).

However, under certain circumstances, an entity would be required to submit financial statements as per a special purpose framework or an audited financial statement, specific elements, accounts, or items of a financial statement to meet the requirements of a specific category of stakeholders, e.g. shareholders, investors, lenders. Financial service entities such as asset managers or management companies may also be required to prepare financial statements for a specific purpose or for specific users. Such financial statements are often called as special purpose financial statements.

Special purpose financial statements can often be more relevant and less costly to prepare than financial statements that are fully GAAP compliant, depending on the intended use of the financial statements. The audits of such special purpose financial statements are required to be conducted in accordance with special consideration standards issued by the ICAI. In February 2024, the Institute of Chartered Accountants of India (ICAI) issued the revised Standards on Auditing (SAs): SA 800 (Revised), “Special Considerations – Audits of Financial Statements Prepared in Accordance with Special Purpose Frameworks; SA 805 (Revised), “Special Considerations – Audits of Single Financial Statements and Specific Elements, Accounts or Items of a Financial Statement”; SA 810 (Revised), “Engagements to Report on Summary Financial Statements”. These Standards will be applicable to audits/engagements for financial years beginning on or after 1st April, 2024, i.e., these Standards will be applicable to audits / engagements for the financial year 2024-25 and onwards.

The objective of this article is to provide an overview of the requirements of the revised SA 800 issued by the ICAI and to explain the key aspects of special purpose financial statements. It is important to understand why special purpose financial statements are prepared and the underlying reporting framework for the preparation of such special purpose financial statements. For example, if the company is required to get a special audit of the financial statements based on a regulatory order, it is important to understand the reporting framework followed for the preparation of such financial statements. If financial statements have been prepared as per the general purpose framework, the auditor will apply the requirements in SAs 100 to 700 series and not SA 800. It is the primary responsibility of the management to prepare financial statements. In order to do so the management should understand the purpose for which such financial statements are being prepared and its intended users.

SA 800 deals with special consideration in the application of the SAs (100-700 series) to an audit of financial statements that are prepared in accordance with a special purpose framework. SA 800 is written in the context of a complete set of financial statements prepared in accordance with a special purpose framework. However, in addition to the application of all SAs (SA 100 to SA 700 series), an auditor is also required to comply with these special considerations specified in SA 800. Therefore, it is important to understand whether the reporting framework in accordance with which financial statements have been prepared is a ‘special purpose framework’ or not.

SA 805 deals with special considerations in the application of the SAs (100-700 series) to an audit of a single financial statement or a specific element, account or item of a financial statement.

In 2016, ICAI issued the revised auditor’s reporting standards, i.e. Revised SA 700 — ‘Forming an Opinion and Reporting on Financial Statements’, Revised SA 705 — ‘Modifications to the Opinion in the Independent Auditor’s Report’ and Revised SA 706 — ‘Emphasis of Matter Paragraphs and Other Matter Paragraph in the Independent Auditor’s Report’. These standards are effective for audits of financial statements for periods beginning on or after 1st April, 2018. The auditor’s reporting requirements for SA 800 and SA 805 engagements are linked directly to the reporting requirements in SA 700 (Revised).

What are special purpose financial statements?

Special purpose financial statements are prepared to meet the information needs of specified users. As a result, the special purpose financial statements are prepared using an applicable special purpose framework that meets those users’ needs.

A special purpose framework, as defined by SA 800, is a financial reporting framework designed to meet the financial information needs of specific users. The financial reporting framework may be a fair presentation framework or a compliance framework1.

The special purpose framework may comprise the financial reporting provisions of a contract. For example, for the purpose of establishing the value of net assets of a company at the date of its sale, the vendor and the purchaser agree that very prudent estimates of allowances for uncollectible accounts receivable are appropriate for their needs, even though such financial information is not neutral when compared with financial information prepared in accordance with a general purpose framework. In this case, the special purpose framework meets the needs of the specified users2.


1 Refer paragraph 7 of SA 700 for definition of fair presentation framework and compliance framework. 
2 Refer paragraph A8 of SA 800.

It is important to note that when financial statements are prepared based on the needs of a regulator, e.g. audit of an overseas subsidiary of an Indian company, which is not required in the host jurisdiction but required under Indian regulations, e.g. pursuant to FEMA regulations (filing of Annual Performance Report), it should not be construed that such financial statements are special purpose financial statements if the underlying framework is general purpose framework. Special purpose financial statements are financial statements with a special purpose framework which is designed to meet the financial information needs of specific users.

Other examples wherein special purpose financial statements may be prepared include:

  •  The cash receipts and disbursements basis of accounting for cash flow information that an entity may be requested to prepare for creditors.
  •  The financial reporting provisions established by a regulator to meet the requirements of that regulator.
  •  The financial reporting provisions of a contract, such as a bond indenture, a loan agreement, or a project grant.
  •  Combined financial statements prepared for submission to lenders or investors3;

3  Refer Guidance Note on Combined and Carve-Out Financial Statements issued by ICAI.

There may be circumstances when a special purpose framework is based on a financial reporting framework established by an authorised or recognised standards-setting organisation or by law or regulation but does not comply with all the requirements of that framework. In such a case, the special purpose framework will not be a fair presentation framework since it does not comply with all the requirements of the financial reporting framework that are necessary to achieve a fair presentation of the financial statements, e.g. all disclosures required by accounting standards, have not been made by a company.

Therefore, it will be inappropriate for the description of the applicable financial reporting framework in the special purpose financial statements (and in the auditor’s report) to imply full compliance with the financial reporting framework established by the authorised or recognised standards setting organisation or by law or regulation.

For example, a contract may require financial statements to be prepared in accordance with most, but not all, of the Accounting Standards. In this case, it is preferable that the description of the applicable financial reporting framework refers to the financial reporting provisions of the
contract (and may also refer to management’s description of those provisions in the disclosures to the financial statements) rather than make any reference to accounting standards.

Under SA 800, financial statements prepared on an accrual basis of accounting as per applicable Indian GAAP for filing with income tax authorities are considered to be general purpose financial statements and not special purpose financial statements.

Key considerations for acceptance of an engagement to express an opinion on special purpose financial statements

In deciding whether to accept an engagement to express an opinion on special purpose financial statements, the auditor should determine whether the special purpose framework applied in the preparation of the financial statements is acceptable. The auditor should obtain an understanding of –

  •  the purpose for which the financial statements are prepared;
  •  the intended users;
  •  the steps taken by management to determine that the applicable financial reporting framework is acceptable in the circumstances.

Such a special purpose reporting framework may comprise financial reporting standards established by an authorised or recognised standard-setting organisation. If so, these standards may be presumed acceptable if the organisation follows an established and transparent process involving deliberation and consideration of the views of relevant stakeholders. It could also be a special purpose framework prescribed by the jurisdiction to be used in the preparation of special purpose financial statements for a certain type of entity.

Forming an opinion and reporting considerations

The standard setter retained the approach in extant SA 800 and SA 805, whereby the reporting requirements in SA 700 (Revised) and other SAs are not repeated in SA 800 (Revised) and SA 805 (Revised). Therefore, SA 700 (Revised) contains the overarching reporting requirements applicable for auditor’s reports on special purpose financial statements and single financial statements, or elements of a financial statement, with additional requirements and guidance as considered necessary in SA 800 (Revised) and SA 805 (Revised). Therefore, when forming an opinion and reporting on special purpose financial statements, the auditor is required to apply the requirements in SA 700 (Revised).

Reference may be made to Illustrative auditor’s reports in the Appendix of SA 800 (Revised) and Appendix 2 of SA 805 (Revised).

Key revisions in SA 800 and SA 805 as compared to extant SA 800 and SA 805 include the following:

  •  Refinements to the requirements and corresponding application material in the standard, where applicable, to clarify the reporting responsibilities of the auditor in light of new concepts established by the new and revised Auditor Reporting Standards (i.e. SA 700, SA 705 and SA 706).
  •  New application material relating to Going concern, key audit matters, Other information and inclusion of the name of the Engagement Partner.
  •  Update illustrative auditor’s report that:

⇒Align with the reporting requirements in SA 700 (revised) in terms of the layout and content, including the ordering of elements (for example, the Opinion section is now positioned first) and use of heading and terminologies consistent with SA 700.

⇒Include more fulsome descriptions of the circumstances that are assumed for each of the illustrative auditor’s reports and indicate the applicability of the auditor’s reporting enhancements.

It is important to note that SA 800 makes reference to SA 700 for forming an opinion and reporting on special purpose financial statements, i.e. the auditor is required to apply the requirements in SA 700 (Revised).

Inclusion of restriction on use paragraph in auditor’s report

When an auditor’s report on special purpose financial statements is intended for the use of specified users, a restriction on use paragraph for the specific users’ needs to be included in the auditor’s report to avoid any unintentional reliance on our auditor’s report by others. For example, a financial reporting framework that is specified in a purchase agreement for the preparation of financial statements of an entity to be acquired may be acceptable, but only with respect to the needs of the parties to the agreement. In this case, the auditor restricts the use of the report to the parties to the agreement. The auditor informs management and those charged with governance, in writing, that the auditor’s report is not intended for use by non-specified parties. Such restriction on use paragraph is included in the auditor’s report as the auditor may not have any control over the distribution of the auditor’s report.

Emphasis of Matter paragraph

When preparing an auditor’s report, the auditor recognises that the special purpose financial statements may be used for purposes other than those for which they were intended; for example, a regulator may require certain entities to place the special purpose financial statements on public record. To avoid misunderstandings, auditors alert users of the auditor’s report by including an Emphasis of Matter paragraph explaining that the financial statements are prepared in accordance with a special purpose framework and, therefore, may not be suitable for another purpose. The auditor describes the purpose for which the financial statements are prepared and, if necessary, the intended users or refers to a note in the special purpose financial statements that contains that information.

Illustrative Emphasis of Matter — Basis of accounting

“We draw attention to Note X to the financial statements, which describes the basis of accounting. The financial statements are prepared to assist [Name of entity] to meet the requirements of [name of regulator]. As a result, the financial statements may not be suitable for another purpose. Our opinion is not modified in respect of this matter.”

The auditor may expand the Emphasis of Matter paragraph to include the restriction on use (instead of adding a separate Other Matter paragraph), and the heading in the auditor’s report can be modified accordingly (refer below).

Emphasis of Matter — Basis of accounting and restriction on use

We draw attention to Note X to the financial statements, which describes the basis of accounting. The financial statements are prepared to assist [Name of entity] in complying with the financial reporting provisions of the contract referred to above. As a result, the financial statements may not be suitable for another purpose. Our auditor’s report is intended solely for the information and use of [Name of entity] and [Name of other contracting party] and should not be used by parties other than [Name of entity] or [Name of other contracting party]. Our opinion is not modified in respect of this matter.

Inclusion of a Reference to the Auditor’s Report on the Complete Set of General Purpose Financial Statements

SA 800 states that the auditor may deem it appropriate to refer, in an Other Matter paragraph in the auditor’s report on the special purpose financial statements, to the auditor’s report on the complete set of general purpose financial statements or to matter(s) reported therein. For example, the auditor may consider it appropriate to refer in the auditor’s report on the special purpose financial statements to a Material Uncertainty Related to Going Concern section included in the auditor’s report on the complete set of general purpose financial statements.

Adequate disclosures in the financial statements

The management should ensure that the special purpose financial statements contain adequate disclosures to enable the intended users to understand the information contained in the financial statements.

Concluding remarks

Financial statements prepared under a special purpose framework or special circumstances are specific engagements that provide specific information relevant to a specified group of users. Therefore, it is imperative for the management and the auditor to understand the requirements of such specific users. As the audit reports of general purpose financial statements and special purpose financial statements are governed by two separate sets of auditing standards, i.e. SA 700 and SA 800, an auditor should understand the difference between the two frameworks. Also, the auditors should exercise professional judgement while accepting such engagements and issuing opinions, as it helps maintain stakeholder confidence in the assurance.

Audit Trail Compliance in Accounting Software

The article covers the Audit Trail requirements in accounting software as mandated by the companies act, 2013. It covers how the auditor can check the compliance of the Audit Trail requirements when the client is using the most used accounting software Tally. The Article covers the comparison of different Tally versions, user access for Audit trail compliance, Frequently Asked Questions from Auditor’s perspective and action points by Auditors for the purpose of reporting. Let’s dive-in.

INTRODUCTION

In today’s digital landscape, maintaining the integrity and transparency of financial data is more crucial than ever. With increasing regulatory scrutiny, Companies must ensure compliance with audit trail requirements as mandated under the Companies Act, 2013. TallyPrime, a leading accounting software, offers a robust feature (called Edit Log) that facilitates the implementation of audit trails, enabling organisations to track changes and maintain comprehensive records of all transactions. This capability not only enhances accountability but also supports businesses in meeting their compliance obligations effectively.

As companies navigate the complexities of financial reporting and regulatory requirements, it is imperative for companies, as well as auditors, to understand how to leverage TallyPrime for audit trail compliance. This article will explore the significance of audit trails in TallyPrime, detailing the software’s features that support compliance, the steps necessary for effective implementation, various reports available for auditors, and best practices for maintaining an accurate audit trail.

We shall discuss the Audit trail compliance in TallyPrime by dissecting in following parts.

  •  Audit Trail compliance requirements as per Companies Act, 2013
  •  Overview of Audit Trail compliance in TallyPrime
  •  Edit Log in TallyPrime
  •  User Access in TallyPrime
  •  Frequently Asked Questions
  •  Conclusion

AUDIT TRAIL REQUIREMENTS AS PER THE COMPANIES ACT, 2013

The introduction of audit trail requirements under the Companies Act, 2013 marks a significant step towards enhancing transparency and accountability in corporate governance. Effective from 1st April, 2023, these requirements apply to all companies, including small companies and not-for-profit organisations. Here’s an overview of the audit trail requirements and their implications. We will examine the Audit trail requirements from the software compliance perspective only.

Definition of Audit Trail

An audit trail is a chronological record that captures all transactions and changes made within an accounting system. This includes details such as:

  •  When changes were made (date and time).
  •  What data was changed (transaction reference)?
  •  Who made the changes (user ID)?

This systematic recording is essential for tracing errors, ensuring compliance, and maintaining the integrity of financial records.

Applicability

The audit trail requirements apply to all types of companies registered under the Companies Act, including:

  •  Private limited companies
  •  Public limited companies
  •  One Person Companies (OPCs)
  •  Section 8 companies (not-for-profit)
  •  Nidhi companies etc.

However, these requirements do not extend to
Limited Liability Partnerships (LLPs) or other non-company entities.

Key Requirements in Accounting Software

  •  Mandatory Implementation: All companies (including small private limited companies) must use accounting software that has a built-in mechanism to record an audit trail for every transaction. This includes creating an edit log for each change made in the electronically maintained books of account.
  •  Non-Disabling Feature: The audit trail feature must be configured in such a way that it cannot be disabled or tampered with. This ensures that the integrity of the audit trail is maintained throughout the financial year.

Compliance and Responsibilities

  •  Management Responsibility: It is the responsibility of the management to implement the audit trail feature effectively. This includes ensuring that the software used for accounting complies with the audit trail requirements.
  •  Auditor’s Role: Auditors must verify the implementation of the audit trail feature in accounting software and report on its effectiveness in their audit reports. They should also ensure that the audit trail is preserved as per statutory requirements.
  •  Reporting Obligations: Auditors are required to report:

♦ Whether the company is using accounting software with an audit trail feature

♦ Whether this feature was operational throughout the year, and

♦ Whether the audit trail covers all transactions.

Overview of Audit Trail Compliance in TallyPrime

Considering the Audit Trail requirements, Tally has given “Edit Log” features in TallyPrime. The Edit Log feature in TallyPrime has been designed with the necessary controls in place to eliminate any scope of tampering with the trail of accounting transactions. These controls are designed as a default feature of the “TallyPrime Edit Log.

The Edit Log feature is introduced in TallyPrime Edit Log Release 2.1 and TallyPrime Release 2.1. This means there are now 2 products of TallyPrime. One is called “TallyPrime Edit Log”, and the other is called “TallyPrime”. Both the products have the same set of features, including Edit Log. However, only the TallyPrime Edit Log meets the Audit Trail compliance requirements. (Note: Edit log feature is available in TallyPrime Release 2.1 and onwards.)

The following table helps to better understand the difference between “TallyPrime Edit Log” and “TallyPrime.”

Hence, as an auditor, the first task is to check whether the company is using “TallyPrime Edit Log” or “TallyPrime”. If the Company is using only “TallyPrime”, one can simply say it is not complying with the Audit trail requirements as mandated by the Companies Act. (Reason: In TallyPrime, the Edit Log can be disabled.)

How to check which product you are using?

There are various ways in which one can check which product he is using.

  1.  Once you start TallyPrime, Click on F1: Help → About→Under Product Information. Check the “Application”

In the case of TallyPrime, it shows “Application: TallyPrime.”

In the case of the TallyPrime Edit Log, it shows “Application: TallyPrime Edit Log (EL).”

2. When you start TallyPrime, check the top left-side corner of the screen.

3. Check the shortcut Icon of TallyPrime; if it shows the word “EL”, it is TallyPrime Edit Log

Edit Log in “TallyPrime Edit Log”

Having understood the different products of TallyPrime and how to check the product you are using, let us now discuss the Edit Log functionality.

Edit Log is a view-only (display) report that maintains track of all activities with your vouchers and masters, like creation, alteration, deletion, and so on,
without the need for any additional controls to restrict access. This means that at any given point, a user can ONLY view the Edit Log report to understand the trail of activities.

The underlying design principle of Edit Log enables users to view the logs and compare them with their previous version, thereby providing more specific insights on the updates done to the vouchers and masters. Additionally, if a user attempts to open the Edit Log using a TallyPrime non-Edit Log version, a log gets created keeping track of this activity. This helps auditors check if any user has opened the Edit Log in any other non-Edit Log version of TallyPrime. Such inbuilt controls designed in TallyPrime make the Edit Log data much more reliable and tamper-proof.

Edit log is available at 3 levels viz. Company level, Master Level, and entry (transaction) level.

Edit log for Company.

The Edit log report at the company level consists of all the activities in the Company data that may affect the existing Edit Logs for transactions and masters.

To view this report, the user needs to follow the below-mentioned steps:

  •  Open the company data
  •  Press Alt + K
  •  Go to “Edit Log”

Once you go into the “Edit log” report at the company level, the sample report appears as follows:

By observing the above report, the auditor can know the various activities affecting the Tally data. E.g., In the above data, one can observe that data was moved from TallyPrime on 20th November, 2024, at 15.21. Kindly note that the above is a sample report.

Edit Log for Masters

Edit log is provided for three masters. Ledgers, groups, and stock items. The activities such as creation, alteration, or deletion in these masters can change the financial reports in the company data. For other masters like cost center or payroll, an edit log is not available. The reason is that these masters do not affect the financial reports like Trial balance, Profit & Loss Account, and Balance sheet.

Let us take the example of a ledger and understand how to view the edit log.

One may be making changes in the ledgers as per requirement. Edit Log tracks all such changes made. One can view the details of changes made in the selected version of the ledger as compared to its previous version, which TallyPrime highlights in red text. Similarly, one can drill down to any version and view the comparison between it and its previous version.

  1. Open the required Ledger.

Press Alt+G(Go To) → type or select Chart of Accounts and press Enter → select Ledger and press Enter.

The Ledger Alteration screen appears.

     2. Press Alt+Q (Edit Log).

Alternatively, press Ctrl+O (Related Reports) →Edit Log and press Enter.

The Edit Log report displays the Version, Activity, Username, and Date & Time.

One can observe that the ledger was created by the user “Urmi” on 7-Feb-23, and the ledger was altered by the user “asap” on 20-Nov-24. If one clicks enter on “Altered”, it will show the detailed comparison of Version 1 of the ledger and Version 2 of the ledger, and differences shall be highlighted in Red text.

Edit log for the Groups and Stock item masters works in a similar manner.

Edit Log for Transactions

The Edit Log report for transactions provides you with an idea of the nature of the activity that a particular user performed at a specific time. This helps you monitor the activities and have better internal control over your Company data.

To access the edit log report of any transaction, one can go inside the transaction in Alter mode or view mode (Alt + Enter) and select “Related reports” from the right-side bar (Press Ctrl + O) and press enter on edit log.

The Edit Log reports for transactions (sample report) are shown below.

 

 

One can view the details of changes made in the selected version of the entry as compared to its previous version, which TallyPrime highlights in red text. Similarly, one can drill down to any version and view the comparison between it and its previous version.

Consolidated reports for Altered entries / Cancelled Entries / Deleted Entries

Many times, an auditor needs a list of entries that are altered or deleted during the period. This report is available in the daybook.

To view the report, follow the below steps:

1. Go to the daybook (from Gateway of Tally →Display more reports → Day book. Alternatively, the day book can be accessed from “Go To”)

2. Select the required period Alt + F2

3. Once the daybook report is open, click on “Basis of Values” or press Ctrl + B

4. The following screen appears

5. In the option “Show report for”, press enter and select “Altered Vouchers.”

6. Press enter and accept the screen

7. A list of altered entries shall appear

8. In the same way, if you select the option “Include Deleted Vouchers” as “Yes”, Along with altered entries, deleted transactions shall appear.

9. One can go inside the deleted entries and check the edit log in deleted entries also.

User-based Access

After understanding the Edit Log functionality in Tally, Let us now answer the “Who” part of the Audit trail requirement, i.e. Who made the changes (user ID).

Tally offers a comprehensive user access management system that allows businesses to define roles and permissions for different users on a need-to-know basis. This feature is crucial for maintaining control over who can view or modify financial data.

For Audit trail compliance, the company needs to ensure that user access is enabled and that all users are given distinct user IDs. This shall help in answering the “Who” part of the question i.e., who made the changes.

There are detailed configurations possible in user-based access in the company data, including restriction to view reports, passing entries based on nature of work or location, implementing password policy, and locking the data backdated, etc.; however, that can be discussed in a separate note. Here, we shall only discuss how the auditor can check whether the company has enabled user-based access or not. User-based access is discussed from the perspective of the audit trail requirements only.

Once you open the company data, click on Alt + K  → Users and Passwords.

Once you enter the above report, a list of users and passwords shall appear. This will ensure that the company has activated user-based access.

Note: The above navigation is available only from the Admin login ID of the Tally data.

As an auditor, one should apply the audit techniques and check whether all the users who are required to access Tally data have been granted username and password.

FREQUENTLY ASKED QUESTIONS (FAQS)

These FAQs are designed based on the common queries faced by auditors.

(Caution: A few FAQs may sound basic to the more advanced users of Tally)

Q: Does Tally.ERP9 comply with the Audit trail requirements?

A: No, it does not comply with the Audit trail requirements.

Q: The client has done the customisation in Tally.ERP9, which reports on What, When, and Who of the Audit trail requirements? Does it comply with the Audit trail requirements?

A: No, it still does not comply with the Audit trail requirements. One of the key requirements of the accounting software is that the Audit trail features should be “non-disabling”. So even if some customisation is done in Tally.ERP9 for audit trail requirements does not comply with the requirements as per the Companies Act since any customisation done in Tally can always be disabled by the admin user.

Q: The client is using TallyPrime (Non-Edit Log version) and has enabled the edit log and has used it for the entire reporting period. Does it comply with the Audit trail requirements?

A: In the above scenario, although the entire audit trail is available for all the Masters and transactions, strictly speaking, it cannot be said that it is compliant with the audit trail requirements. One of the requirements of the Audit trail-enabled software is that the Audit trail feature cannot be disabled or tampered with. In case the
client is using TallyPrime (Non-Edit log version), the Edit log can be disabled. (Whether it is disabled or not is irrelevant).

Q: The client is using TallyPrime, and CA is using TallyPrime Edit Log. What if CA calls the data of the client and restores it in the TallyPrime Edit Log? Does it comply with the Audit trail requirements?

A: No, it does not comply with the Audit trail requirements. One of the requirements of an Audit trail is it should be operated throughout the reporting period. Hence it is not in compliance with the requirements.

Q: Do I need to buy a new license for the TallyPrime Edit Log?

A: No, the Same license works for both the products simultaneously, TallyPrime and TallyPrime Edit Log.

Q: Can we restrict users from viewing the Edit Log reports?

A: Yes, one can define the appropriate user access rights and restrict the users from viewing the Edit Log reports.

Q: If a company is using TallyPrime Edit Log, Can the Edit Log data be completely removed or deleted from the Company data?

A: No, it is not possible to remove or delete the Edit Log data of transactions and masters in the TallyPrime Edit Log Product.

Q: How is the Edit log created when we import the data from Excel to Tally?

A: Edit Log will show Created due to import along with date and time.

Q: How is the Edit log created when we sync the data from one Tally to another Tally?

A: Edit Log will show Created due to sync along with date and time.

Q: Are Tally Audit features and Edit Log features the same thing?

A: No, both are different features. Tally Audit is an old feature available in Tally.

Q: Can we use Tally Audit features and Edit Log features in the same company Tally data?

A: Yes, one can use both the features at the same time in the company data.

Q: Does the TallyPrime Edit Log provide one single report for all the changes made by the user?

A: No, it does not provide such a report, and it is also not required as per Audit trail compliance requirements. However, the said report can be customised. Alternatively, one can view the list of all altered vouchers or deleted vouchers from the daybook. To check what is altered at the entry-level, one needs to go inside the entry in alter mode or view mode (Alt + Enter) and check “Related reports”.

Q: Where can we learn more about the TallyPrime Edit log?

A: Tally has given on its website the details of the TallyPrime Edit Log. One can refer to the link “https://help.tallysolutions.com/tally-prime/edit-log/tracking-modifications/”

CONCLUSION

In the beginning, we understood the basic requirements of the Audit trail-enabled software. To summarise, the software used should be able to answer the following questions:

  •  When changes were made (date and time)
  •  What data was changed (transaction reference)
  •  Who made the changes (user ID)

Apart from the above, it is required that the Audit trail features need to be mandatory, and they cannot be disabled or tampered with.

Also, it is the responsibility of the management to adopt and implement the accounting software that is compliant with the Audit trail requirements. Auditors’ responsibility is to verify and report whether the company has implemented such software or not in compliance with the Audit trail requirements.

When the company is using Tally as Accounting software, As an Auditor, one needs to check the following points before reporting:

  •  The company is using the “TallyPrime Edit Log” and not “TallyPrime” or “Tally.ERP9”.
  •  The company has been using the “TallyPrime Edit Log” from the beginning of the reporting period. (Check Edit Log for Company).
  •  There is no migration of company data from/back in the “TallyPrime Edit log” during the period under Audit.
  •  User access is enabled, and users are given a distinct user ID to access the company Tally data.

Once the above points are checked, the auditor shall be able to report confidently on Audit trail compliance requirements.

Ind AS 117 – Insurance Contracts

INTRODUCTION

We have got used to the Ministry of Corporate Affairs (MCA) introducing new Accounting Standards at the end of a financial year. Both Ind AS 115 — Revenue from Contracts with Customers and Ind AS 116 — Leases were announced in the end of March. One would have thought that the same pattern would play out for the implementation of Ind AS 117 — Insurance Contracts. However, the MCA pulled a surprise on 12th August, 2024 by not only announcing the Standard but also making it applicable for the Financial Year 2024–25. Ind AS 117 is a much more detailed and comprehensive standard than Ind AS 104 – Insurance Contracts. Ind AS 117 takes into account that the insurance and banking industries provide services that complement each other. Ind AS 117 acknowledges this and takes us back to Ind AS 109 wherever there is a trace of a financial instrument in an insurance contract. Ind AS 117 is a detailed standard: the standard has 132 main paragraphs, 154 paragraphs of application guidance, 22 definitions and 57 paragraphs on transition provisions.

SCOPE

Ind AS 117 defines an insurance contract as “A contract under which one party (the issuer) accepts significant insurance risk from another party (the policyholder) by agreeing to compensate the policyholder if a specified uncertain future event (the insured event) adversely affects the policyholder”. By definition, it is clear that Ind AS 117 would apply to plain-vanilla insurance contracts such as fire, life, theft, damage, product liability, professional liability, life-contingent annuities or pensions and medical costs, etc. However, by interpretation of the definition, Ind AS 117 would also apply to product warranties issued by another party on behalf of the manufacturer, surety, fidelity and catastrophe bonds and insurance swaps. (Para B 26 of Ind AS 117).

GROUPING OF CONTRACTS

IND AS 117 requires entities to identify portfolios of insurance contracts, which comprises contracts that are subject to similar risks and managed together. Contracts within a product line would be expected to have similar risks and hence would be expected to be in the same portfolio if they are managed together. Each portfolio of insurance contracts issues shall be divided into a minimum of three cohorts: onerous contracts, contracts that could not turn onerous and a residuary category. An entity is not permitted to include contracts issued more than one year apart in the same group.

RECOGNITION

An entity shall recognise a group of insurance contracts it issues from the earliest beginning of the coverage period, the date when the first payment from a policyholder in the group becomes due or for a group of onerous contracts, when the group becomes onerous.

MEASUREMENT

Ind AS 117 provides three methods to measure insurance contracts:

1. General Measurement Model or Building Block Approach: the default method

2. Premium Allocation Approach: an optional method for certain specific type of contracts

3. Variable fee approach: a specific method for direct participating contracts.

BUILDING BLOCK APPROACH

Ind AS 117 mandates that on initial recognition, an entity shall measure a group of insurance contracts at the total of the fulfilment cash flows (FCF) and a contractual service margin (CSM). FCFs are an explicit, unbiased and probability-weighted estimate (i.e., expected value) of the present value of the future cash outflows minus the present value of the future cash inflows that will arise as the entity fulfils insurance contracts, including a risk adjustment for non-financial risk.

Risk adjustment for non-financial risk

The estimate of the present value of the future cash flows is adjusted to reflect the compensation that the entity requires for bearing the uncertainty about the amount and timing of future cash flows that arises from non-financial risk.

Contractual service margin

The CSM represents the unearned profit of the group of insurance contracts that the entity will recognise as it provides services in the future. This is measured on initial recognition of a group of insurance contracts at an amount that, unless the group of contracts is onerous, results in no income or expenses arising from:

(a) the initial recognition of an amount for the FCF,

(b) the derecognition at that date of any asset or liability recognised for insurance acquisition cash flows, and

(c) any cash flows arising from the contracts in the group at that date.

As a simple mathematical example, assume that over a three-year insurance contract, an insurance company estimates discounted cash inflows to be ₹1,000, discounted outflows to be ₹200, risk adjustment for non-financial risk to be ₹150 and the CSM to be ₹100, the value of the insurance contract at initial measurement would be ₹1,050.

Subsequent measurement

On subsequent measurement, the carrying amount of a group of insurance contracts at the end of each reporting period shall be the sum of:

(a) the liability for remaining coverage comprising:

(i) the FCF related to future services, and

(ii) the CSM of the group at that date;

(b) the liability for incurred claims, comprising the FCF related to past service allocated to the group at that date.

Onerous contracts

Taking a cue from Ind AS 37, Ind AS 117 states that an insurance contract is onerous at initial recognition if the total of the FCF, any previously recognised acquisition cash flows and any cash flows arising from the contract at that date are a net outflow. An entity shall recognise a loss in profit or loss for the net outflow, resulting in the carrying amount of the liability for the group being equal to the FCF and the CSM of the group being zero. On subsequent measurement, if a group of insurance contracts becomes onerous (or more onerous), that excess shall be recognised in profit or loss.

As a simple mathematical example, assume that over a three-year insurance contract, an insurance company estimates discounted cash inflows to be ₹1,000, discounted outflows to be ₹1,200 and risk adjustment for non-financial risk to be ₹150. The net outflow of ₹350 would be recognised in the profit or loss account. CSM would always be Nil for onerous contracts.

PREMIUM ALLOCATION APPROACH

An entity may simplify the measurement of the liability for remaining coverage of a group of insurance contracts using the Premium Allocation Approach (PAA) on the condition that at the inception of the group:

(a) the entity reasonably expects that this will be a reasonable approximation of the general model, or

(b) the coverage period of each contract in the group is one year or less.

Where, at the inception of the group, an entity expects significant variances in the FCF during the period before a claim is incurred, such contracts are not eligible to apply the PAA.

Using the PAA, the liability for remaining coverage shall be initially recognised as the premiums, if any, received at initial recognition, minus any insurance acquisition cash flows. Subsequently, the carrying amount of the liability is the carrying amount at the start of the reporting period plus the premiums received in the period, minus insurance acquisition cash flows, plus amortisation of acquisition cash flows, minus the amount recognised as insurance revenue for coverage provided in that period, and minus any investment component paid or transferred to the liability for incurred claims.

VARIABLE FEE APPROACH

The Variable Fee Approach (VFA) is a modified model for insurance contracts with direct participation features. The VFA defines a variable fee as the entity’s share of the underlying items as a fee for the services it provides. The value of the variable fee changes based on the value of the assets.

REINSURANCE CONTRACTS HELD

The requirements of the standard are modified for reinsurance contracts held.

In estimating the present value of future expected cash flows for reinsurance contracts, entities use assumptions consistent with those used for related direct insurance contracts. Additionally, estimates include the risk of reinsurer’s non-performance.

The risk adjustment for non-financial risk is estimated to represent the transfer of risk from the holder of the reinsurance contract to the reinsurer.

On initial recognition, the CSM is determined similarly to that of direct insurance contracts issued, except that the CSM represents net gain or loss on purchasing reinsurance. On initial recognition, this net gain or loss is deferred, unless the net loss relates to events that occurred before purchasing a reinsurance contract (in which case, it is expensed immediately).

Subsequently, reinsurance contracts held are accounted similarly to insurance contracts under the general model. Changes in reinsurer’s risk of non-performance are reflected in profit or loss, and do not adjust the CSM.

MODIFICATION OF AN INSURANCE CONTRACT

If the terms of an insurance contract are modified, an entity shall derecognise the original contract and recognise the modified contract as a new contract if there is a substantive modification, based on meeting any of the specified criteria.

The modification is substantive if any of the following conditions are satisfied:

(a) if, had the modified terms been included at contract’s inception, this would have led to:

(i) exclusion from the Standard’s scope;

(ii) unbundling of different embedded derivatives;

(iii) redefinition of the contract boundary; or

(iv) the reallocation to a different group of contracts; or

(b) if the original contract met the definition of direct par insurance contracts, but the modified contract no longer meets that definition, or vice versa; or

(c) the entity originally applied the PAA, but the contract’s modifications made it no longer eligible for it.

DERECOGNITION

An entity shall derecognise an insurance contract when it is extinguished, or if any of the conditions of a substantive modification of an insurance contract are met.

Presentation in the statement of financial position

An entity shall present separately in the statement of financial position the carrying amount of groups of:

(a) insurance contracts issued that are assets;

(b) insurance contracts issued that are liabilities;

(c) reinsurance contracts held that are assets; and

(d) reinsurance contracts held that are liabilities.

Recognition and presentation in the statement(s) of financial performance

An entity shall disaggregate the amounts recognised in the statement(s) of financial performance into:

(a) an insurance service result, comprising insurance revenue and insurance service expenses; and

(b) insurance finance income or expenses.

Income or expenses from reinsurance contracts held shall be presented separately from the expenses or income from insurance contracts issued.

Insurance service result

An entity shall present in profit or loss revenue arising from the groups of insurance contracts issued, and insurance service expenses arising from a group of insurance contracts it issues, comprising incurred claims and other incurred insurance service expenses. Revenue and insurance service expenses shall exclude any investment components. An entity shall not present premiums in the profit or loss if that information is inconsistent with revenue presented

Insurance finance income or expenses

Insurance finance income or expenses comprises the change in the carrying amount of the group of insurance contracts arising from:

(a) the effect of the time value of money and changes in the time value of money; and

(b) the effect of changes in assumptions that relate to financial risk; but

(c) excluding any such changes for groups of insurance contracts with direct participating insurance contracts that would instead adjust the CSM.

An entity has an accounting policy choice between including all of insurance finance income or expense for the period in profit or loss or disaggregating it between an amount presented in profit or loss and an amount presented in other comprehensive income (OCI).

Under the general model, disaggregating means presenting in profit or loss an amount determined by a systematic allocation of the expected total insurance finance income or expenses over the duration of the group of contracts. On derecognition of the groups, amounts remaining in OCI are reclassified to profit or loss.

Under the VFA, for direct par insurance contracts, only where the entity holds the underlying items, disaggregating means presenting in profit or loss as insurance finance income or expenses an amount that eliminates the accounting mismatches with the finance income or expenses arising on the underlying items. On derecognition of the groups, the amounts previously recognised in OCI remain there.

DISCLOSURES

An entity shall disclose qualitative and quantitative information about:

(a) the amounts recognised in its financial statements that arise from insurance contracts;

(b) the significant judgements, and changes in those judgements, made when applying IND AS 117; and

(c) the nature and extent of the risks that arise from insurance contracts.

IRDAI

Now that Ind AS 117 has been issued, insurance companies would be looking forward to final formats and instructions from their regulator, Insurance Regulatory and Development Authority of India (IRDAI). In the past, IRDAI has had committees to suggest formats and guidelines for the implementation of Ind AS. A report of an erstwhile Committee was received in 2018 but since there were a few revisions made to IFRS 17, a new committee was formed in early 2024. IRDAI would need to implement the suggestions made by the Committee when its report is received.

IMPLEMENTATION ISSUES

Given the short time provided to insurance companies to implement the standard, they could face a few implementation issues. The fact that most of these companies have also not implemented Ind AS 109 – Financial Instruments further adds to their implementation issues since Ind AS 117 refers to Ind AS 109 quite frequently. The European Insurance and Occupational Pensions Authority (EIOPA) has published a report on the impact of IFRS – 17 and the challenges in implementation of the standard. The challenges were divided into four categories: understanding the standard, getting the data, interpreting the financial statements and building the systems. In India, there could be a further challenge in terms of impact on GST and income tax. GST laws would not recognise concepts such as CSM and risk adjustments while the Income Computation and Disclosure Standards (ICDS) have still not been upgraded to deal with any of the Ind AS accounting standards. Skilling the finance and accounts team on the nuances of the Standard through training programs would probably be the first priority for insurance companies.

Is Surplus in Profit and Loss Account a Free Reserve?

When I pose this question, the immediate answer is, “Any Doubt?” If we see the provisions of the Companies Act, 2013 (CA 2013) as well as the previous Act (CA 1956), one will note that the answer is not free from doubt.

CA 2013 contains several provisions where limits under the sections are calculated as per cent of Paid up Capital and Free Reserves such as section 68 (Buy Back of shares), section 73 (Acceptance of Deposits), section 180 (Borrowing Powers of the Board), section 186 (Loans and Investments by companies). If these calculations are incorrectly made by including an item wrongly in Free Reserves, it can involve a violation under CA 2013.

Let us, therefore, see some of the related provisions of the CA 1956/2013, and related rules and seek a reply to our query regarding surplus in the Profit and Loss Account.

I. PRESENTATION OF SURPLUS IN BALANCE SHEET

Let us have a look at the provisions of Schedule III Part I for the presentation of Reserves and Surplus.

Reserves and Surplus:

i) Reserves and Surplus shall be classified as: (a) Capital Reserves; (b) Capital Redemption Reserve; (c) Securities Premium; (d) Debenture Redemption Reserve; (e) Revaluation Reserve; (f) Share Options Outstanding Account; (g) Other Reserves — (specify the nature and purpose of each reserve and the amount in respect thereof);

(h) surplus, i.e., balance in Statement of profit and loss disclosing allocations and appropriations such as dividend, bonus shares and transfer to/from reserves etc. (Additions and deductions since last Balance Sheet to be shown under each of the specified heads) (ii) A reserve specifically represented by earmarked investments shall be termed as a ‘fund’. (iii) Debit balance of statement of profit and loss shall be shown as a negative figure under the head ‘Surplus’. Similarly, the balance of ‘Reserves and Surplus’, after adjusting the negative balance of surplus, if any, shall be shown under the head ‘Reserves and Surplus’ even if the resulting figure is negative.

We thus note that surplus is referred to as Balance in the Statement of profit and loss Account and stands on a different footing as compared to Reserves which are mentioned in (a) to (g) above.

II. FREE RESERVES UNDER COMPANIES ACT, 1956 (CA 1956)

CA 1956 did not have the definition of Free Reserves in the definition chapter. However, for the limited purpose of its section 372A, the term ‘Free Reserves’ was defined as under:

“372A. Explanation (b)— ‘Free reserves’ means those reserves which as per latest audited balance sheet of the company are free for distribution as dividend and shall include balance to the credit of the securities premium account but shall not include share application money.”

This definition is not exhaustive. The term ‘Free Reserves’ is also defined in other enactments and rules. Under rule 2(d) of the Companies (Acceptance of Deposits) Rules, 1975 (AODR 1975), it is defined as under:

‘Free reserves’ include the balance in the share premium account, capital and debenture redemption reserves and any other reserves shown or published in the balance sheet of the company and created by appropriation out of the profits of the company, but does not include the balance in any reserve created: (i) for repayment of any future liability or for depreciation in assets or for bad debts; (ii) by the revaluation of any assets of the company.”

It is interesting to note that Section 372A was introduced in the statute book by the Companies (Amendment) Act, 1999 w.e.f. 31st October, 1998. Therefore, till then, one needed to refer to the definition of Free Reserves for the limited purpose of AODR 1975. These rules dealt with the Acceptance of Deposits, and for the said purpose, limits were prescribed based on Paid Up Capital and Free Reserves. A clarification was sought from MCA regarding Free Reserves and MCA clarified as under:

Rule 2(d): Whether amount of surplus in the profit and loss account forms part of “free reserve” as defined in the rules?

After re examination of the matter in detail, it has since been decided that the amount of “surplus” shown in the profit and loss account carried forward under the heading “Reserve and Surplus” appearing in the balance sheet of company, may be treated as part of “free reserve”, as defined under the Rules, subject, of course, its satisfying condition that it arises by appropriation out of the profits of the company. [LETTER NO. 3/1/80 CL X, DATED 3rd, February, 1982.]

In fact, this clarification is also conditional, and one needs to look into the highlighted portions at the beginning, which indicates that this clarification is given on re-examination. (Does it mean that there was a contrary view before?) The closing condition that surplus arises out of appropriation of profits is further confusing. But be that as it may, this clarification is for a limited purpose of AODR 1975 and speaks very less and confuses more.

III. RESERVE AND SURPLUS AS DEFINED IN GUIDANCE NOTE* ON TERMS USED IN FINANCIAL STATEMENTS

Para 14.04 Reserve: The portion of earnings, receipts or other surplus of an enterprise (whether capital or revenue) appropriated by the management for a general or a specific purpose other than a provision for depreciation or diminution in the value of assets or for a known liability. The reserves are primarily of two types: capital reserves and revenue reserves.

Para 15.21 Surplus: Credit balance in the profit and loss statement after providing for proposed appropriations, e.g., dividend or reserves.

*Although this Guidance note is withdrawn later on.

Thus, we note that both the terms are not used interchangeably. In fact, one will have to keep in mind a basic premise of how the Reserve comes into existence. The reserve comes into existence with the appropriations from the Profit and loss Account (i.e., surplus), whereas a surplus is the Balance remaining after appropriations. Surplus is a balancing figure, unlike reserves. Thus, the Reserve is an end result arising from the source, which is a Surplus in the Profit and loss Account.

IV. DEFINITION OF FREE RESERVES UNDER CA 2013

As mentioned before, the term Free Reserves is now defined in the Definitions Chapter in the CA 2013. Section 2(43) of CA 2013 defines Free Reserves as:

Section 2(43) ― free reserves means such reserves which, as per the latest audited balance sheet of a company, are available for distribution as dividend:

Provided that — (i) any amount representing unrealised gains, notional gains or revaluation of assets, whether shown as a reserve or otherwise, or (ii) any change in carrying amount of an asset or of a liability recognised in equity, including surplus in profit and loss account on measurement of the asset or the liability at fair value, shall not be treated as free reserves;

If we paraphrase this definition, one notes following essential elements:

  • Definition is exhaustive.
  • Only Reserves are included (such reserves).
  • Such reserves are as per the latest audited balance sheet.
  • Such reserves are available for distribution as dividend.
  • Proviso carves out an exception as to few notional gains etc.

If we look at the essential elements of this definition, prima facie surplus in the profit and loss account does not satisfy the condition because it is not a reserve created from the profit and loss account. It represents a balance in the profit and loss account after appropriations. It satisfies a latter condition of being available for the distribution of dividends, but it is not a reserve.

At this stage, it will not be out of place to note the observation of Mumbai Tribunal in the matter of LIC Housing Finance limited vs. DCIT 2(2), Mumbai (180 ITD 45). The tribunal has observed as under in Para 2.4 of the order:

2.4 We have carefully considered the rival submissions and deliberated on cited decision of the Tribunal. As per the provision of Sec 36(1)(viii), certain specified assesses are eligible to claim deduction to the extent of 40% from profit derived from specified business upon creation of special reserve. As per the proviso, if the amount carried to such special reserve account, from time to time, exceeds twice the amount of the paid-up share capital and of the general reserves, no allowance under this clause shall be made in respect of such excess. The expression used in the proviso is the general reserves. The term general reserves have been used in plural sense and preceded by the words which would indicate that it carries special meaning and connotes general reserves only to the exclusion of other. In our considered opinion, the reserves are created as an appropriation out of Profit & Loss Account and the terms Profit & Loss Account & General reserves as mentioned in the proviso could not be equated with each other, in the manner, as suggested by Ld. AR by relying upon the letter* of Department of Company Affairs. The said circular, in our considered opinion, would have limited applicability in the context of which it has been issued and designed to apply in certain specific situation only. The expression used in the proviso are quite clear which mandates the inclusion of only the general reserves and nothing else. As per doctrine of literal interpretation, when the wordings in the statute are clear, the same has to be given the full effect. Therefore, we are unable to accept the arguments raised by Ld.AR, in this regard. Our view is duly supported by the cited decision of the Tribunal rendered on identical set of facts and circumstances. The coordinate bench has confirmed the stand of learned first appellate authority in excluding the balances in Share premium account, Profit & Loss Account and special Reserve account while computing the general reserves. Nothing on record would suggest any change in facts or as to how the said ruling is not applicable to the facts of the case.

* LETTER NO. 3/1/80 CL X, DATED 3rd February, 1982, is referred in Para 2.3 of the order which is referred in Part II of this article above.

We are reading this judgment only to note the observation that reserves are created out of the Profit and loss Account. In my view, reserves do not come into existence on their own but derive their existence from the source from which they are created.

V. PAYMENT OF DIVIDEND OUT OF RESERVES

As per the provisions of section 123 of CA 2013, dividends can be paid from the following sources:

  • 1(a) out of the profits of the company for that year arrived at after providing for depreciation in accordance with the provisions of sub-section (2), or out of the profits of the company for any previous financial year or years arrived at after providing for depreciation in accordance with the provisions of that sub-section and remaining undistributed, or out of both; or

The Second and third proviso to sub-section 1 of Section 123 reads as under:

  • Provided further that where, owing to inadequacy or absence of profits in any financial year, any company proposes to declare dividends out of the accumulated profits earned by it in previous years and transferred by the company to the reserves, such declaration of dividend shall not be made except in accordance with such rules as may be prescribed in this behalf:
  • Provided also that no dividend shall be declared or paid by a company from its reserves other than free reserves:

We thus note that dividends can be paid from current or past profits as well as from the reserves. However, when dividends are declared out of Free Reserves, The Companies (Declaration and Payment of Dividend) Rules, 2014 (DP Rules, 2014) apply. The crucial words in the second proviso are underlined. This indicates that if there is a balance in the profit and loss account, then provisions of DP Rules, 2014 do not apply since word and is used.

This view is supported by the clarification from ICSI in its Guidance Note on Dividends. The clarification reads as under:

This is to clarify that the declaration of Dividend out of profits for previous year which are disclosed under the head ‘Surplus’ in the Financial Statements will not tantamount to declaration of Dividend out of reserves and accordingly will not attract the statutory requirements relating to declaration of Dividend out of reserves.

So, this is another instance where the legislature itself has distinguished between Free “Reserves” and “Surplus in profit and loss account”.

An interesting proposition was introduced by a few large companies such as Nestle India, and HUL, who have reclassified Reserves and transferred a balance standing in the Reserves to the Profit and Loss account and after that distributed larger dividends.

If we take the case of HUL, the scheme of arrangement was approved by the shareholders and thereafter endorsed by NCLT.

What did HUL achieve in this case?

Rationale and Significant Benefits of the Scheme

The Board of Directors have clarified that “the Company has built up significant reserves from its retained profits by way of transfer to General Reserves. Although the excess reserves can be profitably utilised for overall growth strategy, however, the Board of Directors is of the view that even after considering the foreseeable investments required for such opportunities over the next few years, the funds represented by the General Reserves are in excess of the Company’s current and anticipated operational needs.”

The Board further clarified that the “Company has strong cash flow delivery and the accumulated General Reserves being more than what is needed to fund growth. Further, with a view to providing greater flexibility for the utilisation of such funds, the Company proposes to transfer the amount lying in the credit of General Reserves to the head of the Profit and Loss Account.

Pay-out of Surplus Funds to Members

Upon the Scheme becoming effective, the amount so credited shall be paid out to the Members of the Company, from time to time, by the Board of Directors, at its sole discretion, in such manner, quantum and at such time as the Board of Directors may decide.”

Since HUL desired to make pay-out to its shareholders by reclassifying 100 per cent General Reserves to Profit & Loss Account it was necessary to create a Scheme of Arrangement.

Why it was necessary to frame the Scheme of Arrangement

In terms of the provisions of Section 123 of the Companies Act, 2013, a company generally transfers a certain percentage of profits to the reserves before declaring any dividend during a financial year. Based on that, HUL has created its reserves by transferring profits from time to time.

Rule 3 of the Companies (Declaration and Payment of Dividend) Rules, 2014 provides that in the event of inadequacy or absence of profits in any year, a company may declare dividends out of free reserves provided, amongst others, that the total amount to be drawn from such accumulated profits shall not exceed one-tenth of the sum of its paid-up Share Capital and Free Reserves as appearing in the latest audited financial statement. It means that during any financial year dividends can be declared from Free Reserves only in case of inadequacy or absence of profits and only to the extent of 10 per cent of the paid-up capital and free reserves.

Since HUL desired to make a pay-out to its shareholders by reclassifying 100 per cent General Reserves to Profit & Loss Account and a combined reading of the above provisions puts restrictions for the same, it was necessary to create a scheme of Arrangement. Framing a Scheme of Arrangement was the only option for HUL to reclassify General Reserves to Profit & Loss Account.

All the above discussion will show that one needs to strike a correct balance while transferring profits to reserves. If you transfer more than the required, dividends cannot be freely distributed. If you leave more balance in the Profit and Loss Account, one can pay larger dividends, but such balance may not be treated as the free reserve for certain purposes. This also supports the view that a surplus in the Profit and Loss Account is not a reserve created.

VI. WHY THIS DISCUSSION ON FREE RESERVES IS IMPORTANT

We find several references in the Act to Free Reserves and a few of them are given hereunder:

Section What does it cover Remarks
2(43) Definition.
63 Issue of Bonus Shares. Out of Free Reserves permitted.
68 Power of the company to purchase its own securities. Power to buy back out of free reserves.
73 Prohibition on acceptance of deposits from the public. Limit is w.r.t. Paid up Capital and Free Reserves.
123 Declaration of dividend. Criteria for declaration of dividends out of Free Reserves.
180 Restrictions on powers of the Board. Borrowing up to aggregate of paid-up capital, Free Reserves, and securities premium account.
186 Loan and investment by the company. Criteria for loans and investments tied with Free Reserves being one of the components for determination.

Sections 2(43), 73 (Acceptance of Deposits) and 123 of CA 2013 are already discussed above. As regards sections 180 and 186 of CA 2013, they do not pose a threat because limits can be enhanced by resolution/s passed at AGM. This leaves us with the most popular section of the corporate world regarding Buy Back of Shares.

Section 68 prescribes various sources from which buy back can be made, namely Free Reserves / The Securities Premium / Proceeds of the issue. Sub-section 1 of Section 68 gives these sources as separate sources [sub-section 1(a) to (c)]. However, Explanation II to Section 68 provides that for the purposes of this section (section 68), “free reserves” includes securities premiums. The said explanation thus does not mention about the surplus in the profit and loss account being included in Free Reserves. It is therefore advisable to exercise caution in the matter of buy back, especially when one has a large component of profit and loss account under Reserves and Surplus.

Therefore, having discussed relevant provisions / rules as applicable, one cannot conclusively say that surplus in profit and loss account forms part of free reserves for all purposes. In fact, the discussion made above will lead to the conclusion that Free Reserves do not include a surplus in the profit and loss account. Wherever legislature wanted to clarify that surplus is to be included in Free Reserves, it has done so. However, if one does not come across such a clarification, a caution is advised.

VII. CONCLUDING REMARKS AND SUMMARY AND SUGGESTIONS

  • A surplus in the Profit and Loss Account is presented separately in Financials under Reserves and Surplus, and the Surplus denotes a balancing figure before appropriations.
  • Free Reserves were not defined under CA 1956 except for a limited purpose of section 372A of the CA 1956. In respect of AODR 1975, MCA specifically issued a clarification to state that Free Reserves included surplus in the Profit and Loss Account only for a limited purpose of rule 2(d) of AODR 1975.
  • Guidance Note on Terms used in Financial Statement also clarified that surplus in the Profit and Loss Account only represents a balancing figure and reserves come into existence only from appropriations.
  • The definition of Free Reserves under CA 2013 is exhaustive. Mumbai tribunal has succinctly brought out a difference between surplus in Profit and Loss Account and Reserves.
  • Payment of dividends out of Reserves Rules 1975 and DP Rules, 2014 both do not apply to the payment of dividends from surplus in the Profit and loss Account since surplus in the Profit and Loss Account is not a General Reserve.
  • Treating surplus in the Profit and Loss Account as part of Free Reserves may lead to unwanted complications with the regulators in the absence of clarity in the matter of interpretation.
  • If one is confronted with such a situation of huge surplus in the Profit and Loss Account, one may call for an AGM / EGM and explore the possibility of transfer to Reserves so as to serve one’s purpose. At least that is not restricted presently. This situation can be common these days since the transfer of Profits to Reserves is not mandated under any rules, even in the case of dividend-paying companies.

Sustainability Reporting – Limited Assurance versus Reasonable Assurance

INTRODUCTION

The word “sustainability” is creating a buzz around the world these days. Everyone, including corporates, are echoing about adopting sustainable practices in conducting their business that creates sustainable, long-term shareholder, employee, consumer, and societal value by pursuing responsible environmental, social, economic and or governance strategies. There is an increasing need for companies to act more responsibly in sustainability-related issues due to pressures from their stakeholders. This increased pressure comes with a corresponding need for companies to report on their actions. As the stakeholders of companies do not have the opportunity to assess the credibility of the reporting themselves, the responsibility falls upon a third party to give assurance on the contents of the report. The assurance as such will be an important part in providing reliability to sustainability reporting. Regulators across various jurisdictions are coming up with requirements for sustainability reporting and assurance on sustainability reporting with different timelines.

REPORTING AND ASSURANCE FRAMEWORKS

On perusal of most annual reports, it can be sensed that the theme is increasingly based on sustainability. Not only is there focus on sustainability in the message from the Chairman, CEO and the senior management, but also there is a dedicated section wherein it is disclosed at length on how the business is getting impacted by climate change and vice versa. The “net-zero” commitment statement is used often these days in the statutory reporting. International Federation of Accountants in its vision statement has stated “Sustainability-related disclosure is finally taking its rightful place within the corporate reporting ecosystem, through global and jurisdiction-specific initiatives. Climate, human capital, and other ESG matters are becoming decision critical. The way forward is clear—with the establishment of the International Sustainability Standards Board and support from public authorities like The International Organization of Securities Commissions (IOSCO)—for a system that delivers consistent, comparable, and reliable information.”1


1. https://www.ifac.org/_flysystem/azure-private/publications/files/IFAC-Vision-Sustainability-Assurance.pdf

There are many reporting standards basis which companies are presenting sustainability disclosures, viz., Sustainability disclosure standards issued by Global Reporting Initiative (GRI), IFRS S1, General Requirements for Disclosure of Sustainability-related Financial Information and IFRS S2, Climate-related Disclosures issued by International Sustainability Standards Board (ISSB) and European Sustainability Reporting Standards (ESRS) to name a few.

The stakeholders analyse sustainability disclosures from their own lens. The investor focus is experiencing a gradient shift from the conventional financial metrics to the novel non-financial metrics reported by the companies. The State of Play: Sustainability Disclosure and Assurance benchmarking studies by the International Federation of Accountants (IFAC) and American Institute of Certified Public Accountants (AICPA) & Chartered Institute of Management Accountants (CIMA) captures and analyses the extent to which the largest global companies are reporting and obtaining assurance over their sustainability disclosures, which assurance standards are being used, and which companies are providing the assurance service.2 This study updates understanding based on financial year (FY) 2022 reporting of market practice by 1,400 companies across 22 jurisdictions (including India). As per this study, 98 per cent of the companies reviewed for FY 2022 reported some level of detail on sustainability whereas 69 per cent of the companies that reported sustainability disclosures obtained assurance on at least some of their sustainability disclosures. Further, 82 per cent of these companies have obtained limited level of assurance.3


2. https://www.ifac.org/knowledge-gateway/contributing-global-economy/discussion/state-play-sustainability-assurance
3. https://ifacweb.blob.core.windows.net/publicfiles/2024-02/IFAC-State-Play-Sustainability-Disclosure-Assurance-2019-2022_0.pdf

To standardise the assurance practices, standard-setting bodies across the globe have issued their own version of sustainability reporting assurance standards. In conducting the assurance engagements, professional accountants use standards set in the public interest — including quality management, ethics, and independence — developed by the International Auditing and Assurance Standards Board (IAASB) and the International Ethics Standards Board for Accountants (IESBA). As per The State of Play: Sustainability Disclosure and Assurance benchmarking study, 92 per cent of the firms applied ISAE 3000 (Revised), Assurance Engagements Other Than Audits or Reviews of Historical Financial Information issued by IAASB.3

CURRENT STATE IN INDIA

In India, too, sustainability has grabbed the attention of corporates and regulators. The Securities and Exchange Board of India (SEBI) has mandated the disclosure of attributes relating to ESG parameters in the Business Responsibility and Sustainability Report (BRSR) for the top 1,000 listed entities (by market capitalisation) from FY 2022–23 onwards. To instil investor confidence in the reporting, SEBI has further mandated the assurance of BRSR Core, a subset of BRSR and a collection of nine ESG attributes of BRSR, for the top 150 listed entities (by market capitalisation) from FY 2023–24 onwards. The requirement of mandatory reasonable assurance will increase to the top 1,000 listed entities (by market capitalisation) from FY 2026–27 onwards in a phased manner. The regulator has gone a step ahead and notified that the top 250 listed entities (by market capitalisation) need to disclose ESG attributes with respect to their value chain from FY 2024–25 on a comply-or-explain basis. Further, these disclosures pertaining to the value chain are required to be assured on a comply-or-explain basis from FY 2025–26. It is pertinent to note that SEBI in its circular has differentiated between the level of assurance that a listed entity needs to obtain for ESG disclosures in the BRSR Core and for the disclosures made in respect of value chain — reasonable assurance for the former and limited assurance for the latter.4


4. https://www.sebi.gov.in/legal/circulars/jul-2023/brsr-core-framework-for-assurance-and-esg-disclosures-for-value-chain_73854.html

Further, SEBI clarified that the assurance provider may appropriately use a globally accepted assurance standard on sustainability / non-financial reporting such as ISAE 3000 (Revised) or assurance standards issued by The Institute of Chartered Accountants of India (ICAI), such as Standard on Sustainability Assurance Engagements (SSAE) 3000, Assurance Engagements on Sustainability Information or Standard on Assurance Engagements (SAE) 3410, Assurance Engagements on Greenhouse Gas Statements.5


5. https://www.sebi.gov.in/sebi_data/faqfiles/aug-2023/1691500854553.pdf

Globally, except for a few regions, assurance on non-financial disclosure is voluntary. Wherever this is mandatory, the requirement is usually of ‘limited’ assurance. In India, the regulator has prescribed ‘reasonable’ assurance of ESG disclosure for listed companies, initially for top tier, and then progressively increased the coverage, i.e., reasonable assurance for the top 1,000 listed companies based on market capitalisation in a phased manner and limited assurance for value chain entities. Most of the companies in India were obtaining limited assurance on a voluntary basis. With the mandatory reasonable assurance, it is important to understand the difference between limited assurance and reasonable assurance6.


6. SEBI has recently issued a Consultation paper containing ‘Recommendations of the Expert Committee for Facilitating Ease of Doing Business with respect to Business Responsibility and Sustainability Report (BRSR)’ whereby one of the recommendations proposes that the term “assurance” shall be substituted with “assessment” in LODR Regulations and SEBI circulars on BRSR. The last date for submission of comments is 12th June, 2024.

LIMITED VS REASONABLE ASSURANCE

Limited assurance and reasonable assurance are two levels of assurance that can be provided on reported figures and disclosures. Reasonable assurance provides a positive affirmation on the statements being made by the company as compared to limited assurance which only gives a negative form of assurance that nothing has come to the attention of the assurance provider that the information is not fairly stated. A reasonable assurance engagement, therefore, involves deeper assessment of systems, processes and controls as well as the performance of many more tests on large number of samples in arriving at the conclusion.

Following are few important elements on which reasonable assurance and limited assurance can be distinguished:

Limited Assurance Reasonable Assurance
Level of Assurance Lower — Negative Assurance Higher — Positive assurance
Level of Assurance Conclusion — “Based on our procedures and the evidence obtained, we are not aware of any material modifications that should be made to the subject matter in order for it to be in accordance with the Criteria” Opinion — “In our opinion the subject matter is  presented, in all material respects, in accordance with the criteria”
Subject Matter Understanding on which assurance will be given Sufficient to identify areas where a material misstatement is likely to arise Sufficient to identify and assess the risks of material misstatement
Understanding and evaluating the design of internal controls Obtain an understanding about (a) the control environment; (b) the information system; (c) the results of the entity’s risk assessment process Additionally, obtain understanding to assess the risks of material misstatement at the assertion level and monitoring of controls
Testing of Controls Typically, do not test controls Perform test of controls to reach a conclusion about their operating effectiveness in control reliance strategy
IT and IT General Controls (ITGCs) Typically, do not test or rely on ITGCs When assurance provider decides to place reliance on controls established by the management, we test and determine whether management has effective ITGCs in place.
Procedures Analytical, inquiry procedures. Examples include observation, variance analysis, ratio analysis Substantive testing, test of controls, test of detail.

Examples include reperformance, recalculation, confirmation, statistical sampling

 

Refer to the Appendix for an illustrative list of procedures.

Report Report includes conclusion whether we are aware of any material modifications that should be made to the subject matter for it to be in accordance with the criteria. Report includes opinion whether the subject matter is in accordance with the criteria, in all material respects, or the assertion is fairly stated, in all material respects.

IAASB has issued Non-Authoritative Guidance on Applying ISAE 3000 (Revised) to Extended External Reporting (EER) Assurance Engagements7 in April 2021. For examples of considerations relating to an entity’s process to prepare the subject matter information, and the internal control over that preparation, reference can be made to ‘Appendix 3 Limited and Reasonable Assurance Engagements – EER Illustrative Table of the aforesaid guidance’. The report formats are also given in the EER guidance:

  • Illustration I: Unmodified Reasonable Assurance Report Reasonable assurance engagement on Sustainability Information included within the Annual Report
  • Illustration II: Unmodified Limited Assurance Report Limited assurance engagement on Sustainability Information included within the Annual Report

7. Refer Non-Authoritative Guidance on Applying ISAE 3000 (Revised) to Extended External Reporting

Having mentioned the above, there are few elements which are common to both reasonable and limited assurance engagement such as planning of the engagement, determining of appropriate materiality benchmarks, etc.

IAASB is in the process of issuing a new global standard specific to sustainability assurance called the “International Standard on Sustainability Assurance (ISSA) 5000, General Requirements for Sustainability Assurance Engagements. This is a principle-based standard and currently, it is an exposure draft. The standard setter has received various comments from different stakeholders on the exposure draft and the final standard may undergo revision basis consideration of such comments. The standard is expected to be released by September 2024. Assurance practitioners can use this standard upon its issuance as final standard.

PREPARER RESPONSIBILITIES

While the assurance provider is responsible for providing assurance, preparers also have unique and vitally important responsibilities. Only they can implement the systems, processes, controls and governance that are key to preventing material misstatements in their financial reporting — versus detecting them. Some of the important questions that companies should focus on while they gear up for obtaining assurance on the sustainability reporting are as follows:

  • What systems and processes have the management put in place to ensure they are gathering, analysing and measuring the relevant data?
  • How does the management ensure the data’s reliability and what controls do they have around this data?
  • Which criteria do the board use for the selection of the sustainability assurance provider?
  • Who is responsible for sustainability reporting? Are the sustainability reporting accountabilities clear?
  • Is the management using the same / consistent assumptions and estimations for financial and sustainability reporting?
  • How is the company challenging management to ensure all information that is material to the company is disclosed?
  • Is internal audit (IA) department involved in the company’s ESG transformation, and how?
  • Are all assurance providers (internal and external) coordinating their work and ensuring that proper controls are in place and that there are no significant gaps?

BOTTOM LINE

Reasonable assurance is a much higher level of assurance and requires collaboration of subject matter skills (like carbon emission / other non-financial KPIs) and assurance skills to perform detailed control testing and substantive procedures. There is a need for collaboration of the subject matter experts and the assurance experts to provide high-quality assurance on BRSR Core and other sustainability reporting to enhance credibility of such information. While global and Indian standards exist for assurance providers, there is a need for the regulators to issue detailed methodology / work programs for assurance providers on various KPIs included in BRSR core and guidance for companies as well for the smooth implementation of the requirements.

APPENDIX A

The objective of this appendix is to expand on the procedures for reasonable assurance by way of examples:

Procedures for reasonable assurance

Inquiry and/or observation Analytical procedures Test of controls Test of details / Inspection / recalculation / reperformance / confirmation
Performing walkthroughs of the significant reporting processes to obtain understanding and then inquiring the process owners about whether our understanding of the process and relevant key controls is accurate. Observe whether those who make and review the controls are performing functions and using inputs as we understand they do. Observe whether the process owners, or others, act upon deviations from the expectations for the estimates. Detailed analytical procedures are performed in response to assessed risks of material misstatement which involve developing expectations of quantities or ratios or trends that are sufficiently precise to identify material misstatements. Designing tests of controls for key controls in the significant reporting process to evaluate the operating effectiveness of the control to address the risks. Examining sample controls by obtaining evidence of its design, implementation and operation. Inspecting and examining records or documents or sites to provide direct evidence of existence or valuation on sample basis. We determine whether to perform external confirmation procedures, to obtain relevant and reliable assurance evidence from external third parties. Assessing whether the different locations being aggregated use the same definitions, the same units to express sustainability performance and the same measurement, sampling and analysis techniques.

While reference should be made to assurance standard followed by assurance provider in accordance with SEBI circular read with FAQs on BRSR Core, given below are few examples of reasonable assurance procedures for few KPIs included in BRSR Core.

Green-house gas (GHG) footprint — Greenhouse gas emissions may be measured in accordance with the Greenhouse Gas Protocol: A Corporate Accounting and Reporting Standard.

Illustrative procedures for Scope 1 emission

1. Obtain an understanding of the entity’s business and operations to identify sources of Scope 1 emission (Diesel / Petrol for vehicles, DG sets, etc.) and the reporting process with respect to data collection and aggregation.

2. Basis the understanding obtained in point no. 1 above, assess the completeness of the data to ensure all sources and all units / sites / plants / offices (within the defined Reporting Boundary) have been included.

3. Verify the accuracy and completeness of the energy / fuel consumption data with the data reported under Principle 6, Question 1 (energy consumption). Verify the completeness and accuracy of other sources (other than energy) of scope 1 emissions such as fire extinguisher, refrigerants, etc. by checking the supporting documents on a sample basis.

4. Verify the conversion and emission factors used for calculating the scope 1 emissions.

5. Where estimation has been used by the management, obtain a note on the estimation methodology, assumptions used and evaluate whether they are appropriate and have been applied consistently.

6. Verify if the meters are calibrated periodically (as may be applicable) where computation is based on meter readings.

7. Verify if the data is reported for the relevant reporting period only.

8. Check the presentation and disclosure of the data is in line with the BRSR Core criteria and guidance issued.

Illustrative procedures for Scope 2 emissions

1. Obtain an understanding of the entity’s business and operations to identify sources of Scope 2 emission and the reporting process with respect to data collection and aggregation.

2. Basis the understanding obtained in point no. 1 above, assess the completeness of the data to ensure all sources and all units / sites / plants / offices (within the defined Reporting Boundary) have been included.

3. Verify the accuracy and completeness of the energy consumed from purchased electricity and other sources of scope 2 emissions with the data reported under Principle 6, Question 1 (energy consumption).

4. Verify the conversion and emission factors used for calculating the scope 2 emissions.

5. Where estimation has been used by the management, obtain a note on the estimation methodology, assumptions used and evaluate whether they are appropriate and have been applied consistently.

6. Verify if the meters are calibrated periodically (as may be applicable) where computation is based on meter readings.

7. Verify if the data is reported for the relevant reporting period only.

8. Check the presentation and disclosure of the data is in line with the BRSR Core criteria and guidance issued.

The Bookkeeping in Electronic Mode

Bookkeeping is a way of recording a company’s financial transactions in an organised manner. Bookkeeping creates a trail of all the transactions and serves as evidence for financial reporting. This practice of bookkeeping or maintaining books of account is not an option; multiple laws, like the Companies Act, 2013, Income Tax Act, and Good and Service Tax (GST), mandate maintenance and retention of the books of account in a prescribed manner.

As maintenance of books of account has transitioned from physical record-keeping to electronic mode, the bookkeeping laws have evolved. Section 128 (1) of the Companies Act, 2013 stipulates that every company shall prepare and keep its books of account and other relevant books, papers, and financial statements annually. It also mentions that these books can be kept in electronic mode. While Section 128(1) mentions the allowance for maintaining books in electronic mode, the specific requirements for electronic bookkeeping, like format, accessibility, and security, are provided in the rules made under the Act. For example, the Companies (Accounts) Rules, 2014, especially Rule 3, provides detailed requirements for maintaining books of account in electronic form.

Most of the provisions related to physical books apply to books maintained in electronic mode. The common points between manual and digital books are as follows:

– The statutory laws recognise both physical and digital books of account.

– Both manual and digital books must always be accessible in India.

– The physical books and digital books are subject to inspection.

– Both manual and digital books must be accurate and complete.

– The time period for retention of manual and digital books is the same.

Key requirements that are unique to digital books of account as per the provision of the Companies Act, 2013 are as listed below:

Particulars Requirement
Maintenance Given the nature of digital books and the maturity of accounting systems, it is mandatory that the data from books maintained outside India should be always accessible in India.
Retention The books of account and other important books and papers shall be retained in the original format in which they have been generated, sent, or received or in a format that will present the information generated, transmitted, or received accurately. The information must remain complete and unaltered.
Branch Office The branch can maintain proper books of account to record transactions effected at the branch and periodic summarised returns have to be sent to the registered office. The information received from the branch office shall not be altered and shall be kept in a manner that depicts the information initially received from the branches and the backup shall be kept in servers physically located in India on a daily basis.
Storage There shall be a proper system for displaying, storing, retrieving, or printing electronic records as the audit committee/board of directors may deem appropriate. Unless expressly allowed by the law, the records shall not be disposed of or rendered unusable for disposal.
Backup The electronic copies of account books and other relevant documents, even if stored overseas, the backup must be kept on a daily basis on physical servers situated in India.
Service Provider (Outsourced Vendor maintaining accounts) At the time of filing financials annually, the company must inform the Registrar of Companies:

–     the name of the service provider

–     the IP address of the service provider

–     the location of the service provider (wherever applicable)

–     if maintained in the cloud, then the address as given by the service provider

Recent amendments in the Companies Act, 2013 and rules made thereunder:

Maintenance:

The books of account and other relevant books and papers maintained in electronic mode shall remain accessible in India, at all times. Before the amendment it was only accessible in India, however now the words at all times have been added.

Backup:

The backup of books of account and other books and papers of the company, which is maintained in electronic mode, even if stored at a place outside India shall be kept in servers physically located in India on a daily basis. Before the amendment, it was on a periodic basis and no specific time was prescribed.

Audit trail in the accounting software:

For the financial year commencing on or after the period 1st April, 2023, every company that uses accounting software to maintain books of account shall use only such accounting software that can record an audit trail of each and every transaction as per MCA notification. This will help create an audit log with the changes made and the date when the changes are made. Also, it must be ensured that the audit trail cannot be disabled at any point of time during the year.

Service provider outside India:

If the service provider is outside India, then the company must inform the Registrar of Companies, of the name and address of the person in control of the books of accounts and books and papers in India.

The above amendments in light of the digital evolution in bookkeeping have given rise to the below-mentioned challenges for the companies:

– When books are maintained outside India, daily data backup poses a challenge for companies where the data backup is centralised outside India and servers are physically located outside India.

– For data from outside India to be accessible in India at all times, there must be seamless integration and real-time transfers. This can be challenging for companies with multiple locations outside India.

– Section 128 (5) of the Companies Act, 2013 requires that the books of account must be maintained for eight financial years immediately preceding the financial year, and accordingly, the backup must also be held for eight years. Hence, the company must have the facility to store the backups safely or upload them to cloud storage.

COMPLIANCE CHECKLIST & AUDIT PROCEDURES

To comply with all the provisions of Rule 3, the company needs a robust system in place, and auditors need to check the system in place to certify total compliance. A compliance checklist and audit procedures as given below will ensure that there are no lapses in audit documentation and provide a basis for appropriate conclusion on the maintenance of books of account as prescribed.

Sr. no. Requirement Complied (yes/no) Remarks
1. If the books of account and other relevant books and papers are maintained in electronic mode,

–   whether it is always accessible in India for its subsequent use?

2. From 1st April, 2023, whether the accounting software has a feature of:

–   recording the audit trail of each and every transaction,

–   creating an edit log of each change made in books of account along with the date when such changes were made, and

–   ensuring that the audit trail cannot be disabled?

3. Whether it is ensured that the books of account are

–   entirely retained in the format in which they were originally generated, sent, or received, or in a format which shall present accurately the information generated, transmitted, or received, and

–   the information contained in the electronic records remains complete and unaltered.

4. Is it ensured that the information received from branch offices is not altered and is kept in a manner that depicts what was originally received from the branches?
5. Is it ensured that the information can be displayed in a legible form?
6. Is it ensured that there is a proper system for:

–   storage,

–   retrieval,

–   display or

–   printout

of the electronic records

7. Is there a proper system to ensure that such records are not disposed of or rendered unusable unless permitted by law?
8. Is it ensured that the backup is taken daily?
9. Is it ensured that the server on which the backup is maintained is physically located in India?
10. Has the company intimated the following information to RoC?

–   the name of the service provider,

–   the IP address of the service provider,

–   the location of the service provider (wherever applicable),

–   where the books of account and other books and papers are maintained on the cloud, such address as provided by the service provider,

–   where the service provider is located outside India, the name and address of the person in control of the books of account and other books and papers in India?

Suggested audit procedures:

1. Obtain the list of books and other records maintained in electronic mode from the IT team of the company and document the process of access rights, maintenance of servers, backup policy, IT controls, etc.

2. Assess the need for IT experts for IT General Control (ITGC) testing based on the accounting software used, nature and size of the company.

3. Obtain the information w.r.t. the compliance of Rule 3 and provision of Companies Act, 2013 for maintenance of books of account from the company Secretary of the company.

4. Information Provided by Entity (IPE) testing shouldbe performed on the reports generated from the accounting software to verify the completeness of the information.

5. Understand and document the process of storage, backup, and retrieval from the IT team of the company.

6. In respect of audit trail and maintenance of daily backup, obtain the reports from the IT team and perform test checks to validate the compliance requirements.

7. Obtaining a report or management’s representation in respect of the use of audit trail features throughout the year.

8. With respect to the maintenance of books of account, Form AOC-4 and AOC-5 submitted by the company to the ROC can be verified along with the date of submission and the other relevant information.

COMPARISON BETWEEN VARIOUS ACTS

The following table summarises requirements pertaining to the maintenance of books of account per the Companies Act, 2013, Income Tax Act, 1961, and Central Goods and Services Act, 2017.

Sr. No Particulars Companies Act, 2013 Income Tax Act, 1961 GST Act, 2017
1 Maintenance At the registered office. If maintained elsewhere, notice to the Registrar to be given within seven days (Section 128(1)) Where any person carries on business or profession other than specified professions mentioned in Section 44AA(1), then he is required to maintain books of account if income from business or profession exceeds
R1,20,000 or total sales/turnover/gross receipts exceed R10 lakh in any of the three years immediately preceding the previous year. However,
At the principal place of business (Rule 56 of CGST Rules 2017)
in case the Assessee is an individual or HUF, such limits should be read as R2,50,000 and R25 lakhs, respectively.

Or

where the business or profession is newly set up, the income from the business or profession is likely to exceed the threshold limits.

2 Scope of transactions to be recorded All transactions of registered and branch offices (Section 128(1)) As may enable computation of total income (Sections 44AA(1), 44AA(2)) Production/manufacture, supply, stock of goods, input tax credit, output tax payable/paid, etc. (CGST 2017)
3 Basis of accounting Accrual basis and double-entry system (Section 128(1)) Cash or Accrual Not specifically mentioneds
4 Intimation requirement if maintained outside registered office File notice within seven days with the Registrar (Section 128(1)) Not specifically mentioned Not specifically mentioned
5 Mode of maintenance Can be maintained in electronic mode as prescribed (Section 128(1)) Not specifically mentioned As per Section 35(1) and Rule 56(7) of CGST Rules, 2017, the registered person may keep and maintain such accounts and other particulars in electronic form.
6 Branch office compliance Maintain at branch office; summarized returns to registered office to be sent (Section 128(2)) Not specifically mentioned As per Section 35(1), where more than one place of business is specified in the certificate of registration, the accounts relating to each place of business shall be kept at such places of business.
7 Retention Period For eight financial years or all preceding years if less than eight (Section 128(5)) For six years from the end of the relevant assessment year i.e., for a total period of eight previous years (prescribed by rules (Section 44AA(4))) For at least 72 months (6 years) from the due date of annual return (Section 36 CGST Act 2017)
8 Definition of Books and Papers Includes books of account, deeds, vouchers, writings, documents, minutes, and registers in paper or electronic form (Section 128(12)) Specific books of account to be maintained for Legal, Medical, Engineering, Architectural, Accountancy, Technical Consultancy, Interior Decoration Not specifically mentioned
9 Other records included Receipts and payments, purchases and sales, assets and liabilities, and cost items as prescribed (Section 128(13)) Not specifically mentioned Manufacture of goods, inward and outward supply, stock of goods, input tax credit, output tax payable and paid, etc. (CGST 2017)

CONCLUSION

Digitalisation brings in its wake both solutions and unique challenges. The recent amendments prevent the unique challenges from becoming vulnerabilities and hence, implement stringent measures. Companies and auditors need to adapt to the bookkeeping in the digital age and ensure total compliance with respective applicable laws.

Limited Liability Partnerships — Relevant Auditing and Accounting Considerations

A Limited Liability Partnership (LLP) is a hybrid entity that combines features of a corporation and allows the flexibility of organizing its internal structure as a partnership based on a mutually arrived agreement. The agreement is not required to follow the strict form that applies to a company.

Talking about the key characteristics of an LLP, an entity structured as an LLP will enjoy a separate legal identity, limited liability for the partners, and perpetual succession. An LLP enjoys management and organisational flexibility regarding economic rights, which are freely transferable, and non-economic rights (management participation) which are non-transferable.

The contribution to LLP’s capital can be in cash or in kind. Receipt of consideration in ‘kind’ will entail determining its valuation to be able to determine the proportionate entitlement of the partners.

As stated above, the LLP provides enough flexibility to partners to enter into an LLP agreement, which shall govern the rights and duties of the partners. The LLP Agreement and any changes made therein shall be filed with the Registrar of LLPs. In the absence of agreement as to any matter, the mutual rights and the duties of the partners and the mutual rights and the duties of the LLP and the partners shall be determined by the provisions set out in the First Schedule of the LLP Act.

One may also believe that making changes in the LLP deeds may be comparatively simpler and / or less costly as compared to making changes to the memorandum /articles of association. This may particularly be true where the main deed allows operations-related changes to be carried as part of the Annexure which may be subjected to minimal approvals and is not construed to be leading to a change in the main deed and is accordingly not required to be filed with the Registrar. However, this should strictly be determined in consultation with a legal expert.

LLP as a vehicle has emerged as a great model for Chartered Accountant firms, consulting firms and for structuring joint ventures by corporates.

In this article, we will take a look at the recent regulatory changes that impact these forms of entities with a specific focus on reporting and audit consideration.

FINANCIAL REPORTING CONSIDERATION

Section 34(1) of the LLP Act requires that the LLP shall maintain such proper books of accounts as may be prescribed relating to its affairs for each year of its existence on a cash basis or accrual basis and accordingly, to double entry system of accounting and shall maintain the same at its registered office for eight years. Compared to a company, this flexibility for small businesses comes in handy.

Sub-section (2) of section 34 further prescribes that within a period of six months from the end of each financial year, prepare a Statement of Account and Solvency for the said financial year as of the last day of the said financial year in Form 8 with Registrar, and such statement shall be signed by designated partners of the LLP. Sub-section 4 of section 34 requires that the accounts of limited liability partnerships shall be audited in accordance with sub-rule 8 of rule 24 LLP Rules.

It is observed that timely filing of financial information with the Registrar has been one of the noted areas of non-compliance and thus professionals are expected to keep themselves abreast of key forms and their filing deadlines.

In accordance with section 34A of the LLP Act, the National Financial Reporting Authority (NFRA) would specify the accounting standards and standards on auditing for LLPs as recommended by the Institute of Chartered Accountants of India (ICAI).

In 2023, ICAI issued an exposure draft for the proposed accounting standards on limited liability partnerships (LLPs). As per the said exposure draft Accounting Standards 1 to 5, 7, 9 to 19 and 21 to 29, as notified under Companies (Accounting Standards) Rules, 2021, shall be applicable to the LLPs. AS 20 Earning Per Share shall be exempted from the LLPs.

For applicability of Accounting Standards, ICAI’s exposure draft states that LLPs shall be classified into four categories, viz., Level I, Level II, Level III and Level IV. Level I LLPs will be Large size Limited Liability Partnerships, Level II LLPs will be Medium size Limited Liability Partnerships, Level III LLPs will be Small size Limited Liability Partnerships and Level IV LLPs will be Micro size Limited Liability Partnerships. Level IV, Level III and Level II LLPs shall be referred to as Micro, Small and Medium-sized Limited Liability Partnerships (MSMLLPs).

As clarified in the exposure draft since the LLP Act permits a cash basis of accounting, therefore, if an LLP is following a cash basis of accounting, it shall apply Accounting Standards (read together with the exemptions in II and VIII as may be available) to the extent applicable in the context of a cash basis of accounting.

Considering the present practice and the fact that the exposure draft continues to propose applicability of Companies (Accounting Standards) Rules, 2021 for LLPs, the likelihood of applying Ind-AS remains remote and is contingent upon notification from regulators. Accordingly, there is likely to be a situation where LLP prepares Ind-AS compliant financial statements specifically for the purposes of consolidation as required by the parent company or Joint Venturer who otherwise is required to follow Companies (Indian Accounting Standards) Rules, 2015. Thus, at the time of conversion of financial statements from one GAAP to another GAAP, matters like fair value accounting, deferred tax, business combination etc. require significant consideration.

Guidance Note on Financial Statements of Limited Liability Partnerships: The Accounting Standards Board (ASB) of the ICAI, in June 2022, issued a Technical Guide on Financial Statements of Limited Liability Partnerships to prescribe guidance for the applicability of Accounting Standards to LLPs and to recommend the formats of the financial statements for standardisation of presentation of the financial statements by LLPs.

The ASB has subsequently issued the Guidance Note on Financial Statements of Limited Liability Partnerships. The Guidance Note will enable the LLPs to communicate their financial performance and financial position in standardised formats thereby enhancing their comparability. This Guidance Note is effective for financial statements covering periods beginning on or after 1st April, 2024. The Technical Guide on Financial Statements of Limited Liability Partnerships stands superseded by this Guidance Note.

The Illustrative formats for Financial Statements included in the Guidance Note on Financial Statements for Limited Liability Partnerships have also been given in the Excel file.

AUDITING CONSIDERATIONS

In the absence of any specific auditing standards that may apply to the audit of an LLP, the existing set of Standards on Auditing issued by the ICAI will continue to be applicable mutatis mutandis (with necessary modifications to the audit procedures in the context of an LLP).

The auditing will continue to envisage planning,execution and reporting as its key steps. As an auditor, professional membersshould carefully read andtake necessary notes about important aspects ofthe LLP deed, specifically those in relation to thenature of the business, Profit sharing Ratio, formand manner of capital contribution, valuation(if any), rights, restrictions and obligations of individual partners.

Although one would assume that doing an audit of smaller entities structured as LLP may be relatively easy, however, the same may not always be true. Vide one of the recent amendments, the government has become more conscious of ensuring transparency and has accordingly mandated LLPs to disclose Significant Beneficial Ownership.

Pursuant to the recent amendment Limited Liability Partnership (Third Amendment) Rules, 2023 which are effective from 27th October, 2023, LLPs are required to maintain a register of partners at their registered office.

Another important amendment was in the context of the declaration regarding beneficial interests in any contribution. The Amended Rules make it mandatory for people to declare the nominee or registered holder-beneficial owner relationships (including any changes in the beneficial interest).

MCA also notified the Limited Liability Partnership (Significant Beneficial Owner) Rules, 2023 (SBO Rules) with effect from 9th November, 2023. As per the Rules “Significant beneficial owner” means an individual, who acting alone or together or through one or more persons or trust, possesses one or more of the following rights or entitlements in such reporting LLP, namely —

  • holds indirectly or together with any direct holdings not less than 10 per cent of the contribution;
  • holds indirectly or together with any direct holdings, not less than 10 per cent of the voting rights in respect of the management or policy decisions in such LLP;
  • has the right to receive or participate in not less than 10 per cent of the total distributable profits or any other distribution, in a financial year through indirect holdings alone or together with any direct holdings;
  • has the right to exercise or actually exercises significant influence or control, in any manner other than through direct holdings alone.

In the case of LLPs, the determination of SBO has to be based on the holding of capital contribution, voting rights in respect of management or policy decisions of LLP, and with respect to the right to receive or participate in distributable profits and thus it becomes all the more important for the auditor to assess the same in the context of the LLP deed.

Further, the determination of indirect holding is likely to pose a significant challenge for the auditor since it has to be determined based on the individual’s relationship with the non-individual member of the reporting LLP. For instance, where the member is a Hindu Undivided Family (HUF), the Karta of the HUF shall be considered to be holding indirect right or entitlement in the reporting LLP. Similarly in case where the member is a Trust (through a trustee), an individual’s right or entitlements in a reporting LLP shall be considered to be held indirectly if he is a trustee/settlor/author depending upon the nature of the trust. Auditors are accordingly expected to examine necessary regulatory filings made by LLP / SBOs in this regard.

Other areas that are likely to pose similar audit risks are complex related party relationships and transactions with related parties; accounting estimates, assessment of the use of going concern basis in an evolving geopolitical environment, fraud risk assessment, etc.

At the time of reporting, an auditor needs to ensure that necessary changes are made to the audit report format as illustrated in Standards on Auditing 700, Forming an Opinion and Reporting on Financial Statements, to ensure factual accuracy since the report is to be issued for a separate form of entity. The auditor is expected to consider the key areas that need to be imbibed as part of the audit report as a result of the differing legal and regulatory requirements. Some of the required changes to the audit report are listed below:

  • All references to ‘company’ as stated in the illustrative format of Standards on Auditing 700 Forming an Opinion and Reporting on Financial Statements, need to be amended to ‘limited liability partnership’.
  • All references to ‘directors’ need to be amendedand the recommended term to use is ‘designated partner’ as that is the term that is used in the LLP Act/LLP Deed. The references to the ‘Companies Act 2013’ need to be amended to the Limited Liability Partnership Act 2008 (as amended) read along with LLP Rules.
  • The audit report of an LLP is addressed to the ‘Designated Partner’.
  • The opinion paragraph describes the financial statements, including specifying the titles of the primary statements. However, it is important that the titles of the primary statements precisely match those used by the entity. The opening paragraph of the ‘opinion’ section needs to reflect the financial reporting framework.
  • The audit opinion needs to be amended as follows:
  • In our opinion, the financial statements:
  • give a true and fair view of the state of the limited liability partnership’s affairs as of [date] and of its [profit/loss] for the year then ended.
  • have been properly prepared in accordance with the accounting standards issued by the Institute of Chartered Accountants of India and other accounting principles generally accepted in India; and
  • gives information as required by the LLP Act.
  • The ‘Basis for opinion’ will continue to mention the facts that the audit was done in accordance with the Standards on Auditing (SAs) and other applicable authoritative pronouncements issued by the Institute of Chartered Accountants of India (including those related to ethics and independence). Basis ofopinion will also state that the auditor believes that the audit evidence we have obtained issufficient and appropriate to provide a basis for the opinion.
  • Other information: The Designated Partner of the LLP is not required to prepare an annual report. Accordingly, the requirement for reporting on such other information does not arise.
  • In respect of the signature on the audit report the requirements for LLPs are effectively the same as for companies and the audit report is required to be signed by the statutory auditor, for and on behalf of the audit firm along with the other compliances like UDIN.

WHAT’S AWAITED?

Recently IAASB issued the much-awaited International Standard on Auditing for Less Complex Entities (ISA for LCE). The standard is effective for audits beginning on or after 15th December, 2025, for jurisdictions that adopt or permit its use. It recognizes the importance of smaller businesses and their specific audit needs.

It is a standalone standard that is proportionate & tailored to the specific needs of an audit of less complex entities, which makes it easier to navigate for those practitioners who support these types of engagements. It provides the same level of assurance as an audit performed under the ISAs i.e., reasonable assurance. Considering this being of global relevance we may soon have a similar standard for less complex entities in India. However, the same would require regulatory backing from ICAI and NFRA. In November 2023, an exposure draft was issued proposing the applicability of all 35 standards on Auditing for limited liability partnerships (LLPs).

As noted from MCA’s Annual Report (2022–23) as of 31st October, 2022, the number of LLPs registered in the country was 2,86,377, and out of those 2,57,944 LLPs were active. During the period from 1st December, 2021, to 30th October, 2022, a total of 31,349 LLPs were incorporated.

The statistics clearly indicate that with the extension of tax benefits, the ease of FDI norms, LLP form of structure has gained a lot of momentum recently. With LLPs likely to dominate the constitutional form, more and more professional opportunities would emerge ranging from incorporation to auditing.

Recycling Of Wastes – An Accounting Conundrum?

Old mobile phones. Plastic wrapper of a chocolate bar. Used tyres. Most people would think of this kind of detritus as a future landfill, as the bulk of these wastes goes unprocessed. The ever-growing pile of waste is causing irreversible damage to the environment.

But not anymore. Indian lawmakers are waking up and passing / amending Rules under the Environment (Protection) Act, 1986, to enforce Extended Producer Responsibility for certain entities. These Rules cast an obligation on producers / brand owners / importers for environmentally sound management of their products that have reached their end of life and are now considered a waste. Extended Producer Responsibility includes collection / recycling of waste as prescribed in the Rules.

Based on the ‘Polluter-Pays Principle’ the purpose of these Rules is neither to transfer public expenditure to these entities nor to penalise them, but to set appropriate signals in place in the economic system so that environmental costs are incorporated in the decision-making process and hence arrive at sustainable development that is environment-friendly. These Rules have continuously been expanded to cover major categories of wastes and include manufacturers and importers irrespective of the selling technique used, such as dealers, retailers, e-retailers,etc (i.e. producers) and online platforms / market places and supermarkets/retail chains (i.e., brand owners). Following is a high-level summary of some of the key Rules:

These Rules raise certain fundamental questions regarding accounting for the cost of fulfilling the legal obligation to recycle / collect waste. Some of them are discussed below:

WHEN IS THE OBLIGATING EVENT?

A provision under Ind AS 37 is recognised when an entity has a present obligation (legal / constructive) as a result of a past event, it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation and a reliable estimate can be made of the amount of the obligation. If these conditions are not met, no provision should be recognised.

The definition of a legal obligation refers to an obligation that derives from a contract (through its explicit or implicit terms), legislation or other operation of law. It is worth mentioning that the concept of an obligating event is open to interpretation and requires the exercise of significant judgement, as the obligating event is not always easy to identify. The following views are possible in the extant case:

View I – Sale of goods is the obligating event

The proponents of this view believe that the sale of goods is the event which triggers compliance under the Rules. The timing of recognition of the cost of fulfilment should be contemporaneous with the timing of revenue recognition. Provision should be made for all unfulfilled obligations emanating from historical sales as well as sales made during the current year (for which obligation to recycle would occur in subsequent years). The proponents argue as follows:

  • The minimum recycling targets, as summarised above, are generally based on the products ‘placed in the market’ or products ‘purchased / manufactured / imported’ previously. A product is placed on the market when it is made available for the first time on the market, i.e. when it is first supplied for distribution, consumption or use on the market in the course of a commercial activity, whether in return for payment or free of charge. Thus, the placing of a product in the market occurs on its sale to customers. A similar connotation is relevant where products are purchased, imported, etc.

 

  • The Rules aim to recycle end-of-life (i.e., waste) products and reduce the consequential damage to the environment. The expiration of the life of the product and the damage to the environment potentially begins when the customer starts using the products. Accordingly, the sale of products is the foundational tenet of these Rules.
  • Going concern basis envisages that the financial statements would continue for the foreseeable future. Thus, these entities would be economically compelled to incur the cost of recycling of all products sold to date, including sales made in the current year.
  • Analogy can be drawn from a similar situation where a lessor is obligated to return the leased premise in the same state that existed at the inception of the lease. For example, if an entity has erected partitioning in a leasehold building and the partitioning must be removed at the end of the lease term, then provision is made for this cost at the time of putting up the partition wall.

View II – Existence of the producer on the measurement date is the obligating event

This view is based on the premise that the cost associated with the fulfilment of Extended Producer Responsibility is akin to a levy as described in Appendix C to Ind AS 37. Proponents of this view argue that the obligation can be avoided if the entity ceases to exist on the measurement date. Under this approach, any unfulfilled obligation in relation to historical sales should be provided for. No provision is required for sales made in the current year (for which the obligation to recycle would occur in subsequent years). The following are the relevant arguments:

  • A levy is an outflow of resources embodyingeconomic benefits imposed by Governments (including Government agencies) other than those covered under other Ind AS e.g. income taxes under Ind AS 12 and fines or other penalties imposed for legislationbreaches. As long as the payments are required by law, they are generally considered to be imposed by the government.

Under the Rules, the obligation should be met through authorised recycling agencies, which will inter alia provide the certificates of recycled quantity to the entities. Instead of paying a charge directly to the Government for recycling the waste products, the charge would be paid to the Government’s agents. Thus, the payment made for the purchase of certificates from Government authorised recycling agencies is in the nature of a levy. Appendix C is specific guidance for the accounting of levies that builds on the principles of Ind AS 37. Thus, the assessment of the obligating event of wastes should be based on Appendix C to Ind AS 37.

  • Under Appendix C, the obligating event that gives rise to a liability to pay a levy is the activity that triggers the payment of the levy, as identified by the legislation. For example, if the activity that triggers the payment of the levy is the generation of revenue in the current period and the calculation of that levy is based on the revenue that was generated in a previous period, the obligating event for that levy is the generation of revenue in the current period. The generation of revenue in the previous period is necessary, but not sufficient, to create a present obligation.

Under the above Rules, the payment to recyclers will arise only if the producer exists during the measurement period. For example, a producer would be obligated to meet the obligation in FY 2023-2024 only if the producer is in operation in such year. Since the activity that triggers the payment of the levy is the existence of the producer in the current period and the calculation of that levy is based on the products sold in a previous period, the obligating event for that levy is the existence of the entity in the current period. The sale of products in the previous period is not the activity that triggers the payment of the levy but only affects the measurement of the liability.

  • Merely preparing financial statements under the going concern assumption does not imply that the entities have a present obligation to pay a levy triggered by operating in a future period.

Closing entries:

  • It would be appropriate to follow View II. The accounting policy of a listed company provides as follows:

Provision for E-Waste/Plastic-Waste management costs is recognized when the liability in respect of products sold to customers is established in accordance with E-waste Management Rules, 2016, as notified by the Government of India. Initial recognition is based on liability computed based on Extended Producer Responsibility as promulgated in said Rules, including the cost to comply with the said regulation and as reduced by the expected realisation of collectable waste. The Company has assessed the liability to arise on a year-to-year basis.

  • View II would also be in line with global practices such as the European Union’s Directive on Waste Electrical and Electronic Equipment. The Directive prescribes that the cost of waste management for equipment should be borne by producers of that type of equipment that is in the market during the period specified in the applicable legislation. The manufacturers have to contribute to costs in proportion to their respective share of the market by type of equipment.
  • The International Financial Reporting Interpretations Committee (IFRIC), as set up by the International Accounting Standards Board, has issued certain guidance on the manner of recognition of liability under the above Directive. 1IFRIC 6 concludes that the event that triggers liability recognition is participation in the market during the measurement period. The measurement period is a period in which market shares are determined for the purposes of allocating waste management costs. IFRIC 6 states that this date, rather than the date of production of the equipmentor incurrence of costs, is the triggering event for liability

1   IFRIC on Liabilities Arising from Participating in a Specific Market – Waste Electrical and Electronic Equipment

Measurement of obligation

The above Rules mandate entities to purchasecertificates from authorised recyclers to meet their Extended Producer Responsibility. The cost of obligation is derived basis the target quantity multiplied by the rate per unit as agreed with the authorised recycler. For example, if an entity is required to recycle 100MT of plastics and the authorised recycler charges ₹10 per MT; then an expense of INR 1,000 should be recognised at the end of the current year. The amount of unfulfilled obligation, if any, should be classified as a provision in the Balance Sheet.

Closing entries:

  • Making a reliable estimate is one of pre-conditions for recognition of a provision under Ind AS 37. The Standard takes the view that a sufficiently reliable estimate can almost always be made for a provision except for extremely rare cases. In the extremely rare case where no reliable estimate can be made, a liability exists that cannot be recognised.
  • In certain cases, entities face significant challenges in measuring the obligation. These challenges can stem from the non-availability of certificates with the authorised recyclers or the lack of necessary information to estimate the amount of cash outflow required to recycle a particular category of waste. Relevant extracts from the financial statements of a listed company are as follows:

On 21st July, 2022, the Ministry of Environment, Forest and Climate Change issued notification containing Regulations on Extended Producer Responsibility (EPR) for Waste Tyre applicable to Tyre manufacturers and Recyclers. As per the notification, the Company has a present legal obligation as at31st March, 2023, to purchase EPR certificates online from Recyclers of waste tyre registered with the Central Pollution Control Board to fulfil its obligations,which is determined based on a certain percentage of the quantity of tyres manufactured in the year ended 31st March, 2021.

Currently, the modalities of the above regulations are dynamic. They would be fine-tuned in line with the changing requirements, including measurement of obligation and timeline for achieving compliance by tyre manufacturing companies in consultation with the Industry forum of Tyre companies. Accordingly, the Company has not recognised any provision towards EPR obligation for the year ended 31st March, 2023.

Overview of NFRA Inspection Reports of 2023 on Audit Firms– II

This is the second and final article to cover an overview of the first five NFRA inspection reports. The inspection process, timelines and the structure of the inspection reports were covered in the February 2024 issue of The BCAJ on page 21, including the summary of NFRA observations related to governance and leadership structures or lack / non-disclosure thereof, international and domestic network / affiliations. The article also covered issues pointed out by NFRA related to non-audit services provided to audit clients and SQC 1.

This second part is on the remaining observations of NFRA on audit quality control systems, independence, engagement quality control and points arising from the review of engagement files based on selected areas. From these two articles, one will be able to draw practical nuances relating to Standards on Auditing and other applicable laws and regulations.

At the cost of repetition, the purpose of this compilation is to enable auditors and audit firms to understand the focal points and key issues arising from these inspections. By understanding key features, firms can take the necessary steps to be compliant with applicable regulations.

The five reports covered are as below and referred to with the last two digits to identify the reports:

PART B OF REPORTS

The subheadings in all five reports are different in both sequence and content. Excluding leadership, structure, and Independence matters, which are covered in The BCAJ, vide article of February 2024 on page 21, let us consider Documentation, Engagement Quality Control and some observations arising from the review of the audit files.

FIRM WIDE AUDIT QUALITY CONTROL SYSTEM

1) EQCR Partner: The firm’s procedures fall short of SA 220 and SA 230 and the Firm’s Policy. Two samples selected contained incomplete work papers without sufficient evidence of EQC review done. (Para 30, Report No 01)

2) The practice of deleting all review comments should be reviewed as they may constitute a discussion between the Engagement Team and EQCR, which is mandatory under SQC 1 and SA 220. (Para 31, Report No 01)

3) Evidence of performance of EQCR, i.e., the EQCR docket (summary of EQCR work performed) was not made part of the Engagement Management System (EMS). However, EQCR clearance was obtained prior to the issuance of the audit report. This is despite the firm’s Policy of generating the EQCR docket via the EQCR portal to be incorporated in the EMS. (Para 26 & 27, Report No 02)

4) There was an instance of lack of reassessment of audit risk upon finding some suspicious transactions, etc., which was not in accordance with Para 31 of SA 315 and Firm’s Policy Manual. This matter led to reporting under Section 143(12) to the central government, adverse opinion and eventual resignation from audit later that year whereas suspicious transactions were noticed in the second quarter itself. (Para 18–22, Report No 02)

5) Consultation was taken, a decision taken on that basis, but the rationale was not recorded which is not in accordance with Para 56 of SQC1, which is not in accordance with the firm’s own Policy Manual. (Para 30–32 Report No 02)

6) Engagement Management System (EMS) required annual and engagement level independence confirmations. However, EMS permitted access to audit without obtaining the engagement level independence confirmations (which is an additional control), which is in violation of the Audit Firm’s Policy Manual and Para 18 of SQC 1. (Para 17 Report No 02)

7) An Independence compliance audit done by a network firm partner identified that “35% of the Partners, the sole Executive Director, 55% of the Directors and 38% of the Sr. Manager/Managers had not reported the financial relationships, required to be reported in accordance with the Firm’s independence policies”. Such high rates of non-compliance with the firm’s own independence policies were of serious concern to the NFRA. Despite such significant violations, the sample size was reduced compared to the prior year. The firm failed to provide the complete Independence Compliance Audit Report for FY 2020–21. A sample test of five audit engagements revealed that independence confirmations were absent in the case of some members of the engagement team and in some cases, independence declarations were obtained after the issue of the audit report. The Independence Compliance Tool is not aligned with Indian laws. (Para 22–26 Report No 03)

8) EQCR needs to be a partner who is a member of the ICAI as per SA 220 and SQC 1. However, the Firm’s EQCR Policy did not specify that EQCR shall be a member of the ICAI. (Para 23 Report No 04)

9) There is no document explaining the rationale or criteria for the selection of engagement files for internal quality inspection and specific areas for review by the inspection team. (Para 30 Report No 04)

10) Firm persons interviewed by the NFRA inspection team did not have much clarity on how to choose the value of assurance factor for the desired level of testing so far as sampling was concerned. (Para 28 Report No 04)

11) The Firm had a policy of doing background checks of the auditee company from the database of the network entity. In some cases, background check reports were not positive and yet the firm did not carry out alternative tests to assess client integrity for accepting / continuing. The firm’s reliance solely on a single source (network entity database) was found insufficient and not in accordance with Para 28 of SQC 1. (Para 25 Report No 05)

12) No audit documentation was found in relation to the evaluation of the competence and capabilities of the audit firm to undertake the engagement. (Para 27 Report No 05)

13) Audit documentation by EQCR is not fully compliant with Para 25, SA 220. (Para 28 Report No 05). Working papers had no documentation of the work done by EQCR. (Para 30 Report No 05)

AUDIT DOCUMENTATION

1) The firm’s policies and procedures to ensure integrity of its electronic audit documentation were not fully in accordance with the requirements of SQC 1 (Para 77, 79, 80). (Para 13 Report No 01)

2) The audit evidence, which is reviewed and signed as final, can be edited, altered or modified subsequently without affecting the previously provided signoff. While a report gives information about edits, it doesn’t identify the exact changes made in the document. (Para 13 Report No 01). Such weakness can lead to signing a blank folder and then allowing the engagement team to add documents before archival.

3) The electronic documentation system does not meet the requirement of Para 9 of SA 230. Neither the preparer nor reviewer date marks the completion of an audit procedure.

4) The archival process of the firm’s electronic work papers lacks integrity as the copy of the achieved file is editable while it is used for other post-archival purposes and, therefore, does not serve the purpose of audit documentation under Para 3 of SA 230. (Para 15, Report No 1)

5) Audit Work papers can be modified after sign-off. The application supports multiple sign-offs by the same and / or different people. It does not mandate modifier sign-off after the modification. A blank paper after sign-off can be filled out later without affecting sign-off. In the instances sighted by NFRA, there was no evidence of why and when documents were modified and who made and reviewed the changes. This was in non-compliance with Para 79 of SQC 1 and Para 8, 9 and 13 of SA 230. NFRA noted that “sufficient appropriate audit evidences are not obtained before issue of audit report as evidenced from large scale modification of AWPs post issue of audit report and without signing off AWPs after such modification.”(Para 29–30, Report No 3)

6) Signing partner is not the same as Engagement Partner in violation of Para 46 and 56 of SA 700 and 6.b of SQC 1. In FY 2020–21, there were 40 cases where Engagement Partners did not sign the audit reports. (Para 32, Report No 3)

7) The firm needs to put in place policies to deal with complaints and allegations about non-compliance with professional standards, regulatory compliance or legal requirements or the firm’s system of QC to ensure compliance with Para 101 of SQC 1. (Para 34, Report No 3)

8) NFRA desired that there should not be paper files and electronic files and all papers should be scanned and kept in electronic files. (Para 26, Report No 4)

9) Physical files are neither scanned nor incorporated by electronic files via cross-referencing of paper files with electronic files. Files lacked integrity prior to archival. (Para 12, Report No 5)

10) Sources of audit documents — whether from clients, etc., — were not available. This is a potential risk under SA 500, SA 540 and SA 550. (Para 13, Report No 5)

PART C OF REPORTS — NFRA OBSERVATIONS ON REVIEW OF INDIVIDUAL AUDIT FILES

NFRA selected a few Engagement Files for review (Refer to page 21, The BCAJ, February 2024) and selected three significant audit areas in respect of those selected engagements: Revenue, Trade Receivables and Investments.

1) The Audit Engagement team did not document its judgment for not recognising applicable types of revenue, revenue transactions and assertions as a fraud risk as necessitated by SA 240 to determine the risk of material misstatement due to fraud in the audit of revenue. (Para 32, Report No 1)

2) Audit Evidence in respect of year-end balance was not found in work papers and was obtained from the custodian during the course of the NFRA review. (Para 34, Report No 2)

3) Existence Assertion in respect of Investments at year-end, being 1 per cent, was necessary to be obtained at year-end and not obtaining such evidence was not in conformity with the firm’s policy manual and SA 230. (Para 35-36, Report No 2)

4) NFRA appreciated Non-Audit Services (NAS) guidelines voluntarily issued by the firm with effect from 1st April, 2020. At the same time, the firm delivered tax services related to DRP to an audit client in respect of years when such an entity was not an audit client. The firm had in place certain safeguards where the tax and these fell under transitional provisions of its internal NAS Guidelines. (Para 37–42, Report No 2)

5) In the case of two company audits, the financial statements did not disclose full particulars of the loans given, the investment made or guarantee given or security provided and the purpose for which the loan or guarantee or security was proposed to be utilised by the recipient of the loan or guarantee or security, thus not complying with Section 186(4) of the Companies Act 2013. The auditor did not report on it in CARO para (iv) despite its reporting responsibility. (Para 36, Report No 3)

6) Final financial statements (FS) and independent auditors’ report (IAR) were not available on the audit file and the draft FS and IAR that were on the file were different from those on the website of BSE in violation of Para 30 of SA 330. The firm accepted this as an inadvertent error. (Para 37, Report No 3)

7) In respect to 3 out of 5 selected companies, the firm was found deficient in performing appropriate audit evidence in respect to impairment of investments. (Para 38–42, Report No 3)

a. In respect of one auditee company, uponacquisition of a group of companies under Ind AS 103 Business Combinations, the firm relied on a two-year-old valuation report in respect of the subsidiary and did not perform any audit procedures for identification of impairment indicators. There was also no working in respect of how the amount in respect of investment was arrived at.

b. In respect of the same auditee, the firm wrongly concluded that no impairment loss was required to be recognised:

i. On the grounds that the subsidiary was in the process of issuing shares to an unrelated MNC which will increase the share price in the near future.

ii. On the grounds that the subsidiary was a dividend paying company and 100 per cent subsidiary, therefore, it did not perform impairment testing.

iii. Since it involved the work of a valuation specialist engaged by another audit team which audited that subsidiary was not evaluated.

c. In respect of another auditee, the audit firm wrongly presumed a subsidiary as 100 per cent owned whereas it was 84.18 per cent owned. NFRA stated that had the correct percentage of investment been considered, the impairment value would have been material to be recognised. The detailed enterprise value relied upon by the firm was also not available on the audit file.

d. In the case of another auditee, the Firm concluded that no impairment was required to be recognised for the investment in an associate, on the basis that the associate company had issued shares to unrelated market participants at a value higher than the carrying value. However, the Firm did not perform any audit procedure to check that the referred market participants were not related to the auditee company.

8) The Audit Firm’s Information System Audit Team identified certain deficiencies in the IT Control Environment, i.e., Access to Programs and Data, Entity level controls and Period-end Financial Reporting. The audit firm did not issue a modified audit opinion in respect of the IFC report despite these critical inadequacies and deficiencies. The audit file did not contain any work paper concluding that a modified opinion was not required. (Para 40–41, Report No 4)

9) The Engagement Team’s selection of a sample size of only 25 was not commensurate with the risk level. (Para 40–41, Report No 4)

10) ET had planned to obtain a ‘Low’ level of substantive evidence despite the significantly weak IT General Control environment identified by the Information Systems Audit Team. The total monetary value of transaction testing was ₹19.5 crores, which was 2.09 per cent of Total Revenue of ₹930.14 crores. As a result, the ET did not have sufficient appropriate audit evidence to support its unmodified opinion on the financial statements. The Audit Firm’s response was not accepted as it was not in accordance with the SA 530. (Para 44–47, Report No 4)

11) ET did not perform any substantive audit procedure to check the accuracy and correctness of the ‘price details’ applied to the actual invoices generated. (Para 48–49, Report No 4)

12) The entity’s significant accounting policy in respect to the recognition and measurement of revenue at the fair value of the consideration received or receivable was not in accordance with the Ind AS 115. (Para 50–51, Report No 4)

13) The Engagement Team’s audit in respect of verifying and ensuring the entity’s recognition and measurement for impairment loss allowance in accordance with the ECL approach of Ind AS 109 was inadequate and inappropriate (Para 8(a), A13, Para 8(c), A24, A25 and Para19 of SA 5409).

a. The account policy followed was not in accordance with the accounting policy disclosed.

b. The ET did not check how the management had adjusted the historically observed default rates to forward-looking estimates.

a. The entity had not made the disclosures required as per Para 35M and 35N of Ind AS 107 in respect to the credit risk exposure of Trade Receivables.

(Para 52, Report No 4)

14) Invoice-wise matching of customer collections which had an impact on the aging report was not done. This had a direct consequence on the calculation of impairment loss allowance for Trade Receivables. (Para 54, Report No 4)

15) Although the actual PBT benchmark for calculating materiality was significantly lower than planned materiality levels based on the past 3–5 years PBT, the overall materiality and performance materiality were not changed. This was a non-compliance with SA 450. (Para 56–59, Report No 4)

16) While evaluating the impact of misstatements identified during the audit, the ET had, while computing the uncorrected misstatements as a percentage of PBT, considered the number of uncorrected misstatements net of tax instead of gross of tax, leading to erroneous computation of the impact of uncorrected misstatements and the extent of audit procedures. (Para 60, Report
No 4)

17) The audit file did not have the auditee company’s policy on related party transactions. There was no evidence of obtaining a complete list of related parties at the start of the audit and the audit team having verified management assertion that RPT had taken place at arm’s length. The engagement team was, therefore, in violation of SA 550 (Para 24). In one case, the firm also stated that since the RPT were with subsidiaries, they did not pose an elevated risk. NFRA specifically stated that such presumption was not appropriate. (Para 61–63, Report No 4)

18) For evaluating impairment of investments, the audit firm did not independently evaluate significant assumptions of the auditee. Such assumptions of the auditee were found to be not appropriate and in excess. (Para 32, Report No 5)

19) The assessment of the auditor regarding the forward contract to acquire remaining shares from NCI is not separately traceable from the audit file. The disclosures in the financial statements for FY 2020–21 (year reviewed by NFRA) and 2019–20 in respect of the forward contract to acquire additional shares at a future date and the related contingent consideration arrangements are not in compliance with the requirements of Para B64(g) of Ind AS 103. A disclosure of the arrangement and basis of determining contingent consideration was necessary in the CFS of both years. (Para 33–35, Report No 5)

20) There was non-compliance with Section 186 of the Companies Act, 2013 and Companies (Number of layers) Rules as there was no evidence that the auditee met the criteria of CIC-ND-SI NBFC when it had 92 subsidiaries and 52 associates. The audit firm should have reported this in CARO, which was not done. (Para 36–37, Report No 5)

21) The EP failed to consider the possible effects of misstatements on financial statements, which were material and pervasive and, thus, required consideration of Adverse or Disclaimer Opinion as per SA 705. The possible effect was not only confined to investments but also to other balances such as loans and advances, provisions etc., which indicate their pervasiveness. (Para 38–40, Report No 5)

22) An auditee company having 286 subsidiaries out of which 255 were loss-making. Although there were indicators of impairment, the firm had relied on a management representation letter stating that there was no impairment loss and there was no assessment on AWP. (Para 41–42, Report No 5)

23) AWP did not have sufficient appropriate audit evidence of KAM in respect of the going concern assumption. (Para 43–44, Report No 5)

Part D contained a chronology of events. The appendix at the end of each report carried the actual responses given by each firm.

All five inspection reports make a good read considering they are part of the first set. We can expect several more inspection reports in the coming months and years on the next set of audit firms. I am sure the NFRA reports with time will also become uniform and nuanced and an annual summary of all points brought out during a year will make a good collection for users of such inspection reports. We can expect NFRA to receive a ‘follow up action taken’ from audit firms inspected as a desirable outcome.

Overview of NFRA Inspection Reports of 2023 on Audit Firms – I

(Editorial Note: Given the increasingly important role played by NFRA in the context of auditing, BCA Journal will be commencing reporting on NFRA developments. This reporting will cover orders, reports, circulars, notifications, rules, inspection reports, discussion papers, etc. BCAJ seeks to bring to light some of the important changes affecting the profession of audit via the NFRA with a view that members and readers can learn from some of these developments. The aim is to enable members to improve their audit processes and reduce their audit risk by improving quality and governance frameworks mandated by applicable standards and regulatory expectations. In this context, you will be pleased to read this article as a prelude to the NFRA Digest, a new feature to cover NFRA updates.)

BACKGROUND

Section 132 (2) of the Companies Act, 2013 (the Act) empowers the National Financial Reporting Authority (NFRA) to oversee the quality of service of the professions associated with ensuring compliance with such standards (previously stated in sub-clause (b)) and suggest measures required for improvement in quality of service and such other related matters as may be prescribed.

The NFRA issued a press release on 11th November, 2022, giving about three pages of Audit Quality Inspection Guidelines (AQIG). The said guidelines (about 2.5 pages of content) state “audit quality inspections are a key tool with the Regulator to fulfil its statutory obligations.” The AQIG also laid out the criteria for such inspections to cover:

  • Provisions in the Act, Rules and amendments thereof
  • SQC1 including the Code of Ethics
  • Standards of Auditing
  • Policies, guidelines, manuals, etc., of the firm
  • Ind-AS as may be applicable to selected individual audit engagements
  • Relevant circulars / directions of other regulators, as applicable
  • Directions issued by internal quality boards / committees and QRB, ICAI, as may be applicable

The AQIG also specified the inspection process:

a. Inspections will be carried out on site;

b. Questionnaires may be issued to ensure readiness;

c. Entry meeting with senior management and heads of different verticals;

d. Enquiry meeting with audit engagement team of selected audits;

e. Execution cycle will comprise site visits, interviews, review of controls, substantive testing, issue of queries and observations and follow-up of previously issued observations (to be relevant in case of recurring inspections);

f. Inspected Audit Firm / Auditor will be required to provide written responses / confirmations to queries and observations raised by NFRA;

g. Inspection will close with a meeting with the senior management of the firm or auditor;

h. NFRA will then issue a draft report to obtain responses;

i. Responses to be given within 30 days from the draft report;

j. Issuance of final report.

These NFRA guidelines are somewhat akin to the lines of PCAOB Inspection Procedures1. The Public Company Accounting Oversight Board (PCAOB), USA, has been issuing inspection reports of firms worldwide since the year 2004. It may be noted that in year 1, it issued four reports, but in the year 2005, it issued 172 reports. PCAOB also has cycles and an interesting “deficiency rate”. “This data point indicates, as a percentage of the number of audits reviewed in a particular inspection, the number of audits with respect to which the inspection identified audit deficiencies of such significance that it appeared that the firm, at the time it issued its audit report, had not obtained sufficient appropriate audit evidence to support its opinion on the issuer’s financial statements and/or internal control over financial reporting.”


1. https://pcaobus.org/oversight/inspections/inspection-procedures

Coming back to the NFRA mandate, the Audit Quality Inspections objective2 was to evaluate the compliance of the Firm / Auditor with Auditing Standards and Other Regulatory and Professional requirements, and the sufficiency and effectiveness of Quality control systems of the Audit Firm / Auditor, including:

(a) adequacy of the governance framework and its functioning;

(b) effectiveness of the firm’s internal control over audit quality; and

(c) system of assessment and identification of audit risks and mitigating measures.


2 AQIG, Dated 11th November, 2022, Para No 2

2023 INSPECTION REPORTS

Here are the common salient features of these first set of inspection reports3:

a. These are the first set of NFRA Inspection Reports.

b. The choices of the firms are based on the extent of public interest involved as evidenced by the size, composition, and nature of the audit firm, the number of audit engagements carried out during the year, the complexity and diversity of preparer companies and other risk indicators.

c. Inspection Reports

d. Engagements covered were statutory audits for FY ended 31st March, 2021.

e. Audit areas selected for each engagement were Revenue, Trade Receivables and Investments due to their “inherent higher risk of material misstatement”.

f. Other details of this round of inspections are as follows:

Report Number Name of the Firm # of Pages Engagements Selected
132.2-2022-01 SRBC & Co LLP (SRBC) 19 Five
132.2-2022-02 Deloitte Haskins and Sells LLP (DHS) 17 Five
132.2-2022-03 BSR & Co LLP (BSR) 15 Five
132.2-2022-04 Price Waterhouse Chartered Accountants LLP (PWC) 22 Four
132.2-2022-05 Walker Chandiok & Co. LLP (WCCL) 20 Five

Note: In the overview presented further down, the last two digits are referred to identify the report.


3. https://nfra.gov.in/document-category/inspection-reports/

TIMELINES (PART D)

a. The NFRA initiated inspections in November / December 2022;

b. The entry meetings were held with each of the firms between 23rd November, 2022 and 7th December, 2022;

c. Inspection time taken was about 30 to 43 days based on start and end dates given;

d. All on-site inspections were completed in January 2023;

e. Final inspection reports were issued between 22nd December, 2023, to 29th December, 2023.

It is worth noting that the time between the initiation of inspection and the issuance of the final report has taken more than one year. A detailed chronology of events / correspondence forms part of the report in Part D.

STRUCTURE OF INSPECTION REPORTS

Each report is made of Parts A, B, C and D. Part A carries an executive summary, overview, inspection approach, methodology, firm profile and acknowledgement. Part B is on Firm-wide Audit Quality Control System. Part C is on Individual Audit Engagement Files with a focus on selected areas. Part D is on the Chronology of Inspection. Reports end with an Annexure that carries the Firm’s response to the final Inspection Report.

The inspection covered a review of firm-wide quality controls, adherence to Standard on Quality Control (SQC)-1, Code of Ethics, applicable laws and rules and a review of individual Audit Engagement Files for the annual statutory audit of financial statements 31st March, 2021. The 2022 inspection emphasised crucial aspects of the Firms’ quality control systems, including leadership responsibilities, auditor independence, the acceptance and continuation of audit clients, engagement quality control and the internal quality inspection program of the Audit Firms.

CAVEAT AND GUIDANCE

NFRA has given an important statement: “Inspections are, however, not designed to review all aspects and identify all weaknesses in the governance framework or system of internal control or audit risk assessment framework; nor are they designed to provide absolute assurance about the Audit Firm’s quality of audit work. In respect of selected audit assignments, inspections are not designed to identify all the weaknesses in the audit work performed by the auditors in the audit of the financial statements of the selected companies.” Further, the NFRA has clarified that these reports are neither marketing tools nor are they a rating of any sort. The report also states that “selected sample of five individual audit engagements is not representative of the Firm’s total population of the audit engagements completed by the Firm for the year under review.”

It emphatically states that reports are “intended to identify areas and opportunities for improvement in the Audit Firm’s system of quality control.”

FIRM PROFILE, STRUCTURE, NETWORK AND INDEPENDENCE (PART B, C)

1) Each Audit Firm was a member of a domestic network bearing the same / similar name.

2) The flagship firm selected for NFRA review carried the identical / similar / abridged name of the network.

3) Many members of the domestic network were firms bearing similar names and in some cases different names.

4) Each Audit Firm was a member of an international network.

5) Non-provision of domestic network details / agreement to NFRA (para 11, Report No. 01), (para 11, Report No. 03).

6) Provision of domestic network agreement registered with ICAI to NFRA (para 10, Report No. 04), (para 23 and 24, Report No. 02).

7) Denial of part of a network as envisaged by SQC 1 clause 6(k) although registered with ICAI as a domestic network (para 15 (viii), Report No. 05).

8) Provision of international network agreements — whether asked or given is not clear from the NFRA Report.

9) Leadership / Governance Structure of Domestic Network:

a) Through the LLP Format (para 12, Report No. 03), however, NFRA observed that “Firm could not provide sufficient evidence about Leadership, Governance and Management structure to demonstrate compliance to element 1 of SQC 1 regarding Leadership Responsibilities for Quality within the Firm”.

b) Common Leadership Team / Assurance Leadership Team, consisting of partners of domestic network firms; however, no documentation was there between individual firms or network agreement that delineated the leader’s duty, responsibility and accountability (para 19 and 20, Report No. 01). The charter of the leadership team seemed to be a recently drawn-up document without authenticity. NFRA pointed out that “there was no clarity on the assignment of responsibilities, authority with individuals claimed to be part of the leadership structure, reporting hierarchy, and accountability of the leaders and their respective legal entities.”

c) The Audit Firm did not have a Board to oversee the Network as stated in the Networking Agreement signed by the Audit Firm (para 23, Report No. 02).

d) Partner Oversight Committee had oversight over the domestic network firms and for coordination / alignment with global network standards and policies. However, it did not have management control (para 18, Report No. 04). The domestic network had an advisory committee with each member having different roles, with a minimum of two registered Chartered Accountants. The advisory committee provided assistance, etc., to the non-executive chair on various matters (Para 16, Report No 04).

10) Information provided about Indian entities of Global Network (para 12, Report No. 04). Other reports do not carry such information.

11) Partners in Audit Firms were also partners in other network firms (para 11, Report No. 04).

12) One Audit Firm displayed inconsistency in reporting to PCAOB about its two network firms. The audit firm said that it had no audit-related affiliation, membership, or similar arrangement with any other entity; it was part of the Indian network of two firms bearing same / similar names. At the same time, another Indian firm (having connected names) told PCAOB that it was affiliated with the Audit Firm (para 15, Report No. 5).

13) There were references to a common brand traced from quality control policies and e-audit software, although the audit firm denied network arrangement as per SQC 1 (para 16 (i), Report No. 5).

14) The Audit firm’s relationship with the global network was not recognised in the independence policies. NFRA observed that such relationships are included in the definition of Network (Para 25, Report No. 1).

15) The Audit firm’s Indian clients were provided with non-audit services by global network firms in India to the auditee group in violation of Sections 144 and 141 of the Companies Act, 2013 (Para 25, Report No. 1).

16) A possible disqualification of the audit firm as auditor was observed in two samples under Section 141(3)(e) of the Companies Act, 2013, due to global network relationship (Para 26, Report No. 1).

17) The Audit Firm did not provide the details of non-audit services provided by its International network’s India entities to the Audit Firm’s audit clients during the course of the on-site inspection (Para 15, Report No 03).

18) The Audit Firm had made its association with the International network’s India entities clear to PCAOB; it did not fully disclose global network entities to the NFRA (Para 16, Report No 03) .

19) The international network’s India entity partners were designated as the Audit Firm’s partners in the audit firm’s audit files (Para 17, Report No 03).

20) International Network’s India entity’s audit work is performed by the Audit Firm’s personnel as per the PCAOB website (Para 18, Report No 03).

21) An audit firm which maintained that it was independent of a global network, and disclosed one entity of the global network in India subsequently, had several indicators to demonstrate the audit firm’s dependence on the global network such as inter-relationship of leadership, common control and governance structure, global network’s India entity accepting audit on behalf of the audit firm, use of global network’s domain name by audit executive team and sharing core functions (Para 17, Report No 03).

22) Inspection noted that the Audit Firm was not independent of International network’s India entities, who are member entities of the international network (Para 19, Report No 03).

23) As per reporting to PCAOB, the audit firm and global network’s India entities carried out audits where part of the audit was carried out by the global network’s India entity and ICAI registered domestic network (Para 18, Report No 03).

24) During the inspection, the Audit Firm did not provide details of International network entities and non-audit services provided by those entities to audit clients. Therefore, the NFRA team was unable to determine whether there was compliance with the fundamental requirements of the Code of Ethics (Para 20, Report No 03). However, the Audit Firm responded that it had decided that all India entities of the International network will not provide non-audit services to the firm’s NFRA-regulated clients from 1st January, 2024 (Para 21, Report No 03).

25) The Audit Firm disclosed that each network firm was distinct, not an agent of the other firms or the international network. The Indian network had signed an admission and license agreement. The global membership provided various resources, methodologies, etc. (Para 13, Report No 04).

26) NFRA appreciated the steps taken by the Audit Firm and advised to take further steps to avoid the provision of non-audit services to holding companies by network entities, whose subsidiary is under purview of NFRA in India (Para 34, Report No 04).

This is the first in the line of articles that cover an overview of the first five NFRA inspection reports. The inspection process, timelines and structure of inspection reports have been covered. This article also covers important NFRA observations on audit firms relating to governance and leadership structures or lack / non-disclosure thereof, international and domestic networks / affiliations. It also covers some issues in that context by NFRA such as non-audit services provided to audit clients and issues related to SQC 1.

This compilation is done with a view to enable auditors and audit firms to understand the focal points and key issues in these NFRA inspections. These key features will help firms take necessary steps to be compliant with applicable regulations.

The next article will cover NFRA observations on audit quality control systems, independence, engagement quality control and points arising from the review of engagement files based on selected areas. From that subsequent article, one will be able to draw practical nuances relating to Standards on Auditing and other applicable laws and regulations.

Key Amendments to SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015

SEBI had issued Consultation Papers in November 2022 and February 2023 for amending the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015. SEBI had invited comments on these consultation papers and finally issued the amendments by way of Notification No. SEBI/LAD-NRO/GN/2023/131 dated 14th June, 2023. These amendments majorly relate to enhancing disclosure and governance requirements of listed entities.

EFFECTIVE DATE OF THE AMENDMENTS

The amendments are effective on the 30th day of publication in the official gazette i.e., 14th July, 2023, except for some of the requirements which were effective from 14th June, 2023, e.g., approval requirements in case of sale, lease or disposal of an undertaking outside scheme of arrangement.

The objective of this article is to provide an overview of the key amendments and provide the brief analysis of the amendments. Reference should be made to SEBI notification dated 14th June, 2023, and amended SEBI LODR Regulations, 2015 for a detailed understanding of the entire set of amendments.

TIMELINE FOR SUBMISSION OF FINANCIAL RESULTS SUBSEQUENT TO THE FIRST-TIME LISTING

Clause (j) has been added to the Regulation 33(3) of Chapter IV, Obligations of a listed entity which has listed its specified securities and non-convertible debt securities, to provide clarity on the submission of financial results for the entity listed for the first time. The entity subsequent to the listing, is required to submit its financial results for the quarter or the financial year immediately succeeding the period for which the financial statements have been disclosed in the offer document for the initial public offer, as per the below timeline:

  • period specified in Regulation 33(3)(a) i.e., within 45 days from the end of each quarter other than the last quarter; or
  • period specified in Regulation 33(3)(d) i.e., within 60 days from the end of the Financial Year (in case of the March quarter);
  • within 21 days from the date of listing;

Whichever is later.

This amendment is applicable to the issuers whose public issues open on or after these regulations come into effect.

DISCLOSURE OF MATERIAL EVENTS/INFORMATION UNDER REGULATIONS 30 – INTRODUCTION OF QUANTITATIVE CRITERIA FOR DETERMINING MATERIALITY

The qualitative criteria governing disclosure of material events/information as per Regulation 30(4) is where the omission in discourse of such event/information is likely to result in:

  • discontinuing or altering an event or information already available publicly; or
  • significant market reaction if the said omission came to light at a later date.

Sub-regulation (4) of Regulation 30 has been amended and new quantitative criteria by way of threshold has been included for determining the materiality of events/ information as below:

The omission of an event or information, whose value or the expected impact in terms of value, exceeds the lower of the following:

  • 2 per cent of the turnover as per the last audited consolidated financial statements of the listed entity;
  • 2 per cent of the net worth as per the last audited consolidated financial statements of the listed entity except in case the arithmetic value of the net worth is negative;
  • 5 per cent of the average of absolute value of profit or loss after tax, as per the last 3 audited consolidated financial statements of the listed entity.

The thresholds are based on the last audited consolidated financial statements of the listed entity. Considering that the present financial year is the first year of applicability, the thresholds will need to be determined based on the consolidated financial statements as on 31st March, 2023. In case of profit related parameters, average needs to be computed for the last three financial years i.e., 2022-23, 2021-22, 2020-21.

Turnover has been defined under Companies Act, 2013 as the gross amount of revenue recognised in the profit and loss account from the sale, supply, or distribution of goods or on account of services rendered, or both, by a company during a financial year.

‘Absolute value of profit or loss after tax’ means to take absolute figures of profit / loss i.e., without netting off in case the company has losses in any of the financial year. The threshold for profit/loss is to be computed by taking the absolute values of profit or loss after tax, for the immediately preceding three financial years.

The amended regulations require the materiality policy to be framed in a manner so as to assist the relevant employees in identifying potential material events or information. The listed entity will have to ensure that the policy formulated by the listed entity for determining the materiality cannot dilute any requirement specified under the provisions of these regulations, and is required to assist the relevant employees in identifying any potential material event or information and reporting the same to authorised KMP for determining the materiality of such events or information and for making necessary disclosures to the stock exchange.

The new quantitative threshold would require listed entities to make timely disclosures of material information without exercising their judgement on whether they are required to be disclosed.

TIME PERIOD FOR DISCLOSURE OF MATERIAL EVENTS/ INFORMATION:

The disclosure of the material event or information to the stock exchange is required to be not later than the following:

  • 30 minutes from the closure of Board Meeting where the decision regarding the event/ information is taken.
  • 12 hours from the occurrence of event or information if such event or information emanates from within the listed entity.
  • 24 hours from the occurrence of event or information if such event or information emanates NOT within the listed entity.

In case of delay in such disclosure, explanation for the same need to be disclosed. In case the timelines for the disclosure of events are specified in Part A of Schedule III of the regulations, such timelines need to be followed.

AMENDMENT IN PART A OF SCHEDULE III OF THE REGULATIONS IN RELATION TO EVENTS WHICH NEEDS TO BE DISCLOSED BASIS THE GUIDELINES FOR MATERIALITY

The following events have been added which need disclosure basis the guidelines for materiality:

  • Arrangements for strategic, technical, manufacturing, or marketing tie-up.
  • Adoption of new line(s) of business.
  • Closure of operation of any unit, division or subsidiary (in entirety or in piecemeal).
  • Pendency of any litigation(s) or dispute(s) or the outcome thereof which may have an impact on the listed entity.
  • Frauds or defaults by employees of the listed entity which has or may have an impact on the listed entity.
  • Delay or default in the payment of fines, penalties, dues, etc. to any regulatory, statutory, enforcement or judicial authority.

DISCLOSURE OF EVENTS/INFORMATION IRRESPECTIVE OF MATERIALITY

Para A of Part A of Schedule III has been amended to include certain events which need to be disclosed to the Stock Exchange(s) without any application of guidelines for materiality as specified in Regulation 30(4) as follows:

A. Events relating to fraud/ default in repayment / arrest of certain persons

The following events need to be disclosed:

  • Fraud or defaults by a listed entity, its promoter, director, key managerial personnel, senior management or subsidiary; or
  • Arrest of key managerial personnel, senior management, promoter or director of the listed entity, whether occurred within India or abroad.

‘Fraud’ is defined under Regulation 2(1)(c) of Securities and Exchange Board of India (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 2003. ‘Default’ means non-payment of the interest or principal amount in full on the date when the debt has become due and payable.

In the case of revolving facilities like cash credit, an entity would be considered to be in ‘default’ if the outstanding balance remains continuously in excess of the sanctioned limit or drawing power, whichever is lower, for more than thirty days.

Default by a promoter, director, key managerial personnel, senior management, subsidiary means the default which has or may have an impact on the listed entity.

B. Event relating to restructuring / amalgamation (Amendments have been highlighted in bold)

The following events need to be disclosed:

Details relating to acquisition(s) (including agreement to acquire), Scheme of Arrangement (amalgamation, merger, demerger or restructuring), sale or disposal of any unit(s), division(s), whole or substantially the whole of the undertaking(s) or subsidiary of the listed entity, sale of stake in associate company of the listed entity or any other restructuring.

C. Events relating to resignation of certain persons

The following needs to be disclosed to the Stock Exchange(s) within 7 days from the date resignation comes into effect:

  • resignation of key managerial personnel, senior management, Compliance Officer or director other than an independent director,
  • the letter of resignation along with detailed reasons for the resignation.

D. Events relating to non-availability of certain persons

The following needs to be disclosed to the Stock Exchange(s):

  • The event where MD or CEO was indisposed or unavailable to fulfil the requirements of the role in a regular manner for more than 45 days in any rolling period of 90 days.
  • Reason for such indisposition or unavailability.

E. Event relating to voluntary revision of financial statements or Directors’ report

Voluntary revision of financial statements or the report of the board of directors of the listed entity under section 131 of the Companies Act, 2013.

Communication/ order from regulatory, statutory, enforcement or judicial authority – Disclosure under Regulation 30 (13).

Action(s) initiated, or orders passed by all regulatory, statutory, enforcement authority or judicial bodies against the listed entity or its directors, KMPs, senior management, promoter or subsidiary, in relation to the listed entity requires disclosure. The following events require disclosure:

  • search or seizure; or
  • reopening of accounts under section 130 of the Companies Act, 2013; or
  • investigation under the provisions of Chapter XIV of the Companies Act, 2013;

In case of an action/order, the following details pertaining to the actions initiated, taken or orders passed will be required to be disclosed within 24 hours:

(i) name of the authority; (ii) nature and details of the action(s) taken, initiated or order(s) passed; (iii) date of receipt of direction or order, including any ad-interim or interim orders, or any other communication from the authority; (iv) details of the violation(s)/contravention(s) committed or alleged to be committed; (v) impact on financial, operation or other activities of the listed entity, quantifiable in monetary terms to the extent possible.

Action(s) taken, or orders passed by any of the above mentioned authority against the listed entity or its directors, KMPs, senior management, promoter or subsidiary, in relation to the listed entity, is also required to be disclosed; following details are required:

(i) suspension; (ii) imposition of fine or penalty; (iii) settlement of proceedings; (iv) debarment; (v) disqualification; (vi) closure of operations; (vii) sanctions imposed; (viii) warning or caution; or any other similar action(s) by whatever name called.

Disclosure of Agreements impacting listed entities – New regulation

A new Regulation 30A has been inserted in Chapter IV, Obligations of a listed entity which has listed its specified securities & non-convertible debt securities which requires disclosures of agreements specified in the newly inserted clause 5A of para A of part A of schedule III. There are numerous agreements that are entered into by shareholders e.g., SHAs, SPAs, performance related agreements etc. These may be entered into between investors, joint venture partners, family members etc. These agreements may or may not be having the listed entity as a party or even a confirming party. However, these agreements pertain to management or control of the listed entity and therefore, may require disclosure in terms of Clause 5A.

Who is required to make the above disclosures?

If the shareholders, promoters, promoter group entities, related parties, directors, key managerial personnel and employees of a listed entity or of its holding, subsidiary and associate company are parties to the above-mentioned agreement and the listed entity is not a party to such agreement.

The above mentioned person needs to inform the listed entity about the agreement within 2 working days of entering into such agreements or signing an agreement to enter into such agreements. In case the above agreements subsist on the date of notification of clause 5A to para A of part A of schedule III, then the above mentioned person needs to make disclosure to the listed entity on that date only. The listed entity in turn is required to disclose the information to the stock exchange and on its website within the timelines specified by the Board.

Information/ agreements specified in clause 5A of part A of Schedule III

Agreements entered into by the shareholders, promoters, promoter group entities, related parties, directors, key managerial personnel, employees of the listed entity or of its holding, subsidiary or associate company, among themselves or with the listed entity or with a third party, solely or jointly, which, either directly or indirectly or potentially or whose purpose and effect is to, impact the management or control of the listed entity or impose any restriction or create any liability upon the listed entity, need to be disclosed to the Stock Exchanges, including disclosure of any rescission, amendment or alteration of such agreements thereto, whether or not the listed entity is a party to such agreements:

Disclosure of such information in Annual Report for FY 2022-23 and FY 2023-24

Number of agreements that subsist as on the date of notification of clause 5A to para A of part A of schedule III, their salient features, including the link to the webpage where the complete details of such agreements are available.

Information disclosed under clause 5A of paragraph A of Part A of Schedule III needs to be disclosed in the Annual Report.

This amendment seeks to address information disparity and increases transparency and will also enable the listed entity to be made aware of the obligations that have been imposed upon it by the parties to such agreements.

Circumstances in which disclosure of such information to stock exchange is not required

If such agreements entered into by a listed entity in the normal course of business unless:

  • they, either directly or indirectly or potentially or whose purpose and effect is to impact the management or control of the listed entity; or
  • they are required to be disclosed in terms of any other provisions of the LODR Regulations.

The term “directly or indirectly” includes agreements creating obligations on the parties to such agreements to ensure that listed entities shall or shall not act in a particular manner.

BUSINESS RESPONSIBILITY AND SUSTAINABILITY REPORT (BRSR) – MANDATORY REASONABLE ASSURANCE

Vide Circular No. SEBI/HO/CFD/CFD-SEC-2/P/CIR/2023/122 dated 12th July, 2023, SEBI has mandated reporting of ESG disclosures by top 1000 listed companies (by market capitalisation) from FY 2023-24 onwards in the revised BRSR format. The revised format has added some additional questions in Section C, Principle Wise Performance Disclosures besides making some Leadership indicators as Essential Indicators. To enhance the reliability of disclosures in BRSR, SEBI has mandated the reasonable assurance of BRSR Core to top 150 listed entities (by market capitalisation) from FY 2023-24 onwards which will be extended to top 1000 listed entities (by market capitalisation) by FY 2026-27 in a phased manner vide amendment in Regulation 34(2)(f) of SEBI (Listing Obligations and Disclosure Requirement) Regulations, 2015 (LODR Regulations). BRSR core is a subset of BRSR.

In addition, KPIs for value chain needs to be disclosed by the top 250 listed entities (by market capitalisation) from FY 2024-25 on a comply-or-explain basis. Limited assurance on the same is required to be obtained with effect from FY 2025-26. For this purpose, the value chain encompasses the top upstream and downstream partners of a listed entity, cumulatively comprising 75 per cent of its purchases / sales (by value) respectively. SEBI also released a set of FAQs wherein it provided an indicative list of activities which the assurance provider cannot undertake besides clarifying that assurance of BRSR Core is profession agnostic.

Regulators and Investors are increasingly focussing on the ESG disclosures and their accuracy. Companies need to gear up for providing adequate information in their sustainability report. As reporting and assurance of sustainability related disclosures evolves audit committees have a critical role to play in expanding their existing oversight responsibilities for financial reporting and compliance to sustainability-related disclosures.

REPORTED INFORMATION IN THE MAINSTREAM MEDIA – NEW REQUIREMENT

Regulation 30 (11) of SEBI (LODR) Regulation, 2015 had been amended requiring top 100 and 250 listed companies to confirm, clarify or deny any reported event or information in the mainstream media which is not general in nature and which indicates that rumours of an impending specific material event or information, in terms of the provisions of LODR regulation, are circulating amongst the investing public, as soon as reasonably possible and not later than twenty four hours from the reporting of the event or information. If the listed entity confirms the reported event or information, it shall also provide the current stage of such event or information. SEBI has also defined what constituted mainstream media in that Notification vide amendment in Regulation 2 (1)(ra).

Recently, SEBI vide Notification dated 9th October, 2023, has omitted the timelines and deferred the applicability of the above-mentioned provisions indefinitely. The three industry associations, viz. ASSOCHAM, CII and FICCI, have come together to form Industry Standards Forum (ISF) under the aegis of the Stock Exchanges on a pilot basis. ISF has taken up verification of market rumours as one of the pilot projects for formulating standards. The effective date for the aforesaid requirement would be specified by the SEBI, after reviewing the standards submitted by ISF1.


1 . Source: SEBI Board Meeting - Extension of timeline for verification of market rumours by listed entities – Amendment to the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015.

WAY FORWARD

The Amendment Regulations have attempted to strengthen corporate governance standards and disclosure requirements of listed companies. These changes reflect SEBI’s commitment to create a more robust regulatory framework and promote investor confidence. The changes introduced can be considered as a step in the right direction as it has the effect of empowering the shareholders of listed companies by way of enhanced transparency and additional disclosures.

Tightening the Book-Keeping Requirements: Amendments to the Companies (Accounts) Rules, 2014

Companies are required to maintain their books of account as prescribed in the Companies Act, 2013 (the ‘Act’). MCA issued an amendment to Rule 3 of Companies (Accounts) Rules, 2014 (‘Account rules’) relating to the maintenance of electronic books of account and other relevant books and papers to make the existing requirements more stringent. With this amendment issued in August 2022, Indian Government authorities seek to always have access to books of accounts of Indian companies, even if such books are maintained in electronic form on servers located outside India. The amendment was issued on 5th August, 2022, with no applicability date. The amended rules are effective from the date of their publication in the Official Gazette.

While the first year of the applicability of the amended rule is over, it is important for the companies as well as the auditors to understand the implications of this amendment. Non-compliance with this requirement may constitute non-compliance with the requirement of law in terms of Section 128 and impact the auditor’s assertion in ‘Report on other legal and regulatory requirement’ in Section 143 (3)(b) on maintenance of proper books of account as required by Section 128 of the Act.

Certain multinational companies have refused to provide government authorities access to financial data of Indian entities stored in servers outside India, which may have prompted the government to amend the Accounts Rules.

This amendment includes:

  • Books of accounts should remain accessible in India at all times so as to be usable for subsequent reference.
  • Back-ups of books of account and other relevant books and papers maintained in electronic mode (within or outside India) to be kept in servers physically located in India on a daily basis (Earlier: periodic basis).
  • Disclose annually to ROC the name and address of the person in control of the books of account and other books and papers in India (where the service provider is located outside India).

The above amendment is aimed at preventing any manipulation of the books of account of a company and to ensure that the same are readily accessible and backed up on a daily basis, where required.

ICAI has also issued an announcement, ‘Amendment in the Companies (Accounts) Rules, 2014 relating to the availability of books of account and other relevant books and papers maintained in electronic mode at all times and also details of person in control, if the service provider is located outside India’ in this regard which provides a comparison between the previous and revised requirements.

This article provides specific considerations for the companies and the auditors to comply with the revised requirements of the Act read with rules.

IDENTIFICATION OF RELEVANT BOOKS OF ACCOUNT

The first step is that the companies should identify and back up the documents which qualify as books of account and other relevant books and papers basis the definition under section 2 of the Companies Act, 2013.

Books of Account as per Section 2(13) of the Companies Act, 2013 includes records maintained in respect of –

  • all sums of money received and expended by a company and matters in relation to which the receipts and expenditure take place;
  • all sales and purchases of goods and services by the company;
  • the assets and liabilities of the company; and
  • the items of cost as may be prescribed under section 148 in the case of a company which belongs to any class of companies specified under that section;

Books and papers and books or papers as per section 2(12) of the Companies Act, 2013  include books of account, deeds, vouchers, writings, documents, minutes, and registers maintained on paper or in electronic form.

It is important to note that the backup should include all the documents including underlying support maintained in electronic mode.

The companies will be required to take steps to ensure that there is a server physically located in India for taking the backup of books of account on a daily basis.

CONTROLS TO BE IMPLEMENTED AND OPERATED BY THE COMPANY

It is also important for the companies to ensure that adequate controls have been established for backup to be taken on a daily basis:

  • Controls to ensure that backups are taken digitally on the designated server physically located in India.
  • Controls to ensure that backups are taken locally in India and not overseas.
  • Controls to ensure that backups taken are in a readable format and can be displayed or read when required.
  • Controls to ensure access to the backup logs is restricted to appropriate individuals.
  • Controls to ensure that appropriate actions are taken in case of a backup failure.

OTHER CONSIDERATIONS

The requirements prescribed under Rule 3 are applicable to all companies having their servers in India or outside India. Offline media of backups such as tapes, CDs, drives, etc. may not meet the requirements of the amended provisions of the rules.

The hard copy printouts of such backup or retaining back in pdf (or similar format) will not meet the requirements of the amended Rules.

The backup of books of account and other books and papers maintained under the proviso to Rule 3(5) should be maintained for at least 8 preceding financial years in line with the requirements under section 128(5) of the Companies Act, 2013.

AUDITORS’ CONSIDERATIONS

Considering there is no applicability date given in the amendment rules except that the amended rules are effective from their date of publication in the official gazette, auditor reporting obligation is triggered for financial statements which include any period on or after the effective date of the amendment i.e.,5th August, 2022.

The revised requirements will not trigger reporting requirements in cases the period covered by financial statements has ended before the effective date even if the auditor’s report date is after the effective date.

Section 143(3)(a) to the Companies Act, 2013 provides that the auditor’s report should state whether proper books of account have been kept by the company and also state any qualification, reservation or adverse remark relating to the maintenance of accounts and other matters connected therewith [Section 143(3)(h)].

The expression ‘proper’ means appropriate, in the required manner, fit, suitable, apt.

The auditors will be required to check whether backups of the books of account and other books and papers of the company maintained in electronic mode have been retained on a server located in India with backups taken on a daily basis instead of back-ups on a periodic basis — as provided earlier.

The auditors may test the IT General controls such as security and access, computer operations, system development and system changes basis the guidance provided under SA 315, ‘Identifying and Assessing the Risks of Material Misstatement Through Understanding the Entity and its Environment’ and SA 330, ‘The Auditor’s Responses to Assessed Risks’ and Guidance Note issued by ICAI on Audit of Internal Financial Controls Over Financial Reporting.

The auditors may also perform tests of controls over computer operations which could include:

  • evaluating the backup and recovery processes,
  • reviewing the process of identifying and handling computer operations, and
  • if applicable, control over job scheduling which directly/ indirectly impacts the periodicity of backups.

Auditors should also test the IT environment maintained by a third-party service provider in case the books of accounts of the company are maintained by such service providers.

KEY ASSERTIONS THAT ARE TO BE EVALUATED AS PART OF TESTING

  • Backups are taken daily.
  • Backups are taken on the server. Copies of printouts / PDFs as backups will not meet the requirements.
  • Backups are taken on the server physically located in India.
  • Backups are readable as books of accounts and records in a legible form. This means that a front end would be required to display in readable/legible form.

THIRD-PARTY SERVICE PROVIDER

Some companies may employ third-party service providers to maintain their books of accounts in electronic mode, for example, on cloud is also covered by the new requirement.

Rule 3(6) of account rules requires the company to intimate the following to the RoC on an annual basis at the time of filing of financial statements:

  • the name of the service provider;
  • the internet protocol address of the service provider;
  • the location of the service provider (wherever applicable);
  • where the books of account and other books and papers are maintained on the cloud, such as the address as provided by the service provider.
  • details of the name and address of the person in control of books of account and other books and papers in India.

NON-COMPLIANCE IMPLICATIONS

Section 128(6) provides for the penalty on the specified persons if the requirements of section 128 are not met. For example, not taking daily backups, books of accounts not accessible in India on a daily basis,etc. The company needs to determine the penal provisions and the auditor may consider the reporting implications.

If the auditor identifies an exception, the auditor should report such a matter under section 143(3)(b) under the heading ‘Report on other legal and regulatory requirements’ of the Act. For example, backups are not taken on a daily basis but taken at the year-end or on the date of the auditor’s report.

APPLICABILITY TO REPORTING ON CONSOLIDATED FINANCIAL STATEMENTS

The auditor is required to comment on this matter both in the case of standalone financial statements and consolidated financial statements. However, while reporting on consolidated financial statements, the auditor may observe that certain components included in the consolidated financial statements are (a) either not companies under the Act, or (b) some components are incorporated outside India. The auditors of such components are not required to report on these matters since the provisions of the Act do not apply to them. ICAI has issued similar guidance in its implementation guide on Reporting under Rule 11(g) of the Companies (Audit and Auditors) Rules, 2014.

ILLUSTRATIVE REPORTING

The auditors of various listed companies in the audit report for the year ended 31st March, 2023, have included a comment in the Auditor’s report under the heading ‘Report on other legal and regulatory requirements’ in case of non-compliance with the aforesaid requirements. Some of the examples are as below:

MODIFIED REPORTING – STANDALONE AUDITOR’S REPORT

“In our opinion, proper books of account as required by law have been kept by the Company so far as it appears from our examination of those books except that the backup of all books of account and other books and papers maintained in electronic mode has not been maintained on servers physically located in India on a daily basis.”

MODIFIED REPORTING – CONSOLIDATED AUDITOR’S REPORT

In our opinion, proper books of account as required by law relating to the preparation of the aforesaid consolidation of the financial statements have been kept so far as it appears from our examination of those books and reports of the other auditors, except that with respect to certain entities as disclosed in note XX to the consolidated financial statements, the back-up of books of account was not kept in servers physically located in India on a daily basis as stated in Note XX to the consolidated financial statements.

UNMODIFIED REPORTING

In our opinion, proper books of account as required by law have been kept by the Company so far as it appears from our examination of those books [and proper returns adequate for the purposes of our audit have been received from the branches not visited by us].

BACKUP REQUIREMENTS FOR AUDIT TRAIL (EFFECTIVE FROM 1ST APRIL, 2023, ONWARDS)

The Companies Accounts Rules, 2014 have also been amended to introduce the requirement of an audit trail. Effective 1st April, 2023, onwards, every company which uses accounting software for maintaining its books of account, shall use only such accounting software which has a feature of the recording audit trail of each and every transaction, creating an edit log of each change made in the books of account along with the date when such changes were made and ensuring that the audit trail cannot be disabled.

The Companies (Audit and Auditor) Rules, 2014 have been correspondingly amended wherein auditors are now required to report, as part of the auditor’s report (in the section ‘Report on Other Legal and Regulatory requirements’, as to whether,

(a)the accounting software used by the company being audited has the feature of recording audit trails (edit logs),

(b)the audit trail feature was operational throughout the financial year and had not been “tampered” with, and

(c)such audit trails have been retained for the period as statutorily prescribed.

The MCA has notified that the aforesaid amendments will be effective from 1st April, 2023, which implies that the accounting software employed by companies will need to be compliant with the Accounts Rules from FY 2023-24 onwards.

The revised requirements for back up of books of account and other books and papers of the company maintained in electronic mode may include audit trail records as well since an audit trail is required for books of account records and the audit trail records would fall under the definition of books of account and other books and papers. While ICAI or MCA may issue a clarification on this aspect, reference may be made to paragraph 20 of the Implementation Guide on Reporting under Rule 11(g) of the Companies (Audit and Auditors) Rules, 2014 which requires that the company should establish controls to ensure that periodic backups of the audit trails are taken and archived as per the statutory period specified under Section 128 of the Act.

BOTTOM LINE

The rules have been amended with a view to giving more stimuli to the accessibility of books and papers maintained in electronic mode by companies. The auditor should also assess the requirement as part of their assessment of Non-compliance with laws and regulations and reporting requirements under Standards on Auditing.

FINANCIAL REPORTING DOSSIER

This article provides key recent updates in
financial reporting in the global space that could soon permeate into Indian
financial reporting; insights into an Ind AS accounting topic, viz., other
comprehensive income, tracing its roots, developments and relevance; compliance
aspects of capital disclosures under Ind AS; and a peek at an international
reporting practice in audit committee reports

 

1.   KEY RECENT UPDATES

 

1.1   From disclosing ‘significant accounting
policies’ to disclosing ‘material accounting policies’

The IASB on 1st
August, 2019, proposed amendments to IAS 1 Presentation of Financial
Statements
and IFRS Practice Statement 2 Making Materiality Judgements.
A threshold for disclosing accounting policies is clarified by replacing the
requirement to disclose ‘significant’ accounting policies with ‘material’
accounting policies. Materiality in this context is a threshold that can
influence users’ decisions based on the financial statements.

 

1.2   Exception to recognising deferred tax upon
first-time recognition of assets or liabilities

The IASB has
proposed amendments to IAS 12 Income Taxes on 17th July, 2019
clarifying accounting for deferred tax on leases and decommissioning
obligations. IAS 12 exempts recognising deferred tax upon recognition of assets
or liabilities for the first time. As per the exposure draft, this exemption
would not apply to leases and decommissioning obligations – transactions for which
companies would recognise both an asset and a liability. Recognition of
deferred tax on such transactions would therefore be required.

 

1.3   Useful information on ECL estimation for Ind
AS stakeholders

The FASB has issued
a Staff Q&A on Developing an Estimate of Expected Credit Losses on
Financial Assets.
Akin to IFRS 9, USGAAP requires financial assets held at
amortised cost to be subject to impairment testing using the ECL approach. This
approach requires an entity to consider historical experience, current
conditions and reasonable and supportable forecasts. The Q&A issued on 17th
July, 2019 provides guidance in this area.

1.4   Revisions to the international code of ethics
for professional accountants

The IESBA issued an
Exposure Draft on 31st July, 2019, Proposed Revisions to Promote
the Role and Mindset Expected of Professional Accountants
that inter
alia
enhances robustness of the fundamental principles of integrity,
objectivity and professional behaviour.

 

2.   RESEARCHING – OTHER
COMPREHENSIVE INCOME (OCI)

 

2.1   Introduction

Comprehensive
income as a reported accounting measure is new in the Indian context. The
notion of income is wider under comprehensive income in comparison with a
narrower income statement (profit and loss) concept.

 

2.2   Setting the context

Analysis of three
sample companies’ total comprehensive income (TCI) dissecting their composition
and growth in terms of profit after tax (PAT) and other comprehensive income
(OCI) is provided below:

 

Company 1 – Walt Disney, US listed (Dow
Index Component)

 

2017
($ MN)

2016
($ MN)

2017 (%)

2016 (%)

Growth %

PAT

9,366

9,790

96%

120%

(4.3)%

OCI

426

(1,656)

4%

(20%)

 

TCI

9,792

8,134

100%

100%

20.4%

 

Company 2 – Power Finance Corporation,
India listed, NBFC

 

2019
(Rs. cr)

2018
(Rs. cr)

2019 (%)

2018 (%)

Growth %

PAT

6,953

4,387

103%

108%

58.5%

OCI

(207)

(324)

(3%)

(8%)

 

TCI

6,746

4,063

100%

100%

66.0%

 

Company 3 – British Petroleum, US and UK
Listed
(Dow Index Component)

 

2018
($ MN)

2017
($ MN)

2018 (%)

2017 (%)

Growth %

PAT

9,578

3,468

126%

41%

176.2%

OCI

(1,980)

5,016

(26%)

59%

 

TCI

7,598

8,484

100%

100%

(10.4%)

 

As can be seen from
the table above, Company 1 reported an increase of 20.4% at the TCI layer,
while the PAT witnessed a ‘de-growth’ of 4.3%.

 

Volatility in OCI could
amplify or mask total comprehensive income. Do investors focus on PAT or TCI as
a measure of financial performance? Is TCI an important measure for investors?

 

In this section an
attempt is made to address the following questions:

 

1.

Is the concept of OCI new under Ind AS or did it exist under
AS?

2.

Was IFRS the first GAAP to introduce this concept?

3.

Did OCI develop as an accounting concept or as a practice?

4.

What have been the historical and current developments?

5.

Is OCI relevant to investors?

 

 

2.3   The current position in India

Other Comprehensive
Income (OCI) as an accounting concept and a reporting measure made its way into
India Inc.’s corporate balance sheets with the introduction of Ind AS. OCI
comprises items of income and expenses that are not recognised in profit or
loss as required or permitted by other Ind ASs.

 

Ind AS 1 Presentation
of Financial Statements
lists the components of OCI that inter alia
include changes in revaluation surplus of items of property, plant and
equipment, gains and losses arising from translating the financial statements
of a foreign operation, gains and losses from investments in equity instruments
designated at FVTOCI, gains and losses on financial assets measured at FVTOCI,
re-measurement of defined benefit plans and the effective portion of gains and
losses on hedging instruments in a cash flow hedge.

 

Schedule III to the
Companies Act requires Ind AS companies to report other comprehensive income in
the statement of profit and loss as a separate measure. Investors are provided
in a single statement the accounting measures of profit for the period, other
comprehensive income and total comprehensive income.

 

2.4   Background

 

2.4.1 India

In the Indian GAAP
(AS) dispensation, revaluation of fixed assets was permitted and the process of
consolidating a foreign subsidiary generated a resulting foreign currency
translation reserve (FCTR). These two line items have been taken up for the
purpose of this discussion.

 

AS 10 Accounting
for Fixed Assets
before it made its way to AS 10 Property, plant and
equipment,
permitted an increase in net book value arising on revaluation
of fixed assets to be credited directly to owner’s interests under the head of
revaluation reserve (paragraph 30).

 

AS 11 the
Effects of changes in Foreign Exchange Rates
requires a non-integral
foreign operation to use translation procedures whereby the resulting exchange
differences should be accumulated in an FCTR until disposal of the investment
(paragraph 24).

 

The concept of
OCI is new in India despite the fact that items like revaluation surplus and
FCTR were also accounted under AS.
The AS treatment
for these items bypassed income and had direct entry to the balance sheet,
whereas converged Ind AS does not permit direct entry to the balance sheet.

 

2.4.2 The United
States

IFRS (IAS in its
previous avatar) was not the first GAAP to introduce the concept of
comprehensive income.

 

Comprehensive
income was defined for the first time in USGAAP in 1980. Although the term was
defined, reporting standards for the same did not evolve for a considerable
period of time.

 

The origin of other
comprehensive income reporting in global accounting literature can be traced to
a 1997 USGAAP Statement of Financial Accounting Standard (FAS) – Reporting
Comprehensive Income
. This statement issued by the Financial Accounting
Standards Board (FASB) established standards for reporting and presenting
comprehensive income and its components.

 

The relevant
concepts surrounding how globally accounting income reporting was historically
characterised in terms of a contrast between a ‘dirty surplus’ and a ‘clean
surplus’ income concept is highlighted in the table below:

 

Current operating performance income
concept

All-inclusive income concept

Dirty Surplus in Accounting Theory

Clean Surplus in Accounting Theory

Current operating performance income
concept

All-inclusive income concept

Extraordinary and non-recurring gains
and losses are excluded from income

All revenues, expenses, gains and losses
recognised during the period are included in income regardless of whether
they are considered to be results of operations of the period

 

 

Until 1997, the
FASB followed the all-inclusive income concept but it did make exceptions by
requiring that certain changes in assets and liabilities not be reported in the
income statement but instead be included in balances within a separate
component of equity in the balance sheet. Some examples include foreign
currency translation, accounting for certain investments in debt and equity
securities akin to Indian GAAP ‘AS’ revaluation gains (AS 10, now replaced) and FCTR treatment (AS 11).

 

In 1997, as a step
in implementing the concept of comprehensive income, the FASB required that
changes in the balances of items that were reported directly in a separate
component of equity in the balance sheet be reported in a financial statement
that is displayed as prominently as other financial statements, viz.,
‘Comprehensive Income’.

 

The purpose of
reporting comprehensive income is to report a measure of all changes in equity
of an entity that result from recognised transactions and other economic events
of the period other than transactions with owners in their capacity as owners.

 

OCI and TCI reporting developed more as a practice
than a concept. Further developments and improvements are expected both under
USGAAP and IFRS.

 

2.4.3 The United
Kingdom

In 1992, the UK Accounting Standards Board issued a financial reporting
standard – Reporting Financial Performance. It introduced a ‘Statement
of Total Recognised Gains and Losses’ financial statement component that was
analogous to the US comprehensive income.

 

2.4.4 IFRS

OCI and
Comprehensive income reporting was introduced in IFRS in 2007 with a revision
to IAS 1 Presentation of Financial Statements requiring inter alia
components of OCI to be displayed in the statement of comprehensive income and
total comprehensive income to be presented in the financial statements.


2.5 Recent
developments

The IFRS Conceptual
Summary revised by the IASB in 2018 lends relatively more clarity to the
distinction between net profit and OCI. In the development of standards, the
IASB may now decide in exceptional circumstances that income or expenses
arising from a change in the current value of an asset / liability be included
in OCI when it results in the statement of profit or loss providing more
relevant information or a more faithful representation of financial
performance.

 

In December,
2018, the ICAI issued an Exposure Draft of AS 1 – Presentation of Financial
Statements
, to replace the extant AS 1 – Disclosure of Accounting
Policies
. The wider income concepts of OCI and comprehensive income have
been introduced in this IGAAP exposure draft.

 

2.6   Is OCI relevant to investors?

The IASBs-IFRS
Conceptual Framework (2018 revised) states that an understanding of financial
performance requires analysis of all recognised income and expenses, i.e., PAT
and OCI. The expected focus is therefore on TCI.

 

Net earnings for
the period as reported by the measure PAT lends itself to assessment of
forecast cash flows from a dividend distribution perspective.

 

The ground reality
globally is that Alternate Performance Measures (APMs) are fast becoming
mainstream. Progressive companies continue to strive to provide insights into
real value creation using measures that are alternates to accounting measures,
including TCI.

 

3.  
COMPLIANCE: CAPITAL DISCLOSURES (I
nd AS)

 

Capital
disclosures

This Ind AS
disclosure requirement ensures that users of financial statements are provided
useful information about entity-specific capital strategies.

 

This disclosure in the notes is mandatory for all entities and, moreover
is in addition to other disclosures related to equity and reserves. The
disclosure requirements are contained in Ind AS 1 Presentation of Financial
Statements
(paragraphs 134 to 136). A reporting entity also needs to
consider paragraphs 44A to 44E of Ind AS 7 Statement of Cash Flows
(Changes in Liabilities Arising from Financing Activities) to comply with Ind
AS 1 capital disclosure requirements.

 

The capital
disclosures are applicable to all companies and not only to companies that are subject
to externally imposed capital requirements like banks / NBFCs.

 

An entity is required to disclose information that enables users of its
financial statements to evaluate its objectives, policies and processes for
managing capital. In complying with this, qualitative and quantitative
disclosures are required.

 

Qualitative disclosures

Quantitative disclosures

Description of what an entity manages as
capital

Summary quantitative data about what it
manages as capital

How it is meeting its objectives for
managing capital

 

For entities subject to externally
imposed capital requirements, the nature of those requirements and how the
same is incorporated into capital management

 

 

 

Capital for the
purpose of this disclosure has to be understood the way it is considered as
part of corporate financial management text / practices. Capital is not just
share capital or equity but includes liability components, too.

 

Capital
disclosures should be based on the information provided internally to key
management personnel (KMPs).
For instance, some
entities may consider lease liabilities and / or overdrafts as components of
capital for capital management, while others may not.

 

4. 
GLOBAL ANNUAL REPORT EXTRACTS: AUDIT COMMMITTEE REPORT

 

Extracts from ‘Audit Committee Report’
Section of Annual Report

Company: BAE Systems PLC (2018
revenues GBP 16.8 billion)

 

The Audit
Committee reviews all significant issues
concerning the financial
statements. The principal matters it considered concerning the 2018
financial statements were (see table below):

 

Principal matters considered by Audit
Committee

Taxation

Computation
of the group’s tax expense and liability, the provisioning for potential tax
liabilities and the level of deferred tax asset recognition are underpinned
by management judgement and estimation of the amounts that could be payable

Whilst
tax policy is ultimately a matter for the Board’s determination, we reviewed
the group’s tax strategy. Twice during the year, we (‘the
Audit Committee’
)1 reviewed the group’s tax charge, tax
provisions and the basis of recoverability of the deferred tax asset

relating to the group’s pension deficit

Pensions

Accounting
for pensions and other post-retirement benefits involves making estimates when
measuring the group’s retirement benefit obligations. These estimates require
assumptions to be made about uncertain events such as discount rates
and longevity

Recognising
the scale of the group’s pension obligation, we (‘the Audit
Committee
’)1 reviewed the key assumptions supporting the
valuation of the retirement benefit obligation
. This included a
comparison of the discount and inflation rates used against externally
derived data.
We also considered the adequacy of disclosures in respect
of the sensitivity of the deficit to changes in these key assumptions

 

 

5. FROM THE PAST – ‘IMPROVED OUTSIDE AUDITING
IN THE FINANCIAL REPORTING BUSINESS’

 

The Former
Securities Exchange Commission’s Chairman, Mr. Arthur Levitt’s 1998 remarks (NYU
Center for Law and Business)
are relevant even today. Extracts of the same
are reproduced below:

 

‘As I look at
some of the failures today, I can’t help but wonder if the staff in the
trenches of the profession have the training and supervision they need to
ensure that audits are being done right. We cannot permit thorough audits to
be sacrificed for re-engineered approaches that are efficient, but less
effective.

 

Numbers in the abstract are just that – numbers. But
relying on the numbers in a financial report are livelihoods, interests and,
ultimately, stories
: a single mother who works two jobs so she can save
enough to give her kids a good education; a father who laboured at the same
company for his entire adult life and now just wants to enjoy time with his
grandchildren; a young couple who dreams of starting their own business.

 

These are the stories of American investors. Our
mandate and our obligations are clear. We must re-dedicate ourselves to a
fundamental principle: markets exist through the grace of investors.

 

FINANCIAL REPORTING DOSSIER

This article
provides key recent updates in financial reporting in the global space;
insights into an accounting topic,
viz., subsequent
accounting of goodwill
tracing its roots, developments and upcoming
changes; compliance aspects of tax reconciliation disclosure under Ind
AS; and a peek at an international reporting practice in the Directors’
Remuneration Report

 

1.
   KEY RECENT UPDATES

1.1     Audit quality in a multidisciplinary firm

The International
Federation of Accountants (IFAC) released a publication, Audit Quality in a
Multidisciplinary Firm – What the Evidence Shows
, on 25th September,
2019 aimed at contributing to the debate on multidisciplinary firms. A
multidisciplinary firm provides audit and non-audit services under a single
brand name. The publication strives to provide readers with a better
understanding of how the multidisciplinary model is the most effective
structure to serve the audit function and how the rules that have evolved over
the past decades serve to mitigate risks associated with audit firms providing
non-audit services to some audit clients.

 

1.2     USGAAP
– Simplifying the classification of debt

The Financial
Accounting Standards Board (FASB) issued an Exposure Draft (ED) on 12th
September, 2019 proposing changes to Topic 470, Debt, of USGAAP. The
proposed accounting standards update – Simplifying the Classification of
Debt in a Classified Balance Sheet (Current vs. Non-Current)
– would shift
the classification of certain debt arrangements between non-current and current
liabilities.

 

The ED introduces a
principle for determining whether a debt arrangement should be classified as
non-current liability. The principle is that an entity should classify an
instrument as non-current if either of the following criteria is met at the
reporting date: (1) the liability is contractually due to be settled
more than one year (or operating cycle, if longer) after the balance sheet
date; (2) the entity has a contractual right to defer settlement of the
liability for at least one year (or operating cycle, if longer) after the
balance sheet date. As an example of the proposed changes, current USGAAP
requires short-term debt that is refinanced on a long-term basis (after the
balance sheet date but before issue of financial statements) to be classified
as non-current liability. The amendment proposed prohibits an entity from
considering a subsequent financing when determining classification of debt at
the balance sheet date.

 

1.3     IFRS – Business Combinations Under Common
Control

The International
Accounting Standards Board (IASB) at its 22nd October, 2019 meeting
finalised its discussion on the scope of the project ‘Business Combinations
Under Common Control’
and is exploring how companies should account for the
same. It tentatively decided that a receiving entity should recognise and
measure assets and liabilities transferred in a business combination under
common control at the carrying amounts included in the financial statements of
the transferred entity. A discussion paper is expected to be published in the
first quarter of 2020.

 

2.    RESEARCH:
DAY 2 GOODWILL ACCOUNTING

2.1     Introduction

The Day 2
(subsequent measurement) accounting for goodwill is a contentious issue in
accounting literature. Over the years, different accounting models have been
evaluated / mandated by global standard setting
bodies. The FASB and the IASB are both currently working on projects involving
research on goodwill and impairment.

 

Stakeholders
continue their quest to seek answers to related questions that include (a) how
is the consumption of economic benefits embodied in the asset ‘goodwill’
reflected in the financial statements? (b) whether an impairment of goodwill
communicates its periodic consumption or erosion in value, etc.

2.2     Setting the context

Analysis of three sample companies’ data is provided below:

 

Company 1 –
Microsoft Corporation, US listed (USGAAP)

 

2019
($ millions)

2018
($ millions)

% change

Goodwill

42,026

35,683

18%

Total equity

102,330

82,718

24%

Goodwill as % of equity

41.1%

43.1%

 

Company 2 – Tata
Steel, India listed (Ind AS)

 

2019 (Rs. cr.)

2018 (Rs. cr.)

% change

Goodwill

3,997

4,099

(2)%

Total equity

71,290

61,807

15%

Goodwill as % of equity

5.6%

6.6%

 

Company 3 –
GlaxoSmithKline plc. (GSK), UK listed (IFRS)

 

2018
(GBP million)

2017
(GBP million)

% change

Goodwill

5,789

5,734

1%

Total equity

3,672

3,489

5%

Goodwill as % of equity

157.7%

164.3%

 

 

As can be seen from
the table above, company 3 has goodwill that is 157.7% of its total
equity.
It may be noted that the company uses Alternate Performance
Measures (APMs) in reporting business performance to stakeholders (in
management commentary / presentations, etc.). In arriving at APMs, the company
adjusts its IFRS results for some items that include amortisation of
intangibles and impairment of goodwill. The resultant adjusted measures include
‘Adjusted Operating Profit’, ‘Adjusted PBT’ and ‘Adjusted EPS’. The objective
of reporting APMs is to provide users with useful complementary information to
better understand the financial performance and position of the company.

 

In the following sections (2.3 to 2.7), an attempt is made to
address the following questions:

Is goodwill an asset or an accounting
‘plug’ figure?

How has Day 2 accounting for goodwill
developed historically in international GAAP?

What are the various models explored /
mandated by standard setters over the years?

What is the current position in India?

Is there consistency in the accounting
concepts underlying Day 2 accounting of goodwill across prominent GAAPs as of
date?

Would amortisation of goodwill be back
under USGAAP / IFRS?

What are the developments expected in
this space?

 

2.3     Goodwill

IFRS / Ind AS
define goodwill as ‘an asset representing the future economic benefits
arising from other assets acquired in a business combination that are not
individually identified and separately recognised’.
The USGAAP definition
of goodwill is in line.

 

AS has not
specifically defined goodwill but explains as follows:

(a)     Goodwill
arising on amalgamation represents a payment made in anticipation of
future income and it is appropriate to treat it as an asset to be amortised to
income on a systematic basis over its useful life.
(Para 19, AS 14);

(b)     Goodwill arising on acquisition represents a
payment made by an acquirer in anticipation of future economic benefits.
The future economic benefits may result from synergy between the identifiable
assets acquired or from assets that individually do not qualify for recognition
in the financial statements
. (Para 79, AS 28).

 

Goodwill is
invariably an accounting plug as the quantum recorded is a function of the
accounting model and the policy choices adopted on the date of acquisition. At
the same time it is an accounting asset as it represents future economic
benefits arising from other assets in a business combination that are not
separately recognised.

 

2.4     Accounting models evaluated / mandated by
standard setters

A summary of
various approaches evaluated / mandated by standard setters over the years is
summarised
below:

 

S.No.

Approach

1

Immediate charge off to the Profit
and Loss Account

2

Immediate charge
off to Other Comprehensive Income
(OCI)

3

Immediate charge off to equity

4

Componentising goodwill and accounting for components
separately

5

Capitalise goodwill and amortise over estimated period of benefit (with
a rebuttable presumption with respect to period over which benefits derived).
Impairment testing is in addition

6

Capitalise goodwill and amortise over estimated period of benefit (with
a rebuttable presumption with respect to period over which benefits derived).
No further impairment testing

7

Capitalise and subject to impairment testing only

Source: (1) IASB’s ‘Goodwill and
Impairment Research Project’;
(2) FASB’s ‘Invitation to comment –
Identifiable Intangible Assets and Subsequent accounting for Goodwill’;
(3)
European Financial Reporting Advisory Group’s (EFRAG) ‘Discussion Paper –
Goodwill Impairment Test: Can it be improved?’; (4) AS 14 & 28; (5) Ind
AS 36 & 103, (6) IFRS for SMEs and US FRF standards

 

2.5     Development of Goodwill Day 2 accounting

2.5.1 USGAAP

APB Opinion No. 17,
Intangible Assets issued in August, 1970 by the Financial
Accounting Standards Board (FASB), explained goodwill as the excess of the cost
of an acquired company over the sum of identifiable net assets. Goodwill was
required to be amortised to the income statement on a systematic basis
over the period estimated to be benefited, not exceeding forty years.

 

In June, 2001
the FASB issued SFAS No. 142, Goodwill and Other Intangible Assets that
prohibited amortisation of goodwill. Goodwill would instead be tested at
least annually for impairment
. The impairment of goodwill was based on a two-step
approach. In Step 1, the fair value of a reporting unit (to which goodwill was
assigned) was compared with its carrying amount and in case the carrying value
exceeded the fair value, then the entity undertook Step 2. In Step 2, the
impairment of goodwill was measured as the excess of the carrying amount of
goodwill over its implied fair value. The implied fair value of goodwill was
calculated in the same manner in which goodwill is recognised in a business
combination.

 

The FASB issued ASU
2017-04 in January, 2017 Simplifying the Test for Goodwill Impairment
(effective for public listed entities for fiscal years beginning after 15th
December, 2019) eliminating Step 2
, thereby requiring the annual goodwill
impairment test to be conducted by comparing the fair value
of a reporting unit with its carrying amount.

 

At present, non-controlling
interests
(NCI), if any, need to be accounted in USGAAP by measuring the
same at their fair value.

 

2.5.2 IFRS

The current
standard governing the accounting for acquisitions and the resultant
recognition of goodwill as an asset is IFRS 3, Business Combinations,
issued in March, 2004 by the IASB. IFRS 3 treats goodwill as an asset akin to
an indefinite-life intangible asset and permits an
impairment-only approach. Para 90 of IAS 36, Impairment of Assets,
states that a cash-generating unit to which goodwill has been allocated shall
be tested for impairment annually and whenever there is an indication that the
unit may be impaired. The carrying amount of a cash-generating unit (to
which goodwill is allocated) is compared with its recoverable amount to
determine the impairment loss.

 

Prior to the
addition of IFRS 3 to the authoritative literature, its predecessor, IAS 22,
Business Combinations, required goodwill to be amortised with a
rebuttable presumption that its useful life did not exceed 20 years from
the date of initial recognition. In case a reporting entity rebutted the
presumption, goodwill was compulsorily required to be subject to annual
impairment testing even if there was no indication that it was impaired.

 

IFRS 3 permits an accounting
policy choice
with respect to calculation of NCI at the date of
acquisition. An entity can opt to measure NCI either at fair value
(resulting in recording of ‘full goodwill’) or as its proportionate
share in the acquiree’s identifiable net assets (resulting in recording
of ‘partial goodwill’) per Para 19, IFRS 3. For the purposes of
impairment testing, goodwill needs to be notionally grossed up in
arriving at the carrying amount of the cash-generating unit to which goodwill
has been assigned when the ‘partial goodwill’ method has been adopted (Appendix
C, IAS 36).

 

2.6     Current positions under various GAAPs for
goodwill accounting

 

Accounting framework

Accounting model for
acquisitions / business combinations giving rise to Day 1 Goodwill

Subsequent accounting of
goodwill

Rebuttable presumption
(goodwill life)

Standard

USGAAP

Acquisition method

Impairment only

NA

ASC 350 – Intangibles –
Goodwill and Other

IFRS

Acquisition method

Impairment only

NA

IAS 36, Impairment of
Assets

AS

Purchase method

Amortisation and impairment

5 years

AS 14, Accounting for
Amalgamations

Ind AS

Acquisition method

Impairment only

NA

Ind AS 36, Impairment of
Assets

IFRS for SMEs1

Purchase method

Amortisation and impairment

10 years2

Section 19, Business
Combinations and Goodwill

US FRF3

Acquisition method

Amortisation only.
No impairment

15 years4

Chapter 13, Intangible
Assets

1 IFRS for SMEs issued by the
IASB

2 If the useful life of
goodwill cannot be established reliably, the life shall be determined based
on management’s best estimate
but shall not exceed 10 years

3 US Financial Reporting
Framework (US FRF) for small and medium-sized entities issued by the AICPA, a
special purpose framework that is a
self-contained financial reporting framework not based on USGAAP

4 Goodwill should be
amortised generally over the same period as that used for federal income tax
purposes or, if not amortised for
federal income tax purposes, then a period of 15 years

 

2.7     Coming up next

(1) The IASB
(that issues IFRSs) has planned to release a Discussion Paper (DP) in February,
2020
to present its preliminary views on ‘Goodwill and Impairment’ that inter
alia
include the following:

 

1

Not to reintroduce amortisation of goodwill

2

Introduce a requirement to present
total equity before goodwill

3

Provide relief from the mandatory
annual quantitative impairment test

 

 

(2) The FASB
(that issues USGAAP) in July, 2019 issued an Invitation to Comment
– Identifiable Intangible Assets and Subsequent Accounting for Goodwill

that includes invitation to comment inter alia on the project area
‘Whether to change the subsequent accounting for goodwill’.

 

Ind AS and IFRS
preparers and auditors need to watch this space.

 

3.    GLOBAL
ANNUAL REPORT EXTRACTS: ‘RELATIVE IMPORTANCE OF SPEND ON PAY’

3.1     Background

UK Company Law
requires disclosures of ‘The Relative Importance of Spend on Pay’ in the
Directors’ Remuneration Report.

 

The Large and
Medium-sized Companies and Groups (Accounts and Reports)
(Amendment)
Regulations 2013
(effective 1st October, 2013) require the Directors’
Remuneration Report
to set out in a graphical or tabular form the actual
expenditure for the financial year and the immediately preceding financial year
and the difference in spend between those years on – (i) remuneration paid /
payable to employees, (ii) distribution to shareholders by way of dividend and
share buyback, and (iii) any other significant distributions / payments deemed
by the directors to assist in understanding the relative importance of spend on
pay.

 

3.2     Extracts from the ‘Directors’ Remuneration
Report’ section of an Annual Report

Company: Burberry Group Plc, FTSE 100 Index constituent (2019 Revenues: GBP
2.7 billion)

 

Relative
importance of spend on pay for 2018/19

The table below
sets out the total payroll costs for all employees over FY 2018/19 compared to
total dividends payable for the year and amounts paid to buy back shares during
the year. The average number of full-time equivalent employees is also shown
for context.

 

Relative Importance of Spend on Pay

 

 

FY 2018/19

FY 2017/18

Dividends paid during the year (total)

GBP million

171.1

169.4

% change

+1.0%

 

Amounts paid to buy back shares during
the year

GBP million

150.7

355.0

% change

-57.5%

 

Payroll costs for all employees

GBP million

519.8

515.2

% change

+0.9%

 

Average number of full-time equivalent
employees

Nos.

9,862

9,752

% change

+1.1%

 

 

 

4.
   COMPLIANCE: TAX RECONCILIATION
DISCLOSURE (Ind AS)

Tax reconciliation disclosure

4.1     What is the disclosure
requirement?

Ind AS requires a Tax Reconciliation Disclosure in the
notes. The objective of the disclosure is to enable users understand whether
the relationship between Tax Expense and profit before Tax (PBT)
is unusual and to understand the significant factors that could affect the
relationship in the future. The disclosure facilitates users to model a
long-term forecast tax rate in valuation analysis.

 

4.2     Where
are the disclosure requirements contained?

The disclosure
requirements are contained in Para 81(c) of Ind AS 12, Income Taxes. An
entity also needs to take into consideration paragraphs 84 to 86, 46 to 52B and
Para 5 of the standard.

 

4.3     Is the disclosure mandatory?

This disclosure is
mandatory for all entities preparing financial statements under the Ind AS
framework.

 

4.4     What needs to be disclosed?

An explanation of
the relationship between tax expense and accounting profit (PBT) is required to
be
disclosed and the same is summarised in the table given below:

 

Disclosure Alternate 1

Numerical reconciliation
between tax expense and the product of accounting profit multiplied by the
applicable tax rate

 

 

(Amount in Rs.)

Tax at Applicable Tax Rate1
on Accounting Profit

(Applicable tax rate X PBT)

xxx

Reconciling items2,3

 

+/- xxx

Tax expense

Tax as per P&L (current
tax plus deferred tax)

xxx

Disclosure Alternate 2

Numerical reconciliation
between the average effective tax rate and the applicable tax rate

 

 

(%)

Applicable tax rate1

 

xx.x%

Reconciling items2,3

 

+/- xx.x%

Average effective tax rate

(Tax as per P&L/ PBT)

xx.x%

• An entity can provide the
disclosure in either or both of the above alternates

• The basis of
computing applicable tax rate also needs to be disclosed

1 The applicable tax rate
used in the reconciliation has to be the one that provides the most
meaningful information to users. The applicable tax rate often is the domestic
rate of tax
in the country in which the entity is domiciled. An entity
that operates in several tax jurisdictions may have to aggregate the
reconciliation prepared using domestic rate of tax for each individual tax
jurisdiction in determining the applicable tax rate

2 Illustrative list of
reconciling factors include (1) tax effect of non-deductible expenditure,
(2) tax effect of non-taxable income, (3) prior year
adjustments, (4) changes to unrecognised deferred tax assets, (5)
effect of overseas tax rates, (6) re-assessment of deferred tax
assets, (7) effect of tax rate changes related to DTA/DTL, (8) effect
of tax losses, etc.

3 Income taxes relating to
items of Other Comprehensive Income (OCI) do not enter the reconciliation
statement

 

5.    FROM
THE PAST – ‘ROOT CAUSE ANALYSIS OF AUDIT DEFICIENCIES’

Extracts of remarks
made by Mr. Brian T. Croteau (former Deputy Chief Accountant, US Securities
Exchange Commission) before the American Accounting Association Annual Meeting
in August, 2012 is reproduced below:

 

‘Consider for a
moment the investigation of the tragic crash of the Air France flight on its
way from Brazil to France in June, 2009. Like the National Transportation
Safety Board does in conducting objective, precise accident investigations and
safety studies in the United States, France’s Bureau of Investigation and
Analysis studied this crash. Only recently, three years later and after careful
study, it issued a report detailing its conclusions of the various contributors
and the underlying root cause of the crash. Understanding the root cause
in these circumstances included a challenging two-year relentless search for
the black box and piecing together many pieces of evidence to develop the
entire picture.
Doing so has already resulted in changes to the way
pilots are trained in an effort to reduce the risk of future accidents.

 

I believe with
today’s audit documentation and technology
, auditors, academics, standard
setters, regulators and others can continually strive to do more to understand
and assess
the contributing factors
and root causes
of audit deficiencies so we can
effect improvements in auditor performance and audit quality.’
 

 

FINANCIAL REPORTING DOSSIER

This article
provides (a) key recent updates in the financial reporting global space;
(b) insights into an accounting topic, viz. convenience translation; (c)
compliance aspects of transition disclosure under Ind AS 116 from the
lessee’s perspective; (d) a peek into an international reporting practice in
the Auditor’s report; and concludes with (e) an extract from a
regulator’s speech from the past on MD&A disclosure

 

KEY RECENT UPDATES

 

Revised International Standard on Auditing (ISA 315)

On 19th December, 2019 the IAASB issued ISA 315 (Revised
2019), Identifying and Assessing the Risks of Material Misstatement.
ISA 315 (Revised) sets out enhanced requirements and application material
to support the auditor’s risk assessment process. The revised ISA has enhanced
requirements
related to exercise of professional scepticism,
separate focus on understanding the applicable financial reporting
framework
, clarifications on which controls need to be identified
for the purposes of evaluating the design of a control, and determining whether
the control has been implemented and also considerations for using automated
tools and techniques
incorporated within the application material of the standard.
A new Appendix (Appendix 6) has also been added to provide the auditor with considerations
for understanding general IT controls.

 

The revised ISA is
effective for audits of financial statements for periods commencing on or after
15th December, 2021.

 

SEC Guidance on Reporting KPIs and Metrics in MD&A

On 30th January, 2020 the US SEC issued a Guidance on
Management Discussion and Analysis (MD&A)
related to disclosure of
Key Performance Indicators (KPIs) and metrics. SEC registrants are required to
discuss and analyse statistical data in the MD&A section that in the
company’s judgement enhances a reader’s understanding. Such information could
constitute KPIs and other metrics.

 

The SEC, based on
the issued guidance, expects the following disclosures to accompany the metric:
(i) a clear definition of the metric and how it is calculated, (ii) a
statement indicating the reasons why the metric provides useful information
to investors, and (iii) a statement indicating how management uses the
metric in managing or monitoring
the performance of the business. A company
should also consider whether there are any estimates / assumptions underlying
the metric or its calculation and whether disclosure of such items is necessary
for the metric not to be materially misleading.

 

It may be noted
that examples of metrics to which the guidance applies include operating
margin, same store sales, sales per square foot, average revenue per user,
active customers, total impressions, traffic growth, employee turnover rate, number
of data breaches
, etc.

 

USGAAP – Simplifying the Accounting for Income Taxes

The FASB issued
Accounting Standards Update (ASU) No. 2019-12 in December, 2019, Simplifying
the Accounting for Income Taxes
, amending Topic 740, Income Taxes.
The ASU makes a number of amendments and is part of the FASBs USGAAP
simplification initiative. One such amendment relates to intra-period tax
allocation.

 

Intra-period tax
allocation is the process of allocating income tax expense (or benefit) to
components of income statement, i.e. continuing and discontinuing operations,
other comprehensive income and equity. Under extant USGAAP, the general
accounting principle is that an entity determines the tax expense / benefit for
continuing operations and then proportionally allocates the remaining tax
expense / benefit to other items. USGAAP made an exception to this general
principle in a situation when there was a loss in continuing operations and a
gain / surplus in OCI / discontinuing operations. The ASU has removed the exception
and the amended position is that ‘the tax effect of pre-tax income or
loss from continuing operations should be determined by a computation that does
not consider the tax effects of items that are not included in continuing
operations
’. This has an impact in situations when income from
continuing operations is subject to a tax rate that is different from the tax
rate applicable to chargeable / capital gains on discontinued operations / OCI.

The amendment is
effective for public companies for fiscal years commencing 15th
December, 2020. It may be noted that IFRS (IAS 12, Income Taxes) does
not explicitly provide guidance on such intra-period tax allocation.

 

RESEARCH: CONVENIENCE TRANSLATION

Introduction

Convenience
translation is ‘a display of financial statements or selected
portions of financial statements
in a currency other than the
presentation currency
, as a convenience to some users
’.

 

Setting the
Context

An analysis of a
sample of four companies’ data based on their annual reports filed with the US
Securities Exchange Commission (SEC) is provided below.

 

It may be noted
that the ‘functional currency’ is the currency of the primary
economic environment in which an entity operates
.

 

The ‘presentation currency’ (or the reporting currency) is the
currency in which the financial statements are presented.


Case Study 1: Baidu Inc. (Listed on NASDAQ)

GAAP for SEC filing

USGAAP

Functional Currency

US $

Reporting Currency

RMB

Extracts from the Income Statement and Balance Sheet for
the Year ended 31st December, 2018

(Amount in millions)

2016 (RMB)

2017 (RMB)

2018 (RMB)

2018 (US$)

(Convenience Translation)

Total revenue

70,549

84,809

102,277

14,876

Net income

11,596

18,288

22,582

3,284

 

 

 

 

 

Total assets

 

251,728

297,566

43,279

Total equity

 

119,350

175,036

25,459

Convenience Translation

Translations of amounts from RMB into US$ for the
convenience of the reader have been calculated at the exchange rate on 31st
December, 2018, the last business day in fiscal year 2018

Case Study 2: Honda Motor Co. Limited (Listed on NYSE)

GAAP for SEC filing

IFRS

Functional Currency

Japanese Yen

Presentation Currency

Japanese Yen

Extracts from the Income Statement and Balance Sheet for
the Year ended 31st March, 2019

(Amount in millions)

2017 (JPY)

2018 (JPY)

2019 (JPY)

Convenience Translation

Total revenue

13,999,200

15,361,146

15,888,617

NA

Net income

679,394

1,128,639

676,286

 

 

 

 

Total assets

 

19,349,164

20,419,122

Total equity

 

8,234,095

8,565,790

Convenience Translation

NA

Case Study 3: Wipro Limited (Listed on NYSE)

GAAP for SEC filing

IFRS

Functional Currency

Indian Rupees

Reporting Currency

Indian Rupees

Extracts from the Income Statement and Balance Sheet for
the Year ended 31st March, 2019

(Amount in millions)

2017 (INR)

2018 (INR)

2019 (INR)

2019 (US$)

(Convenience Translation)

Total revenue

550,402

544,871

585,845

8,471

Net income

85,143

80,084

90,173

1,302

 

 

 

 

 

Total assets

 

760,640

833,171

12,045

Total equity

 

485,346

570,753

8,252

Convenience Translation

The accompanying consolidated financial
statements have been prepared and reported in Indian Rupees, the functional
currency of the parent company. Solely for the convenience of readers, the
consolidated financial statements as at and for the year ended 31st
March, 2019 have been translated into US$ at the exchange rate on
31st March, 2019

Case Study 4: Infosys Limited (Listed on NYSE)

GAAP for SEC filing

IFRS

Functional Currency

Indian Rupees

Presentation Currency

US Dollar

Extracts from the Income Statement and Balance Sheet
for the Year ended 31st March, 2019

(Amount in millions)

2017 (US $)

2018 (US $)

2019 (US $)

Convenience Translation

Total revenue

10,208

10,939

11,799

NA

Net income

2,140

2,486

2,200

 

 

 

 

Total assets

 

12,255

12,252

Total equity

 

9,960

9,400

Convenience Translation

NA


As can be seen from
the above table, Company 1 presents its financial statements in RMB although
its functional currency is US$. It also presents US$ figures for the latest
financial year based on a convenience translation converting all balance sheet
and income statement items at the year-end exchange rate.

 

Company 3 and 4
are India listed entities whose functional currency is the INR. Company 4 presents
its financial statements in US$ (applying IAS 21) while the other company
presents its financial statements in INR with a convenience translation of only
the current period figures in US$ [based on year-end exchange rate (applying
SEC Regulation S-X)].

 

In the following
sections an attempt is made to address the following questions:

1.  What is the current position with respect to
convenience translation under prominent GAAPs?

2.  Is there consistency among GAAPs with respect
to convenience translation?

3.  Is there a difference between displaying
financial statements in a presentation currency (that is different from an
entity’s functional currency) and convenience translation of financial
statements?

4.  Is convenience translation an option or mandatory
for a US listed entity?

5.  Why do entities adopt convenience translation
if it is optional?

 

The position
under prominent GAAPs

US GAAP

USGAAP does not
contain any guidance
on convenience translation. Even the SEC
regulations
do not permit full-fledged convenience translations for foreign
private issuers (FPIs) with the exception of a ‘limited convenience
translation’.

 

The Accounting
Standards Codification (ASC 830) that covers the accounting topic Foreign
Currency Matters
in USGAAP states that, ‘this topic does not cover
translation of the financial statements of a reporting entity from its
reporting currency into another currency for the convenience of readers
accustomed to that other currency’
. (ASC 830-10-15-7).

 

US-listed
entities
that are subject to SEC regulations may
at their option present convenience translation
of financial statements.
The salient aspects of the said rule [Regulation S-X, Rule 3-20 (b)] are
summarised below.

a.  An FPI shall state amounts in its
primary financial statements in the currency which it deems appropriate.

b. If the reporting currency is not the US
dollar, dollar-equivalent financial statements or convenience translations
shall not be presented
, except a translation may be presented of the
most recent fiscal year
and any subsequent interim period presented using
the exchange rate as of the most recent balance sheet
, except that a rate
as of the most recent practicable date shall be used if materially different.

 

IFRS and Ind AS

IAS 21 The
Effects of Changes in Foreign Exchange
Rates permits an entity to present
its financial statements in any currency
or currencies.

 

IFRS also does not prohibit an entity from providing, as
supplementary information, ‘a convenience translation’. Such a
‘convenience translation’ may display financial statements (or selected
portion of financial statements)
in a currency other than the presentation
currency as a convenience to some users. The ‘convenience translation’ may be
prepared using a translation method other than that required by the
Standard.
These types of ‘convenience translations’ should be clearly
identified as supplementary information to distinguish them from information
required by IFRSs and translated in accordance with IAS 21 (para 57 and BC14).

 

The position under IND
AS 21
The Effects of Changes in Foreign Exchange Rates is the same
as under IAS 21.

 

AS

AS 11 The
Effects of Changes in Foreign Exchange Rates
does not contain any explicit
guidance with respect to ‘convenience translation’. It also does not prohibit use
of a currency other than the currency of country of domicile as the reporting
currency:

 

  •     This standard does not
    specify the currency in which an enterprise presents its financial statements.
    However, an enterprise normally uses the currency of the country in which it is
    domiciled. If it uses a different currency, this standard requires disclosure
    of the reason for using that currency
    (para 3).

Conclusion

At present there is
no consistent principle underlying the preparation and presentation of financial
statements applying convenience translation across GAAPs. USGAAP and AS do not
contain explicit guidance on this topic. IFRS (and Ind AS) does permit
convenience translation, albeit it does not contain the prescriptions
available when financial statements are translated into a presentation currency
(other than the functional currency). The SEC regulations provide the
methodology to be adopted for presenting convenience translation figures that
is very limited in scope.

 

Presenting
financial statements in a presentation currency (both under IFRS and USGAAP)
requires standard procedures to be adopted (with balance sheet items being
translated at closing rate and income statement figures at average rates and
resultant exchange differences accounted in other comprehensive income).
Convenience translation, on the other hand, under SEC regulations requires all
items in the balance sheet and income statement to be translated at closing
rate (with no comparatives). Some entities that have dual listing status opt for
providing additional information by way of such a translation for the
convenience of their investors. A summary of the case studies is provided in
the table below:

 

 

Global Listed Entities

Indian Listed Entities

US SEC reporting

Case Study 1

Case Study 2

Case Study 3

Case Study 4

GAAP adopted

USGAAP

IFRS

IFRS

IFRS

Functional currency

US $

JPY

INR

INR

Presentation / reporting currency

RMB

JPY

INR

US$

Whether US$ figures are made available to
investors on face of financial statements?

Yes, with convenience translation

No

Yes. With convenience translation

Yes. Without convenience translation

GAAP literature adopted for convenience
translation

SEC Regulation S-X and not USGAAP ASC 830

NA

SEC Regulation S-X and IAS 21

NA (IAS 21 adopted for translation to
presentation currency)

 

GLOBAL ANNUAL REPORT EXTRACTS: ‘APPLICATION OF
MATERIALITY’
IN
AUDIT REPORT

Background

Unlike SA 701 in
the Indian context, International Standard on Auditing (UK) 701 Communicating
Key Audit Matters
in the Independent Auditor’s Report issued by the
Financial Reporting Council (FRC), UK also deals with the auditor’s
responsibility
to communicate other audit planning and scoping matters
in the auditor’s report (paragraph 1-1).

 

As per para 16-1 of
ISA (UK) 701, Communicating other Audit Planning and Scoping Matters,
the auditor’s report is required to provide:

1   An explanation of how the auditor applied
the concept of materiality in planning and performing the audit. Such
explanation shall specify the threshold used by the auditor as
being materiality for the financial statements as a whole

2   An overview of the scope of the audit
including an explanation of how such scope: addressed each Key Audit Matter
relating to one of the most significant risks of material misstatement
disclosed and was influenced by the auditor’s application of the materiality
disclosed

 

It may be noted
that ISA (UK) 701 that was effective 2016 has undergone a revision in November,
2019 (further updated in January, 2020) and amendments require the auditor’s
report to specify the threshold used by the auditor as being materiality
for financial statement as a whole
and performance materiality, and
to also provide an explanation of the significant judgements made by the
auditor in determining materiality and performance materiality. The revised ISA
is effective for audits of financial statements for periods commencing on or
after 15th December, 2019.

 

Extracts from an
Independent Auditor’s Report

Company:
Whitbread PLC (2018/19 revenues: GBP 2.05 billion, FTSE 100)

 

Our Application of Materiality

We define
materiality as the magnitude of misstatement in the financial statements that
makes it probable that the economic decisions of a reasonably knowledgeable
person would be changed or influenced. We use materiality both in planning the
scope of our audit work and in evaluating the results of our work. Based on our
professional judgement, we determined materiality for the financial statements
as a whole as follows (refer to the table below):

We agreed with the Audit Committee that we
would report to the Committee all audit differences in excess of GBP
1.25 m
(2018: GBP 1.3 m), as well as differences below that threshold that,
in our view, warranted reporting on qualitative grounds. We also report to the
Audit Committee on disclosure matters that we identified when assessing the
overall presentation of the financial statements.

 

Adjusted PBT

GBP 509 m

Group Materiality

GBP 25 m

Component Materiality range

GBP 10 m to 20 m

Audit Committee reporting threshold

GBP 1.25 m

 

 

COMPLIANCE: TRANSITION
DISCLOSURE UNDER IND AS 116

Background:

Ind AS 116 Leases became effective from 1st April,
2019. The ensuing fiscal year ending 31st March, 2020 financial
statements of Ind AS preparers need to
incorporate disclosures
mandated
by Appendix C – Effective Date and Transition of Ind AS
116.

 

The disclosure requirements from the lessee’s perspective is a
function of the transition option elected and a
ready reference to the same is provided in the table given below: (
Disclosures – A Referencer)

 

FROM THE PAST – ‘DISCLOSURES ARE DRIVEN BY WHAT INVESTORS
WANT TO KNOW’

Extracts from a
speech made by Elisse B. Walter (former Commissioner, US SEC) at the
Stanford Directors’ College meeting in June, 2013 are reproduced below:

‘Regulations
are the floor but not the ceiling.
They tell
companies what, at a minimum, should be covered, but it’s up to the company to
make sure the story gets told. That’s where MD&A
(Management’s Discussion and Analysis) becomes a real opportunity for
the company to tell shareholders what’s really going on. No MD&A
should be merely a recitation of the financial statements. Give
investors the when, the where, the why and, perhaps most importantly, the what’s
next.
You should address your investors like they are your business
partners, and the MD&A should reflect that perspective. Disclosure isn’t driven
by what the company wants to disclose but by what the investors want to know.
That should be front and centre as you review the MD&A.

 

 

Group Financial Statements

Parent Company Financial
Statements

Materiality

GBP 25.0 m (2018: GBP 27.3 m)

GBP 10.0 m (2018: GBP 10.9 m)

Basis for determining
materiality

  •  Group materiality was based on 5% of
    statutory profit before tax
    excluding certain items related to the sale
    of Costa, being costs associated with the restructure of the continuing
    business and non-recurring pension scheme costs. The adjusted profit used in
    our determination was GBP 509 m

  • Materiality was determined on the basis of the
    parent company’s
    net assets. This was then capped at 40% of
    group materiality

Rationale for the benchmark
applied

  •  Profit before tax is a key metric for the users
    of the financial statements and based on our judgement, we considered
    this to be the most appropriate measure for business performance

Profit before tax was used
as the basis for our calculation in the prior year

  • The entity is non-trading and contains an
    investment in all of the Group’s trading components and as a result, in line
    with prior year, we have determined materiality on the basis of net assets
    for the current year

 

Group Financial Statements

Parent Company Financial
Statements

The accounting choice to
transition to Ind AS 116

‘Rull Retrospective’ Transition Method (Ind AS 116 applied retrospectively to each
prior reporting period presented applying Ind AS 8)

‘Cumulative Catch-up’ Transition Method1

(New lease standard applied
retrospectively with the cumulative effect of initially applying Ind AS 116
recognised at the date of initial application2)

 

Para 40A, Ind AS 1

An entity is required to
present a third balance sheet (at the beginning of the preceding period) if
it applies an accounting policy retrospectively that has a material effect on
the balance sheet at the beginning of the preceding period

NA

Para 28(f) of Ind AS 8 and
Para C12 of Ind AS 116

For the current period and
each prior period presented, to the extent practicable, the amount of the
adjustment:

(i)    for each financial statement line item affected, and

(ii)   if Ind AS 33 Earnings per Share applies to the entity, for basic
and diluted earnings per share.

 

(Para 28(f), Ind AS 8)

a) The weighted average
lessee
’s incremental borrowing rate applied to the lease
liabilities recognised in the balance sheet at the date of initial
application

b) An explanation of any
difference between: (i) operating lease commitments disclosed applying Ind AS
17 at the end of the annual reporting period immediately preceding the date
of initial application, discounted using the incremental borrowing rate at
the date of initial application, and (ii) lease liabilities recognised in the
balance sheet at the date of initial application.

[Para C12, Ind AS 116
instead of para 28(f) of Ind AS 8)]

Para C13 and C10, Ind AS 116

NA

An entity that uses one or
more of specified practical expedients needs to disclose
that fact

Specified practical
expedients (Para C10) include (i) lessee applying a single discount rate to a
portfolio of leases, and (ii) electing not to apply the new lease accounting
model to leases for which the lease term ends within 12 months of the date of
initial application

 

Disclosures applicable under
both methods w.r.t. change in accounting policy:

Para 28 of Ind AS 8

An entity is required to disclose:

a) The title of the Ind AS,

b) When applicable, that the
change in accounting policy is made in accordance with transitional
provisions,

c) The nature of the change
in accounting policy,

d)    When applicable, a description of the transitional provisions,

e) When applicable, the
transitional provisions that might have an effect on future periods.

f) ….

g) The amount of the
adjustment relating to periods before those presented, to the extent
practicable.

h)If retrospective
application is impracticable, the circumstances that led to the existence of
that condition and a description of how and from when the change in
accounting policy has been applied.

 

Para C4 and C3, Ind AS 116

An entity that chooses the practical
expedient
of not reassessing whether a contract is, or contains, a
lease at the date of initial application is required to disclose that fact

 

 

Ask yourself, what do I know about the company’s
performance that cannot be reasonably inferred from the financial statements?
You are the investor’s voice and as the company’s stewards, you should also be
their advocate as well. You play such a crucial role in ensuring that the company’s
true story
is told, and that’s the story that investors deserve to
hear.’
 

 

_________________________________________________________________________

1   Para BC279, IFRS 16

2     The date of initial application is the
beginning of the annual reporting period in which an entity first applies Ind
AS 116. For Ind AS steady-state preparers, 1st April, 2019 is the date of
initial application (FY 2019-20).

FINANCIAL REPORTING DOSSIER

This article
provides (a) key recent updates in the financial reporting space
globally and in India; (b) insights into an accounting topic, viz., accounting
for development costs; (c) compliance aspects of disclosure of NCIs’
interest
in group activities and cash flow under Ind AS; (d) a peek into an
international reporting practice in the Director’s Report, and (e) an
extract from a regulator’s speech from the past on high-quality financial
information

 

1      KEY RECENT UPDATES

1.1   IFRS: Covid-19 Accounting for ECL

On 27th
March, 2020 the IASB issued a document for educational purposes, viz. IFRS
9 and Covid-19Accounting for Expected Credit Losses
(ECL)
highlighting requirements within IFRS 9 – Financial
Instruments
that are relevant to preparers considering how the current
pandemic affects ECL accounting. The document acknowledges that estimating ECL
on financial instruments is challenging under the present circumstances and
highlights the importance of companies using all reasonable and supportable
information available – historic, current and forward-looking to the extent
possible in the measurement of ECL and in the determination of whether lifetime
ECL should be recognised on loans.

 

1.2   IFRS: Covid-19 – Related Rent Concessions

On 24th
April, 2020 the IASB issued an Exposure Draft: Covid-19 – Related Rent
Concessions
proposing amendments to IFRS 16 – Leases to make it
easier for lessees to account for the pandemic-related rent concessions (rent
holidays, temporary rent deductions, etc.). The proposed amendments exempt
lessees from having to consider whether Covid-19 related rent concessions are
lease modifications, allowing them to account for the changes as if they were
not lease modifications. The amendments would apply to Covid-19 related rent
concessions that reduce lease payments due in 2020.

 

1.3   USGAAP: Accounting for Leases during Pandemic

The FASB on
10th April, 2020 issued a Staff Q&A on Accounting for Leases
during
Covid-19 Pandemic. The interpretations provided in the
Q&A include: (i) it would be acceptable for entities to make an election to
account for Covid-19 related lease concessions consistent with extant USGAAP
(Topics 842 and 840) as though enforceable rights and obligations for those
concessions existed, and (ii) an entity should provide disclosures about
material concessions granted or received and the related accounting effects to
enable users to understand the nature and financial effect of Covid-19 related
lease concessions.

 

1.4   PCAOB: Covid-19: Reminders for Audits Nearing
Completion

Earlier, on
2nd April, 2020, the PCAOB released a staff spotlight document, Covid-19:
Reminders for Audits Nearing Completion
to provide important reminders to
auditors in light of Covid-19 considering the breadth and the scale of the
pandemic that may present challenges to auditors in fulfilling their
responsibilities and require more effort in audit completion.

 

Key
takeaways from the document include: (i) new audit risks may emerge from the
effects of the pandemic, or assessments of previously identified risks may need
to be revisited, (ii) auditors may need to obtain evidence of a different
nature or form than originally planned which may affect considerations of its
relevance and reliability, (iii) some financial statement areas may present
challenges to the auditor’s evaluation of presentation and disclosures, e.g.
subsequent events, going concern, asset valuation, impairment, fair value,
etc., (iv) significant changes to the planned audit strategy or the significant
risks initially identified are required to be communicated to the Audit
Committee, and (v) including additional elements in the auditor’s report such
as explanatory language / paragraph when there is substantial doubt about the
ability of the company to continue as a going concern.

 

1.5   ICAI Guidance on Going Concern

On 10th
May, 2020 the ICAI issued its Guidance on Going ConcernKey Considerations
for Auditors amid Covid-19
. The Guidance focuses on the implications of
Covid-19 for the auditor’s work related to going concern including: (a) matters
the auditor should consider for going concern assessment, (b) management and
auditor’s respective responsibilities, (c) period of going concern assessment,
(d) additional audit procedures required, and (e) implications for the
auditor’s report. The Guidance includes FAQs to deal with various situations in
the current environment.

 

1.6   ICAI Guidance on Physical Inventory
Verification

And on 13th
May, 2020, the ICAI issued Guidance on Physical Inventory Verification
Key Considerations amid Covid-19. It highlights the use of alternate
audit procedures where it is impracticable to attend physical inventory
counting (on account of the pandemic) that include: (i) using the work of the
internal auditor, (ii) engaging other CAs to attend physical verification, and
(iii) use of technology. The corresponding implications for the Auditor’s
Report being (a) where such alternate audit procedures provide sufficient
appropriate audit evidence, the auditor’s opinion need not be modified (in
respect of inventory), and (b) if it is not possible to perform alternate audit
procedures, the auditor should modify the opinion per SA 705 (Revised).

 

2      RESEARCH: ACCOUNTING FOR DEVELOPMENT COSTS

2.1   Introduction

Development
is ‘the application of research findings or other knowledge to a plan or
design for the production of new or substantially improved materials, devices,
products, processes, systems or services before the start of commercial
production or use’
. Expenditure incurred internally on development by a
company could be either charged off to expense or capitalised as an intangible
asset and the accounting treatment is a function of the GAAP applied.

 

2.2   Setting the context

An analysis
of a sample of three companies’ data based on their annual reports filed with
the regulators is provided in Table A below.

As can be seen from the table above, the expenditure in the P&L
related to development costs and the intangible asset recognised on the balance
sheet arising out of development costs is a function of the GAAP applied.
Development costs are expensed under USGAAP while IFRS / Ind AS requires
capitalisation if specified criteria are met. IFRS for SMEs and the US FRF
accounting frameworks that apply to SMEs also differ in the accounting
treatment for this topic.

 

In the
following sections, an attempt is made to address the following questions:

 

1.     What is the current position with respect
to accounting for development costs under prominent GAAPs?

2.     Is there consistency among GAAPs with
respect to the accounting treatment?

3.     What have been the historical developments
globally with respect to accounting for development costs?

4.     What are the different accounting methods
that were considered by global accounting standard setters?

5.     Is accounting information for development
costs provided under current accounting frameworks useful to investors?

 

2.3   The Position under Prominent GAAPs

USGAAP

Extant ASC
730 – Research and Development requires costs incurred on both Research
and Development to be charged to the income statement when incurred

(ASC 730-10-25-1).

 

Tracing the
historical developments, in October, 1974 the FASB issued SFAS No. 2 – Accounting
for Research and Development Costs
. In developing the standard, the Board
considered certain alternative methods of accounting for R&D costs. These
included:

i)   Charging all R&D costs to the income
statement when incurred,

ii)  Capitalising all R&D costs when incurred,

iii)  Capitalising R&D costs when incurred if
specified conditions are met and charging all other costs to expense, and

iv) Accumulating all costs in a special category
until the existence of future benefits can be determined.

 

The Board
decided to adopt the accounting alternative of expensing R&D costs when
incurred considering the uncertainty of associated future benefits. USGAAP
literature has special capitalisation criteria that are industry specific
(e.g., software developed for internal use, software developed for sale to
third parties, etc.). It may be noted that USGAAP allowed capitalisation of
development costs prior to the issue of SFAS No. 2.

 

SFAS No. 86
Accounting for the Costs of Computer Software to be Sold, Leased or
Otherwise Marketed
, issued in August, 1985 specified that costs incurred
internally in creating a computer software product should be charged to expense
when incurred as R&D until technological feasibility has been established
for the product (which is upon completion of a detailed programme design or, in
its absence, completion of a working model). Thereafter, all software
production costs should be capitalised and subsequently reported at the lower
of the unamortised cost or net realisable value. (Current codification – ASC
985-20-25-1.)

 

IFRS

IAS 38 Intangible
Assets
requires an intangible asset arising from development (or
from the development phase of an internal project) to be recognised if
an entity can demonstrate: (a) technical feasibility of completing the
intangible asset, (b) its intention to complete the intangible asset and use or
sell it, (c) its ability to use or sell the intangible asset, (d) how the
intangible asset will generate probable future economic benefits, (e) the
availability of adequate technical, financial and other resources to complete
the development and to use or sell the intangible asset, and (f) its ability to
measure reliably the expenditure attributable to the intangible asset during
its development.

 

If the capitalisation criteria are not met, then an entity is required to
expense the same when incurred unless the item is acquired in a business
combination and cannot be recognised as an intangible asset, in which case it
forms part of the amount recognised as goodwill at the date of acquisition (IAS
38.68). It may be noted that as per IFRS 3 – Business Combinations, an
acquirer is required to recognise at the acquisition date, separately from goodwill,
an intangible asset of the acquiree irrespective of whether the asset had been
recognised by the acquiree before the business combination.

 

Prior to the issuance of IAS 38 (in 1998), IAS 9 Accounting for
Research and Development Activities
(issued in 1978) required both Research
and Development expenditure to be recognised as expense when incurred, except
that a reporting entity had the option to recognise an asset arising from
development expenditure when certain specified criteria were met. IAS 9 limited
the amount of expenditure that could initially be recognised for an asset
arising from development expenditure to the amount that was probable of being
recovered from the asset. In 1993, IAS 9 Research and Development Costs
was issued which changed the previous accounting requirement and required
recognition of an asset from development expenditure when specified criteria
were met.

2.4   Current Position Under Various GAAPs

 

Table
B:

Accounting Framework

Accounting for Development
Expenditure

Standard

USGAAP

Expense to P&L

ASC 730 – Research and
Development

IFRS

Capitalise if specified criteria
are met

IAS 38 – Intangible
Assets

Ind AS1

Capitalise if specified criteria
are met

Ind AS 38 – Intangible
Assets

AS2

Capitalise if specified criteria
are met

AS 26 – Intangible Assets

IFRS for SMEs3

Expense to P&L

Section 18 – Intangible
Assets Other than Goodwill

US FRF4

Accounting policy choice
to either (a) charge it to expense, or (b) capitalise if specified
criteria
are met

Chapter 13, Intangible
Assets

1 Converged with IFRS

2 AS 26 replaced AS 8 – Accounting for Research and Development
that required deferral of R&D costs if specified criteria were met

3 Issued by the IASB

4 AICPA’s Financial Reporting Framework (FRF) for SMEs, a special
purpose framework that is a self-contained financial reporting framework not
based on USGAAP

 

2.5   Utility to Users of Financial Statements

Current
accounting standards for R&D costs across GAAPs do not lend themselves to
communication of an organisation’s value drivers. Nor do they help in valuation
exercises by investors. Alternate non-financial metrics and models, including
integrated reporting, the balanced scorecard, the intangible assets monitor,
the value chain scoreboard, etc. are being used by corporates globally to
communicate relevant and useful information to shareholders with respect to
their R&D investments. Investors focus inter alia on outcomes of
R&D investment and R&D productivity rather than just the spends that
are reported per GAAP.

 

The
following case study provides an interesting management view-point on the
relevance of current R&D financial reporting.

 

Case Study

Amazon.com,
Inc. (listed on NASDAQ, 2019 Revenues – US$ 280.5 billion, USGAAP reporting
entity) does not disclose separately expenditure on R&D in its financial
statements. The company is reportedly the largest R&D spender globally.
Such expenditure is included in the line item ‘Technology and Content
expenses’ (US$ 35.9 billion in 2019 representing 12.8% of revenues).

 

The
accounting policy of the company is: ‘Technology and content costs include
payroll and related expenses for employees involved in the research and
development
of new and existing products and services, development,
design and maintenance of our stores, curation and display of products and
services made available in our online stores, and infrastructure costs. Technology
and content costs are generally expensed as incurred
.

 

In 2017, the
US Securities and Exchange Commission questioned such non-disclosure. The
management’s response (available in the public domain) is extracted herein
below:

 

Because of
our relentless focus on innovation and customer obsession, we do not manage our
business by separating activities of the type that under USGAAP ASC 730 are
‘typically… considered’ research and development from our other activities that
are directed at ongoing innovation and enhancements to our innovations.
Instead, we manage the total investment in our employees and infrastructure
across all our product and service offerings, rather than viewing it as related
to a particular product or service; we view and manage these costs
collectively as investments being made on behalf of our customers in order to
improve the customer experience.
We believe this approach to managing our
business is different from the concept of planned and focused projects with
specific objectives that was contemplated when the accounting standards for
R&D were developed under FAS 2.

 

We do not
believe that separate disclosure of the costs associated with activities of the
type set forth in ASC 730 would be material to understanding our business. We
are concerned that separate disclosure of such costs would focus our financial
statement users on a metric that understates the level of innovation in which
we are investing.

 

3      GLOBAL ANNUAL REPORT EXTRACTS: ‘EMPLOYEE
ENGAGEMENT’

Background

UK Companies
(employing more than 250 employees) are required to include in their Annual
Reports
(for the F.Y. commencing 1st January, 2019) a statement
describing action taken to engage with employees
. Such a statement is
required to be included as part of the Director’s Report. The relevant
provision of The Companies (Miscellaneous Reporting) Regulations,
2018 that include new corporate governance and reporting
regulations is extracted herein below:

 

The
Director’s report for a financial year must contain a statement

a)     Describing the action that
has been taken during the financial year to introduce, maintain or develop
arrangements aimed at –

i)      providing employees systematically with
information on matters of concern to them as employees,

ii)     consulting employees or their
representatives on a regular basis so that the views of the employees can be
taken into account in making decisions which are likely to affect their
interests,

iii)    encouraging the involvement of employees in
the company’s performance through an employees’ share scheme or by some other
means,

iv)    achieving a common awareness on the part
of all employees of the financial and economic factors affecting the
performance of the company.

b)     Summarising

i)      How the Directors have engaged with
employees
, and

ii)     How the Directors have had regard to
employee interests, and the effect of that regard, including on the principal
decisions taken by the company during the financial year.

 

Extracts
from an Annual Report

Company:
EVRAZ PLC
[Member of FTSE 100 Index, 2019 Revenues – US$ 11.9 billion,
employees (Nos.) – 71,223]

 

Extracts from Director’s Report:

‘Engagement
with employees remains key, and the Board closely monitors the results of the
annual engagement survey which has seen satisfactory levels of improvement.

 

Two
independent non-executive directors have taken responsibility for engaging with
employees in our businesses in North America and Russia, respectively, and this
is undertaken by their attendance at key staff briefing events and town hall meetings.

 

Throughout
the year, senior management attend the Group’s board meetings to present the
annual budget for their respective business units, and to present key
investment projects which require the Board to approve significant capital
expenditure sums. All presentations made to the Board consider both the benefit
to shareholders of the proposal and the impact on other key stakeholders.

 

The
Remuneration Committee receives a detailed presentation from the Vice-President
of HR which outlines remuneration and incentive plans across the whole business
at each level.

 

A
whistle-blowing arrangement is in place which allows staff to raise issues in
confidence and the responses to the issues are routinely monitored by the Audit
Committee who escalate key issues to the Board.’

 

4      COMPLIANCE: NCI’s INTEREST IN GROUP
ACTIVITIES AND CASH FLOWS UNDER IND AS 112

Background

Ind AS 112 Disclosure of Interests in Other Entities, inter alia, mandates disclosures with respect to
the interest that non-controlling interests (NCIs) have in a group’s activities
and cash flows. Such disclosures are required in the Notes to the Consolidated
Financial Statements when there is a presence of subsidiaries in a group
structure. Such disclosures are applicable for subsidiaries in a group that are
not wholly controlled by the parent.

 

One of the
issues in current financial reporting
for groups
is that while net income, total comprehensive income and net assets are
allocated between owners of the parent and the NCI, the operating cash flows
are not similarly allocated
. Such information is an important input in a
valuation exercise. Ind AS attempts to provide such information by way of
disclosures.

 

Consolidated
financial statements present the financial position, comprehensive income and
cash flows of the group as a single entity. They ignore the legal boundaries of
the parent and its subsidiaries. However, those legal boundaries could affect
the parent’s access to and use of assets and other resources of its
subsidiaries and, therefore, affect the cash flows that can be distributed to
the shareholders of the parent
(IFRS 12, BC 21).

 

Summarised
financial information about subsidiaries with material non-controlling
interests helps users predict how future cash flows will be distributed among
those with claims against the entity, including the non-controlling interests
(IFRS
12, BC 28).

 

The disclosure requirements are summarised in Table C. It
may be noted that the disclosures are required for each subsidiary (that have
NCIs that are material to the reporting entity).

 

Table C:
Disclosures – Interests that NCIs have in the group’s activities and cash flows

Disclosures

 

Ind AS 112 Reference

An entity shall disclose
information that enables users to understand:

(i) The composition of the
group, and

(ii) The interests that
NCIs have in the group’s activities and cash flows

Para 10

u The proportion of:

u Ownership interests held by an NCI

uVoting rights held by the NCI if different from above

u Profit or loss allocated to the NCI for the reporting period

u Accumulated NCIs at the end of the reporting period

Para 12 (c) to (f)

u Summarised financial information related to Assets,
liabilities, profit or loss and cash flows of the subsidiary that enables
users to understand the interest that NCIs have in the group’s activities and
cash flows. This information might include, but is not limited to, for
example, current assets, non-current assets, current liabilities, non-current
liabilities, revenue, profit or loss and total comprehensive income

u The above amounts shall be before inter-company eliminations

u Dividends paid to the NCIs

Para 12 (g) and B10-B11 of
Application Guidance

It may be noted that Ind AS
1 Presentation of Financial Statements has separate presentation
requirements related to NCIs

 

5      FROM THE PAST – ‘HIGH-QUALITY FINANCIAL
INFORMATION IS THE CURRENCY THAT DRIVES THE MARKETPLACE’

Extracts
from a speech by Mr. Arthur Levitt (former US SEC Chairman) to
the American Council on Germany in New York in October, 1999
are reproduced below:

 

Information
is the lifeblood of markets
. But unless investors trust
this information, investor confidence dies. Liquidity disappears. Capital dries
up. Fair and orderly markets cease to exist.

 

High-quality
financial information
is the currency that drives the
marketplace
. And nothing honours that currency more than a strong and
effective corporate governance mandate. A mandate that is both a dynamic system
and a code of standards. A mandate that is measured by the quality of
relationships
: the relationship between companies and directors; between
directors and auditors; between auditors and financial management; and
ultimately, between information and investors
.

 

If strong corporate governance is to permeate every facet of our
marketplace, its practice must extend beyond merely prescribed mandates,
responsibilities and obligations. It is absolutely imperative that a corporate
governance ethic emerge and envelop all market participants: issuers, auditors,
rating agencies, directors, underwriters and exchanges. Its foundation must be
an unwavering commitment to integrity. Its cornerstone
– an undying commitment to serving the investor.

 

Private Affairs Impacting Public Interest Entities — A Sift Through a Recent SEBI Amendment

The Primary Marked Advisory Committee (‘PMAC’) of the Securities and Exchange Board of India (‘SEBI’) had identified and deliberated on certain challenges and issues arising out of (i) agreements indirectly binding public listed entities, (ii) special rights granted to shareholders of a public listed entity, (iii) sale, disposal or lease of an undertaking of a listed entity and (iv) the provision for board permanency in the context of a public listed entity. Based on PMAC recommendations, SEBI released a Consultation Paper1 for public feedback, basis of which released a Board Memorandum2 and consequently, on 14th June, 2023 introduced certain amendments to the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (‘Listing Regulations’) under the SEBI (Listing Obligations and Disclosure Requirements) (Second Amendment) Regulations, 2023 (‘Listing Regulations Amendment’).3


1 Consultation Paper on 'Strengthening Corporate Governance at Listed Entities by Empowering Shareholders' on February 21, 2023.
2 Board Memorandum on ‘Strengthening corporate governance at listed entities by empowering shareholders - Amendments to the Securities and Exchange Board of India (Listing Obligations and Disclosure Requirements) Regulations, 2015’ dated 17th April, 2023
3 The Listing Regulations Amendment came into force on July 14, 2023 (except certain specified amendments which will come into force on the date of their publication in the Official Gazette).

One of the key amendments under the Listing Regulations Amendment relates to approval and disclosure requirements for certain types of agreements indirectly binding listed entities. These agreements could be in the nature of family arrangements, trust deeds, settlement agreements, shareholder agreements, voting agreements, family charters, consent terms, etc. to which the listed entity may not have been privy or party.

In this article, our attention is directed toward analysing the disclosure requisites emanating from this particular facet of the amendment, accompanied by a critique exploration of the attendant complexities.

CONTEXT

Regulation 30 of Listing Regulations relates to the disclosure of material events and information by a listed company to stock exchanges. Prior to the Listing Regulations Amendment, clause 5 of Para A of Part A of Schedule III of Listing Regulations covered a disclosure requirements as under:

Clause 5: Agreements [viz. shareholder agreement(s), joint venture agreement(s), family settlement agreement(s)] (to the extent that it impacts management and control of the listed entity), agreement(s) / treaty(ies) / contract(s) with media companies) which are binding and not in the normal course of business, revision(s) or amendment(s) and termination(s) thereof.

The Listing Regulations Amendment introduced a new Clause 5A with an expanded scope as under:

“5A. Agreements entered into by the shareholders, promoters, promoter group entities, related parties, directors, key managerial personnel, employees of the listed entity or of its holding, subsidiary or associate company, among themselves or with the listed entity or with a third party, solely or jointly, which, either directly or indirectly or potentially or whose purpose and effect is to, impact the management or control of the listed entity or impose any restriction or create any liability upon the listed entity, shall be disclosed to the Stock Exchanges, including disclosure of any rescission, amendment or alteration of such agreements thereto, whether or not the listed entity is a party to such agreements:

Provided that such agreements entered into by a listed entity in the normal course of business shall not be required to be disclosed unless they, either directly or indirectly or potentially whose purpose and effect is to, impact the management or control of the listed entity or they are required to be disclosed in terms of any other provisions of these regulations.
Explanation- For the purpose of this clause, the term “directly or indirectly” includes agreements creating an obligation on the parties to such agreements to ensure that listed entities shall or shall not act in a particular manner.

The impetus behind the amendment through the introduction of Clause 5A primarily seems to originate from the context of shareholders agreements (‘SHA(s)’) and the requisite disclosures pertaining to these agreements as they pertain to shareholders of listed companies. SHAs manifest either as agreements between shareholders themselves or encompass agreements involving both shareholders and the listed entity. In practice, the rights and responsibilities stipulated within an SHA are normally seamlessly incorporated into the Articles of Association (‘AoA’) of the company.4


4 (i) V. B. Rangaraj vs. V.B. Gopalakrishnan and Ors, as reported in CDJ 1991 SC 464 + S.P. Jain vs. Kalinga Tubes Ltd, 1965 AIR (SC) 1535, (ii) World Phone India Pvt. Ltd. & Ors. vs. Wpi Group Inc. (2013) 178 Comp Cas 173 (Del)

 

Furthermore, considering that any alteration to a company’s AoA mandates shareholder endorsement via a special resolution, the assimilation of an SHA into the AoA would necessitate a similar level of endorsement. In this context SEBI discerned an incongruity wherein SHAs absent from the AoA evaded the scrutiny that would normally arise through the special resolution, thus negating the very purpose of disclosures as prescribed under Schedule III of the Listing Regulations.

SEBI’s review also brought to light another issue, specifically concerning scenarios where listed company promoters entered into agreements with third parties (or within themselves) but did not involve the listed company as a contracting party. Such agreements might potentially impose restrictions, direct or indirect liabilities or obligations on the listed entity. Although the mechanism for generating obligations on a non-signatory to a contract might not be immediately evident from the Consultation Paper or the Board Memorandum; SEBI noted that if the listed entity were a party to such agreements, shareholders would gain access to copies for an assessment. This transparency would enable shareholders to evaluate potential adverse implications for their interests. Given that, before Listing Regulations Amendment stipulations pertained exclusively to agreements binding on listed companies, promoters could have evaded existing shareholders’ scrutiny by excluding the listed entity as a contracting party in these agreements. In response to an observation received from the Consultation Paper, SEBI underscored the necessity for symmetry in information dissemination pertaining to any agreement impacting the management or control of a listed entity, irrespective of whether the listed entity is a direct party to the agreement.

The Listing Regulations Amendment categorises such agreements into two groups: (a) pre-existing and subsisting agreements and (b) agreements to be executed in the future.

For pre-existing and subsisting agreements that fall within the scope of the above Clause 5A, the Listing Regulations Amendment prescribed their disclosure on or before
14th August, 2023, in addition to the disclosure on the website as well as in the annual report of FY 2022-2023 and FY 2023-24. This requirement has been introduced through the inclusion of Regulation 30A.

For agreements to be executed in the future, the concerned parties are required to intimate the listed entity within two working days of entering into such agreement, and the listed entity would then be required to disseminate to the public within prescribed timelines.

COMMENTARY AND CRITIQUE ANALYSIS

Formerly, only binding agreements such as shareholder agreements, joint venture agreements, and certain family settlement agreements (insofar as their impact on the management and control of the listed entity was concerned), as well as agreements, treaties, or contracts with media entities, were subject to disclosure requirements. These obligations encompassed both the original agreements and any subsequent modifications, amendments, or terminations. However, this approach sometimes led to the omission of other arrangements involving promoters, shareholders, and other relevant parties, even if they held the potential to influence the management and control of the listed entity or impose restrictions upon it.

The newly introduced clause 5A broadly intends to cover agreements that:

(i) impact the management or control of the listed entity or

(ii) impose any restriction on the listed entity or

(iii) create any liability upon the listed entity.
in each case either directly, indirectly or potentially.
The Listing Regulations Amendment instates an additional disclosure requirement upon not only the listed entity but also the promoters, shareholders and other contractual parties. This marks a departure from the previous stance and broadens the scope of disclosure obligations encompassing agreements. It is pertinent to note that such a disclosure is mandated without a predetermined assessment of their materiality.

Moreover, this amendment mandates the disclosure of previously undisclosed existing arrangements involving listed entities. Parties involved in such agreements, along with the listed companies themselves, are tasked with compiling a comprehensive inventory of all active agreements associated with the listed company. Subsequently, this information must be furnished to the relevant listed companies or stock exchanges within stipulated timelines.

It is widely acknowledged that the Indian listed securities landscape is characterised by a robust emphasis on disclosure. SEBI has consistently undertaken measures to address information asymmetry between listed entities and market participants. These measures encompass the enactment of amendments and regulations designed to bolster transparency and enhance stakeholder engagement in the governance of listed entities. Nevertheless, in the pursuit of these objectives, SEBI faces the intricate challenge of striking a delicate balance between promoting pertinent disclosures and imposing concurrent burdensome obligations on the concerned stakeholders.

While the Listing Regulations Amendment aligns with SEBI’s overarching commitment to fostering transparency, certain aspects of the language and current formulation of the amendments may appear onerous and overly expansive to market participants unless subjected to further refinement.

1. Sweeping scope with unintended coverage: The current rendition of Clause 5A has a notably sweeping scope, encompassing agreements that not only directly or indirectly impact the management and control of a listed company but also those that create restrictions or liabilities for the listed entity, regardless of whether the listed entity is a direct party to such agreements.

The current wording of the clause being comprehensive has the potential to inadvertently encompass unintended categories of contracts. Such an arrangement, despite being irrelevant to the listed entity’s shareholders and potentially including confidential nominee-related information, would be subject to mandatory disclosure to the exchanges.

2. The vast expanse of the terminology ‘impose any restriction or create any liability upon the listed entity’: Each and every agreement will impose some kind of restriction or liability on the listed entity. It is the actual purpose of any agreement to create certain restrictions or cast obligations and liabilities. The choice of words used in clause 5A goes beyond obligations that affect the management or control of the listed entity but covers any and all restrictions or liabilities created on the listed entity. Unless the listed entity is able to prove that such a restriction or liability is in the ‘normal course of business’, any restriction or liability, without application of materiality would warrant a disclosure.

This aspect was categorically considered by SEBI and below verbatim feedback from the Board Memorandum guides the regulatory through-process:

As regards the suggestions made by some commenters to define the terms ‘restrictions’ and ‘liability’, it is viewed that these terms are themselves self-explanatory and any attempt to define them with precise words may lead to unwarranted interpretational issues which should be avoided.

3. Whether possible to impose restrictions without a listed entity being a signatory: The concept of a contract imposing restrictions or liabilities on a listed entity in the absence of the company’s direct involvement poses conceptual challenges. If such restrictions or liabilities result from the commitment of shareholders to vote their shares in a specific manner, this would be encompassed under part (i), rendering part (ii) and (iii) of Clause 5A redundant.

4. Implications of retroactive disclosures: The application of the amendments to existing arrangements effectively renders the legislation retroactive, as the parties to such arrangements would not have anticipated their disclosure or the requirement for shareholder approval, as currently stipulated. The obligations on confidentiality, sub-judice, etc. may warrant close consideration.

5. Duplication with principles under SEBI Takeover Code: The SEBI (Substantial Acquisition of Shares and Takeover) Regulations, 2011 (‘Takeover Regulations’) encapsulates detailed provisions in relation to disclosure as well as tender offer provisions about acquisition / change of control of a listed entity. To introduce an additional requirement and its interplay with Takeover Regulations may result in unintended consequences. In addition to the word ‘control’, agreements impacting ‘management’ are also covered within the purview of the newly introduced Listing Regulations Amendment. The word ‘management’ however, is not defined under the Listing Regulations and SEBI considered this critique feedback in its response under the Board Memorandum as:

While the word ‘control’ will always connote the meaning and explanation as defined under the Takeover Regulations, the term ‘management’ being a broader term should not be subject to a hard-coded definition and it is desirable to leave the term ‘management’ to connote the meaning used in common parlance.

6. Lack of guiding principles: Clause 5A is positioned within Para A of Part A of Schedule III, which implies that disclosures hereunder are required irrespective of materiality thresholds, thereby mandating disclosure without an accompanying set of guiding principles. This broad inclusion would necessitate the disclosure of numerous agreements falling within the purview of Clause 5A, even if they bear a minimal impact on information symmetry between the listed entity and market participants. A notable contrast arises when juxtaposing this approach with the LODR’s treatment of related party transactions, which mandates board approval only when transactions surpass a defined materiality threshold.

In the six months from February 2023, SEBI has floated over three dozen consultation papers seeking to overhaul the ground rules for market players and intermediaries. Such a frenzied pace or regulatory overhaul has been unprecedented. While it is de rigueur for market participants to crib and carp about ease of doing business whenever regulations are tightened, it would do good if these changes provide the right set of guidance, definitions and clear ambiguities. While SEBI’s proactive approach is laudable, being on a regulatory overdrive runs a risk of skirting the robustness of a law-making process and resulting in implementation challenges, unintended consequences as well as needless litigation.

FOOTNOTE DISCLOSURES

Selected excerpts from disclosures made by certain listed entities in compliance with Clause 5A:
1. Titan Company Limited: Tamil Nadu Industrial Development Corporation Limited (TIDCO) and Tata Sons Limited (now known as Tata Sons Private Limited) (“TSPL”) (which was replaced by Questar Investments Limited was replaced by TSPL) are parties to the Investment Agreement entered on 8th February, 1984 and the Supplementary Agreement entered on 10th April, 2007 (“Agreements”). TIDCO and TSPL are Promoters of the Company holding 27.88 per cent and 25.02 per cent respectively.

The purpose of entering into the Investment Agreement was for the establishment of the Company for the manufacture and sale of watches and watch components.

2. Bharti Airtel Limited: Bharti Telecom Limited (“BTL”), Promoter has entered into Shareholders’ Agreement on 22nd January, 2009 with Pastel Limited, Bharti Enterprises (a partnership firm subsequently converted into Bharti Enterprises (Holding) Private Limited (“BEHPL”) is the holding company of BTL), Bharti Infotel Private Limited (since the execution of the SHA, been merged with BEHPL0 and Indian Continent Investment Limited (“ICIL”), is a person acting in concert with BTL to set out their inter se rights and obligations in relation to BTL and its subsidiaries. (ii) Bharti Airtel Limited (“BAL”) entered into a Shareholders’ Agreement on 22nd January, 2009, with Bharti Telecom Limited, Pastel Limited to set out their inter se rights and obligations of BTL and Pastel about BAL and its subsidiaries.

3. Sun Pharmaceutical Industries Limited: Certain specific rights have been granted to the Promoter under the Article 108 of the Articles of Association of the Company.

4. Marico Limited: Harsh C. Mariwala, Chairman and promoter of Marico Limited entered into a Shareholders’ Agreement to record the understanding of the parties to the SHA in relation to their shareholding in Marico to provide full support to the Mariwala family in the management of Marico.

5. Kirloskar Brothers Limited: A Joint Venture Agreement was executed on 27th January, 1988, between Kirloskar Brothers Limited, Kirloskar Ebara Pumps Limited and Ebara Corporation to establish a limited joint venture to be operated under and by virtue of the laws of the Republic of India in order to promote manufacture and sell industrial process pumps and / or such other products as the parties mutually agreed.

6. Hikaal Limited: Disclosure From Promoters, Mr. Jai Hiremath and Mrs. Sugandha Hiremath of the Hikaal Limited entered into a Family Arrangement in the year 1994 between Mr. Babasaheb N Kalyani (“BNK”) and his father, whereby the shares of the Hikaal Limited held by KICL (Kalyani Investment Company Limited) and BFIL(Bharat Forge Investment Limited), both of which are under the ownership and control of the BNK Group, were required to be transferred to Mrs. Sugandha Hiremath. KICL and BFIL hold 34.01 per cent in Hikaal Limited.

7. Godfrey Phillips India Limited: A Shareholders Agreement was executed amongst Godfrey Phillips India Limited and Philip Morris Global Brands Inc. (erstwhile Philip Morris International Finance Corporation) (“PMGB”), promoter of the Company, Philip Morris Products S.A. (“PMSA” together with PMGB referred to as “Philip Morris Entities”) and Modi Shareholders on dated 28th May, 2009, to record inter alia certain rights and obligations of Philip Morris Entities and Modi Shareholders concerning the Company and inter se mutual rights and obligations of Philip Morris Entities and the Modi Shareholders.

8. Geojit Financial Services Limited: A Promotional Agreement was executed between Kerala State Industrial Development Corporation Limited (“KSIDCL”) and C.J. George (“Promoter of Geojit Financial Services Limited”) on 23rd March, 1995 for Promotional association with KSIDCL when the Geojit Financial Services Limited was unlisted.

A Shareholders Agreement has been executed amongst C.J. George, Shiny George, BNP Paribas S.A., BNP Paribas India Holding Private Limited and Geojit BNP Paribas Financial Services Limited (presently Geojit Financial Services Limited) on 22nd January, 2016, for the purpose of governance of the Company and dilution of rights of BNPP in the Company to protect the Company from BNPP’s conflict of interest consequent to BNPP acquiring full ownership and control of Sharekhan Limited, though the shareholding in the Company remains the same.

Sustainability Reporting and Opportunities for Practitioners

INTRODUCTION

The nations across the world are in a race to become the most developed economies. This race has not only exploited the resources to the extent of their near extinction, but also resulted in the world becoming a gas chamber of pollution. People are now realising the irreversible damage that they have done to the environment and are trying to gather as much information as possible to understand the causal-effect relationship of this never-ending race. Investors and other stakeholders are holding the industries and companies responsible for the depletion of the quality of the environment. Their expectations are being evaluated by the regulatory authorities, and in return, relevant regulations have been passed for adequate disclosures by the companies. G20 nations in New Delhi also reiterated their commitment to achieve global net zero GHG emissions / carbon neutrality by or around mid-century in the recently concluded G20 Summit.

Globally, the companies are now disclosing how their operations are making use of the natural resources and what is the impact of the same on the neighbouring environment. There are many sustainability reporting frameworks which are commonly used by companies for disclosing their sustainability-related information, viz. GRI Standards issued by the Global Sustainability Standards Board (GSSB), Task Force on Climate-related Financial Disclosures (TCFD) recommendations issued by the Financial Stability Board, SASB standards issued by the Sustainability Accounting Standard Board (SASB)(now part of International Sustainability Standards Board (ISSB)). Recently, ISSB has issued IFRS S1 (General Requirements for Disclosure of Sustainability-related Financial Information) and IFRS S2 (Climate-related disclosures), which will be effective for annual reporting periods beginning on or after 1st January, 2024, with a ‘climate first’ transition option available to entities, allowing them to provide only climate-related disclosures in the first year of applying IFRS S1 and IFRS S2.

Environmental-Social-Governance (ESG) disclosures have become a popular tool to attract investors and other stakeholders. Few companies are marketing their sustainability policies without executing the same in action at the ground level. By doing so, these policies may convey misleading information about how a company’s products / services and practices are environmentally sound. To avoid these instances of green washing, the regulators in various countries felt the need for assurance of ESG disclosures.

Assurance providers provide assurance on the ESG disclosures made by the company under various assurance frameworks and guidance like International Standard on Assurance Engagements (ISAE) 3000 (Assurance Engagements Other than Audits or Reviews of Historical Financial Information) / ISAE 3410 (Assurance Engagements on Greenhouse Gas Statements) (issued by International Auditing and Assurance Standards Board (IAASB)), AA1000 Assurance Standard v3 issued by Account Ability Standards Board, etc.

The objective of this article is to provide the regulatory requirements on sustainability reporting in India and the mandatory reasonable assurance requirements from financial year 2023-24 onwards. It also covers the role of Chartered Accountants in Sustainability reporting and assurance.

SUSTAINABILITY REPORTING IN INDIA

Business Responsibility and Sustainability Reporting (BRSR) for listed entities

India, in response to the worldwide changes, has come up with a sustainability framework of Business Responsibility and Sustainability Reporting (BRSR), which helps the companies to meet the stakeholders’ expectations on disclosures relating to the area of ESG. Securities and Exchange Board of India (SEBI) vide circular1 dated 10th May, 2021 had issued the guidelines for the top 1,000 listed entities (by market capitalisation) to voluntarily provide BRSR disclosures in FY 2021–22 and mandatorily from FY 2022–23 as a part of their annual report. The goal of the new reporting format is to co-relate the financial performance of an entity to its sustainability performance. These disclosures are based on the principles covered in the National Guidelines on Responsible Business Conduct (NGRBC) issued by the Ministry of Corporate Affairs in 2019, which itself emanates from the UN Sustainable Development Goals. The circular also provided the format of BRSR along with guidance on certain aspects of some key performance indicators (KPIs) of BRSR.


1. https://www.sebi.gov.in/legal/circulars/may-2021/business-responsibility-and-sustainability-reporting-by-listed-entities_50096.html

The BRSR disclosures are segregated into the following three different sections:

1. Section A: General Disclosures
Information relating to the listed entity, like products / services offered, operations, markets served by the entity, CSR details, etc., needs to be disclosed.

2. Section B: Management and Process Disclosures
This section is aimed at helping businesses demonstrate the structures, policies and processes put in place towards adopting the NGRBC Principles and Core Elements.

3. Section C: Principle Wise Performance Disclosures
This section is aimed at helping entities demonstrate their performance in integrating the Principles and Core Elements with key processes and decisions.

There are nine principles (mentioned below) under which an entity needs to provide ‘Essential’ and ‘Leadership’ disclosures. Essential indicators need to be provided mandatorily, and Leadership indicators are voluntary in nature.

ASSURANCE ON BRSR CORE FOR LISTED ENTITIES

To take the BRSR to the next level, SEBI has introduced the concept of “BRSR Core” as a subset of BRSR. It contains selected KPIs related to BRSR. To enhance the reliability of disclosures in BRSR, SEBI has mandated the reasonable assurance of BRSR Core to the top 150 listed entities (by market capitalisation) from FY 2023 – 24 onwards, which will be extended to the top 1,000 listed entities (by market capitalisation) by FY 2026 – 27 in a phased manner vide amendment in Regulation 34(2)(f) of SEBI (Listing Obligations and Disclosure Requirement) Regulations, 2015 (LODR Regulations). The format of BRSR Core has been prescribed by SEBI vide circular2 dated 12th July, 2023.


2. https://www.sebi.gov.in/legal/circulars/jul-2023/brsr-core-framework-for-assurance-and-esg-disclosures-for-value-chain_73854.html

In line with the BRSR Core attributes, the format for BRSR has also been amended. BRSR Core consists of KPIs under the following nine ESG attributes:

ESG Attribute Description
Change in GHG footprint Scope 1 & 2 emissions & intensity
Change in water footprint Water consumption & intensity
Energy footprint Details of total energy consumed from renewable
Embracing circularity Break-up of waste management across 8 categories
Employee well-being & safety Amount spent (per cent of revenue) on employee wellbeing initiatives (including health insurance, daycare, maternity benefits, etc. and details on safety-related incidents)
Gender diversity  per cent of wages paid to women and complaints on POSH
Inclusive development  per cent of materials sourced from MSMEs, small producers and job creation opportunities in small towns
Fair engagement with customers & suppliers No. of days of accounts payable and per cent of negative media sentiment
Open-ness of business Conducting business with concentrated (limited) parties along with loans and investments made to related parties

 

BRSR CORE FOR VALUE CHAIN PARTNERS OF LISTED ENTITIES

SEBI has also mandated the disclosures as per BRSR core for value chain partners of the top 250 listed entities (by market capitalisation) from FY 2024–25 on a comply-or-explain basis. These value chain partners encompass top upstream and downstream partners of a listed entity, cumulatively comprising 75 per cent of purchases / sales (by value), respectively. A listed entity covered above will be required to report the KPIs in the BRSR Core for their value chain to the extent it is attributable to their business with that value chain partner.

Further, with effect from FY 2025–26, SEBI has directed the limited assurance of the disclosures in BRSR Core for value chain partners on a comply-or-explain basis.

Disclosing data with respect to value chain partners may involve several practical challenges, e.g., a compilation of data for entities outside the group, defining reporting boundaries, and assurance of such data.

BRSR FOR LISTED ENTITIES NOT COVERED ABOVE

As regards listed entities which are not covered within the ambit set in the abovementioned circulars, SEBI has provided that these entities, including the ones listed on SME Exchange, can voluntarily comply with the requirements to disclose their and their value chain’s disclosures in the BRSR / BRSR Core as the case may be, as a part of their annual report and to provide reasonable / limited assurance on such disclosures.

GENERAL GUIDANCE TO ASSURANCE PROVIDERS

Information provided by the companies in BRSR relates to both financial as well as non-financial information. Financial information like paid-up share capital, corporate social responsibility details, products / services sold by the entity, related party transactions, employee-related benefits, etc., can be referenced from the financial statements and notes / disclosures annexed to those. However, non-financial disclosures which relate to the information pertaining to the measure of greenhouse gas emissions (Scope 1 and 2), water discharge, circular economy, etc., require technical expertise. Assurance providers should have requisite knowledge of both financial and non-financial metrics for providing quality assurance services. Technical knowledge of planning, executing, and concluding the assurance engagement as per the auditing standards and framework governing the assurance of sustainability reports is also a prerequisite for providing effective and efficient assurance services.

The International Federation of Accountants (IFAC) has performed an annual benchmarking study3 on global practices in sustainability disclosure and its assurance for three consecutive years: 2019, 2020 and 2021. For 2021, a study on 1,350 companies across 21 jurisdictions was done. 1,283 of 1,350 companies reported ESG information in 2021 compared to 1,283 of 1,400 in 2020. Further, 63 per cent of the assurance engagements were provided by audit firms as against 61 per cent and 57 per cent in 2020 and 2019, respectively. For the remainder of the engagements, other assurance providers were appointed.


3. https://ifacweb.blob.core.windows.net/publicfiles/2023-02/IFAC-State-of-Play-Sustainability-Assurance-Disclosures_0.pdf

In the Indian context, according to a publication by a large firm, for the FY 2021–22, basis analysis of the data for the top 20 listed companies (by market capitalisation as on 31st March, 2023), 14 of these companies have disclosed information pertaining to BRSR. 13 Companies out of 14 (i.e., 93 per cent), have specifically disclosed that the sustainability report or integrated report have been subject to assurance in accordance with International Standard on Assurance Engagements (ISAE) 3000, Assurance Engagements Other than Audits or Reviews of Historical Financial Information (issued by International Auditing and Assurance Standards Board (IAASB)) / AA1000 Assurance Standard v3 issued by Accountability Standards Board. Some of the non-financial disclosures / metrics disclosed in the BRSR also form part of such an integrated report. The assurance providers on four companies are non-audit firms. Out of the remaining nine companies, one has not included the assurance report in its annual report. It is pertinent to note that only two companies out of the balance seven companies have appointed a Chartered Accountant (member of the Institute of Chartered Accountants of India) as the assurance provider.

To provide a reasonable / limited level of assurance on sustainability reporting, the Sustainability Reporting Standards Board (SRSB) of the Institute of Chartered Accountants of India (ICAI) has issued the following standards:

  • Standard on Sustainability Assurance Engagements (SSAE) 3000, ‘Assurance Engagements on Sustainability Information.’
  • Standard on Assurance Engagements (SAE) 3410, ‘Assurance Engagements on Greenhouse Gas Statements.’

SSAE 3000 is an umbrella standard applicable to all assurance engagements on sustainability information. In case there is subject matter information to which a specific assurance standard applies (e.g., GHG emissions), SSAE 3000 will apply in addition to the subject matter-specific standard (e.g., SAE 3410). The effective date of application of SSAE 3000 and SAE 3410 is as follows:

  • Voluntary basis for assurance reports covering periods ending on 31st March, 2023.
  •  Mandatory basis for assurance reports covering periods ending on or after 31st March, 2024.

SEBI’s recently issued FAQs4 has specified that assurance of BRSR is profession-agnostic. In its recent circular dated 12th July, 2023, SEBI clarifies that assurance providers should have the necessary expertise for undertaking assurance. However, what constitutes “necessary expertise” has not been defined in the circular. The Board of the listed entity shall ensure that the assurance provider appointed for assuring the BRSR Core has the necessary expertise for undertaking reasonable assurance in the area of sustainability.


4. https://www.sebi.gov.in/sebi_data/faqfiles/aug-2023/1691500854553.pdf

Furthermore, a person appointed as an assurance provider should have no conflict of interest with the listed entity. SEBI circular read with FAQs lays down the over-arching principle that there should not be any conflict of interest with the assurance provider appointed for assuring the BRSR Core. If an assurance provider sells its products or offers any non-audit or non-assurance services to a listed entity or its group entities, irrespective of whether the nature of the product / service is financial or non-financial, it will not be eligible to undertake assurance of the BRSR Core. The Circular does not mandate or recommend the use of any specific assurance standard. The assurance provider may appropriately use a globally accepted assurance standard on sustainability / non-financial reporting, such as the International Standard on Assurance Engagements (ISAE) 3000 or assurance standards issued by the ICAI. Whilst requiring certain prescribed entities to get an independent assurance of their data, the lack of clarity or uniformity in the qualifications/affiliations of the assurance service providers may result in different standards / yardsticks being adopted, thereby making it difficult for the stakeholders to assess the level of compliance by different entities. It would be desirable if SEBI lays down some common yardsticks / format of assurance reporting as well as the professional qualifications for the assurance service providers, other than CAs.

An assurance on sustainability-related disclosures can be at a limited level or reasonable level. For a limited assurance engagement, the assurance procedures are limited as compared to reasonable assurance but sufficient to express negative assurance. For a limited assurance engagement, we may place relatively greater emphasis on inquiries of the entity’s personnel and analytical procedures and relatively less emphasis, if any, on tests of controls and obtaining evidence from external sources than would be the case for a reasonable assurance engagement.

ROLE OF CHARTERED ACCOUNTANTS IN SUSTAINABILITY REPORTING AND ASSURANCE

With the increasing focus on environmental sustainability, governance, and ethical practices, there is no better time than now for CAs to explore this area. Similarly, new regulatory standards and emerging requirements for non-financial reporting add a new layer to the demand. For effective implementation of the new framework prescribed by SEBI and to meet the increasing need of stakeholders for such information, it is essential for the companies to establish a comprehensive data management system, as such information needs to be collated and coordinated between various functional departments / units within the entity. Further, if the management decides to disclose information on a consolidated basis, then information relating to various components / affiliates needs to be accumulated in one place without any impact on the quality and reliability of the same. All these can be achieved only when the entity invests in designing and implementing adequate internal controls over the processes, systems and information produced by the company for disclosures in the BRSR.

A CA may support the management in designing and implementing the relevant internal controls to ensure that there are reduced or no instances of unintentional errors / intentional green washing. The professionals may also support the companies in assessing their readiness for BRSR. They may support in developing ways to measure the metrics in BRSR, developing processes and controls to produce and verify the information and supporting in preparation of BRSR reports. While the collection mechanisms are different, CAs are well-positioned to help companies design methods to track and analyse ESG data. However, they will have to comply with the provisions of the ICAI code of ethics and SEBI circular for listed entities (i.e., they cannot provide assurance on BRSR core in case they provide the above-stated services).

A CA in practice or statutory auditor has relevant knowledge of standards on auditing (SA) along with knowledge of how an assurance engagement is planned, executed, concluded, and documented. Considering SEBI circular permits even CAs to provide assurance services, they must involve subject matter experts in accordance with SA 620, ‘Using the Work of an Auditor’s Expert’ while providing assurance, primarily in respect of various environmental aspects like calculation of emissions, measures adopted towards “net zero” etc. Similarly, for reporting/disclosing data in respect of the value chain partners, practitioners may have to rely on the work of their auditors in accordance with SA-600, ‘Using the Work of another Auditor’. The regulators may issue suitable clarifications/guidance in this regard.

ICAI has already opened the doors of opportunities for Chartered Accountants by issuing SSAE 3000 for Chartered Accountants who can provide assurance under this standard. Moreover, ICAI has also announced a BRSR certificate course whose aim is to disseminate knowledge and awareness amongst its members on Global Trends in Corporate Sustainability Reporting, Disclosure requirements- BRSR and BRSR Lite and Assurance aspects of Sustainability Report.5


5. https://learning.icai.org/committee/business-responsibility-certificate-course-batch17/

CONCLUSION

India being the first country to mandate reasonable assurance on BRSR core from the FY 2023 – 24 onwards, companies should gear up and assess their readiness for independent assurance mandated by the regulator. The focus should be on establishing internal controls, systems, and processes akin to financial reporting systems. Assurance providers may enhance their understanding of the assurance framework and standards, a transition from limited to reasonable assurance, considering many companies were obtaining limited assurance on a voluntary basis, engage in timely discussions with the audit committees to identify the issues, if any and better plan their engagements.

Natural Hedging – A Practical Approach to Designation and Effectiveness

A. Introduction

 

Predictability of cash flows is one of the primary goals of a business while charting its short-term as well as long-term capital management plan. For this, risk management is one of the important aspects. The company is exposed to various risks ranging from political, geographical, economical to natural risks. One of the risks that we are going to discuss is exposure to foreign exchange fluctuation risk and hedging through a non-derivative instrument. Foreign currency exposure in a business originates on various transactions such as import and export of goods/services, foreign currency borrowings, overseas investments, etc. A company can manage this risk with a clear risk management and treasury policy. If the company opts to hedge its foreign exchange risk, it can do it by passive hedging or active hedging.

 

B. Hedging

 

In simple terms, from a foreign currency risk perspective, it is a technique or an approach whereby an entity can secure or ring-fence its cash flows while the exchange rate may fluctuate in future till the expected foreign currency cash flows hit the bank account.

 

It is to be noted that hedging is not about gaining or losing. It is about fixing the price risk and freezing the volatility for the future. It can arise on account of interest rates, commodity prices, currency, etc.

 

“To hedge, in finance, is to take an offsetting position in an asset or investment that reduces the price risk of an existing position. A hedge is, therefore, a trade that is made with the purpose of reducing the risk of adverse price movements in another asset.” – Investopedia

 

An entity can protect its profits/cashflows by entering into various types of derivative contracts. Exposure to foreign currency can be hedged by forward contracts, future contracts and currency options, call options, swaps, etc. These contracts can be entered into with commercial banks / authorised dealers as counterparties.

 

Another way of viewing risk is net basis. The company could be exposed to the same foreign currency risk exposure on, say, trade receivables, highly probable revenue, loans, investments, etc., as well as on outflows arising on account of trade payables, borrowings, interest payments, etc. In this scenario, depending on the matching profile of cash inflows and outflows, the company may enter into derivative contracts to hedge its net open exposure on foreign currency. The strategy to hedge on a net basis brings in the concept of Natural Hedge.

 

C. Passive hedging

 

Passive hedging is not an accounting term but is used by businesses while formulating risk management policies. Passive hedging means taking hedge positions matching with underlying maturities and are held till maturity. With this approach, the company is insulated from unwanted volatility in the income statement at a minimal/no hedge cost. At the same time, it could miss a potential gain if that arises in the short term.

 

Passive hedging can be done by either taking a derivative instrument such as forward contracts or a non-derivative financial instrument such as trade receivables or trade payables / borrowings depending on the side of forex risk a company wants to hedge.

 

D. Active hedging

 

Active hedging, on the other hand, is undertaking a foreign currency position in the market with a derivative instrument which caps the loss and retains the potential of an upside in a derivative position, which again should be in line with the Company’s Risk Management and Treasury Policy. Here the position is not held till maturity of the underlying, but will be squared off if the trade hits the stop loss limits or becomes favourable at any point of time during the contract period. Given the dual objective of loss protection and trying to generate some returns, this cannot be done through non derivative instruments. 

 

Thus, from Company’s Risk Management and Treasury policy, Natural hedging will form part of its Passive hedging strategy. 

 

E. Regulatory framework

 

This section brings out some aspects which are allowed by regulators but may not strictly pass the accounting test.

 

RBI has issued comprehensive guidelines on derivatives vide RBI/FMRD/2016-17/31FMRD Master Direction No. 1/2016-17, where it defines hedging as an activity of undertaking a derivative contract to offset the impact of an anticipated or a contracted exposure. It allows an entity to take Short i.e., Sell position without having a corresponding purchase option. (“Written option”).

 

A written option does not qualify as a hedging instrument unless it is designated as an offset to a purchased option. [para B6.2.4 of Ind AS 109]

 

‘Specific Directions’ under the RBI guidelines allow domestic non-retail corporates having a rupee liability may, at their discretion, to convert the rupee liability into a foreign currency liability through a currency swap. This position can be taken by the entity with authorised dealers without proving any foreign currency exposure.

 

Thus, an entity having, say Rs. 500 crore loan from Indian institutions can approach the authorised dealer and take a rupee swap to US dollar / Japanese Yen / Swiss Franc / any other currency.

 

Further, it states that entities may take positions (long or short), without having to establish the existence of underlying exposure, up to a single limit of USD 100 million equivalent across all currency pairs involving INR, put together, and combined across all exchanges.

 

Attention is also drawn to Master Direction No.5, dated 1st January, 2016, on “External Commercial Borrowings, Trade Credit, Borrowing and Lending in Foreign Currency by Authorised Dealers and Persons other than Authorised Dealers”, as amended from time to time and A P (DIR Series) Circular No. 11 dated 6th November, 2018, in terms of which certain eligible borrowers raising foreign currency denominated External Commercial Borrowing (ECB), having an average maturity of less than five years, are mandatorily required to hedge 70 per cent their ECB exposure.

 

For hedge purposes, an ECB may be considered naturally hedged if the offsetting exposure has the maturity/cash flow within the same accounting year. (para 2.5.1 of Master Direction No 5, issued on 1st January, 2016, issued by RBI)

 

Under Ind AS 109, a derivative maturing, say on, 15th March, 2024, with underlying offsetting cashflow occurring on 15th April, 2023, would be difficult to qualify as an effective hedge on two counts, viz, 1) Timing mismatch, and 2) from 16th April, 2023, till 15th March, 2024, the derivative is without an underlying and thus, won’t qualify as a qualifying hedge during FY 23–24.

 

F. Chapter 6 Hedge accounting – Ind AS 109 Financial Instruments (Relevant extracts)

 

It is well understood that Ind AS 109 allows entities to designate non-derivative instruments under hedge relationships and hence in this article, we will focus on non-derivative instruments that are allowed to be designated under hedging relationships.

 

Hedging Instrument:

 

Para 6.2 of Ind AS 109 states that for a hedge of foreign currency risk, the foreign currency risk component of a non-derivative financial asset or a non-derivative financial liability may be designated as a hedging instrument provided that it is not an investment in an equity instrument for which an entity has elected to present changes in fair value in other comprehensive income.

 

Hedge Item:

 

As per para 6.3.1 of Ind AS 109, a hedged item can be recognised as asset or a liability, an unrecognised firm commitment or a highly probable forecast transaction or a net investment in a foreign operation.

 

Further, para 6.3.5 of Ind AS 109 states that for hedge accounting purposes, only assets, liability, firm commitments or highly probable forecast transactions with a party external to the reporting entity can be designated as hedge items.

 

Hedge Qualification:

 

6.4.1 “A hedging relationship qualifies for hedge accounting only if all of the following criteria are met:

 

(a) The hedging relationship consists only of eligible hedging instruments and eligible hedged items.

 

(b) At the inception of the hedging relationship, there is a formal designation and documentation of the hedging relationship and the entity’s risk management objective and strategy for undertaking the hedge. 

 

(c) The hedging relationship meets all of the following hedge effectiveness requirements:

 

(i) There is an economic relationship between the hedged item and the hedging instrument;

 

(ii) The effect of credit risk does not dominate the value changes that result from that economic relationship.

 

(iii) The hedge ratio of the hedging relationship is the same as that resulting from the quantity of the hedged item that the entity actually hedges and the quantity of the hedging instrument that the entity actually uses to hedge that quantity of hedged item……” 

 

Key takeaways from Ind AS 109 perspectives:

 

1. Hedging of only foreign currency risk elements can be done through non-derivative financial instruments i.e., borrowings, receivables.

 

2. The counterparty in a hedge relationship should be an external party from a reporting group perspective.

 

3. To be effective, there should be an economic relationship between the hedge item and the hedge instrument.

 

4. The company should have a formal risk management policy and strategy in place.

 

5. Formal designation and documentation should be in place at the inception of the relationship and in alignment with the management policy.

 

G. Hedge item vis-a-vis hedge instrument:

 

Table 1 tabulates the choice of hedging instruments available under both (derivative / non-derivative) categories for a qualifying hedge relationship under Ind AS 109.

 

Table 1
Sr. No Hedge item Derivative Instruments Non-Derivative instruments
1.  Interest-bearing foreign currency liability (FX risk) Forward contract, Interest rate swap, Principal swap, Cross currency swap, Call options, Floor options, etc. Foreign currency receivable on balance sheet, loan receivables, dividend receivables, etc
2. Highly probable foreign currency revenue (FX risk) Forward contract, Put options, etc. Foreign currency liability on balance sheet
3. Receivables (FX risk) Forward contract, Put options, etc. Foreign currency liability, etc.
H. Natural hedge accounting

 

Guidance is available in terms of testing effectiveness for a “derivative” instrument used for hedging foreign currency risk of an underlying exposure as compared to a “non-derivative” instrument. In this article, we will run through effectiveness testing for a non-derivative instrument.

 

If both the hedged item and non-derivative instrument as tabulated above, are on the balance sheet and monetary in nature, under Ind AS 21, both will be marked to market, thereby offsetting in P&L. (B5.7.4 of Ind AS 109)

 

To select a relationship which impacts P&L, we will take the example of designation for those relationships where the hedge item is off the balance sheet, such as point 2 in table 1. This is because if there is no designation, borrowing will be marked to market at every reporting date under Ind AS 21 while forecasted revenue will not, and thus impacting P&L if not hedge accounted.

 

Example: Company A, with INR as a functional currency, has a US$400 of borrowing @ 4.5 per cent p.a. interest, payable on a monthly basis, with bullet repayment in the ninth month. The company has highly probable forecasted US$ linked revenues on a monthly basis that match the cash flows linked to US$ borrowings, both for interest and repayment of principal.

 

Company A designates highly probable foreign currency revenue as a hedge item and existing foreign currency interest-bearing liability as a non-derivative hedging instrument under Cash Flow Hedge.

 

Foreign currency liability is measured at amortised cost in financial statements, while highly probable revenue is an off-balance sheet item.

 

In accordance with B6.5.4 of Ind AS 109, when measuring hedge ineffectiveness, Company A shall consider the time value of money of the Hedge item to make it comparable to the Hedging instrument, which is subject to amortised cost and is also a present value measurement.

 

The IASB noted that hedging instruments are subject to measurement either at fair value or amortised cost, both of which are present value measurements. Consequently, in order to be consistent, the amounts that are compared with the changes in the value of the hedging instrument must also be determined on a present-value basis. The IASB noted that hedge accounting does not change the measurement of the hedging instrument, but that it might change only the location of where the change in its carrying amount is presented. As a result, the same basis (i.e. present value) for the hedged item must be used in order to avoid a mismatch when determining the amount to be recognised as hedge ineffectiveness [BC6.281 IFRS 9].

 

In the given case, foreign currency liability is measured at amortised cost. Considering no outstanding interest payments, discounting the borrowing with its coupon rate, the present value of borrowing matches with its amortised cost. Refer to Table 2 on the right.

 

Similarly, Company A present values the expected designated revenue against each corresponding cash flow of the Hedge instrument, discounted at the same discount rate of the Hedge instrument, giving us the present value of the hedged item. Refer Table 3 below.

 

(Table 2 – The net present value of non-derivative hedging instrument)
(Table 3 – NPV of the hedged item at inception)
In Table 3, to provide a broader view of assessing effectiveness under different scenarios, the table considers three different sets of cash flows designated as Hedge items against the Hedge instrument, which is kept constant.

 

It can be seen that in scenario 2.1 of Table 3, the effectiveness is 100 per cent, which reduces to 98.92 per cent in scenario 2.2 and further goes down to 95.61 per cent in scenario 2.3, where we altered revenue designations assuming different revenue expectations. Table 3 reflects the effectiveness at the inception of the hedge.

 

As a first step to establish hedge qualification, apart from applying critical terms match test, the Company establishes an approach to test effectiveness at every reporting date. Though there is no 80-125 principle prescribed under Ind AS 109, Company A will have to document a logical range, beyond which Company A will not apply hedge accounting. Say in the above example, if the result of effectiveness was 72 per cent, then it would be subjective on the Company to adopt hedge accounting.

 

One may debate on what discount rate should be used to measure the change in fair value of the hedged item (forecast sale) for effectiveness testing. There is no explicit guidance on what rate should be used under Ind AS or in IFRS. An acceptable approach would be to use a risk-free rate / borrowing’s coupon rate to discount both the hedged item and the hedging instrument for the purposes of calculating ineffectiveness.

 

We now move towards splitting the effective and ineffective MTM in the above example. In accordance with paragraph 6.5.11 of IFRS 9, the lower of the cumulative gain or loss on the hedging instrument (borrowing) and the cumulative change in fair value of the hedged item (revenue) is recognised through other comprehensive income in a separate component of equity.

 

At every subsequent reporting date (say Month 6), Company A remeasures the NPV at a constant discount rate and arrives at the revised effectiveness percentage and the amount to be accounted in Other Comprehensive Income (‘OCI’) and Income Statement (‘P&L’). Refer to computation table 4.

 

(Table 4 – NPV of the hedged item at subsequent reporting rate with OCI vs. P&L impact)
*Month 0 - 1US$ = Rs. 80 and Month 6 - 1US$ = Rs. 82

 

NPV of the hedging instrument is assumed to be the same, considering no outstanding interest payments and borrowing accounted at amortised cost. The above is performed at every reporting date till Borrowing is settled. The MTM in OCI is recycled to the income statement when the underlying hedge item hits the income statement.

 

Disclosures:

 

21A of Ind AS 107, states the disclosure requirements for those risk exposures that an entity hedges and for which it elects to apply hedge accounting. Hedge accounting disclosures shall provide information about:

 

a. Entity’s risk management strategy and how it is applied to manage risk;

 

b. How the entity’s hedging activities may affect the amount, timing and uncertainty of its future cash flows.

 

c. The affect that hedge accounting has had on the entity’s balance sheet, statement of profit and loss and statement of change in equity.

 

I. Documentation for hedging of a foreign currency exposure using a non-derivative hedging Instrument:

 

Company: XYZ Limited

 

Functional Currency: INR Table 5
Hedging objective The objective of the transaction is to hedge currency exchange fluctuations with respect of forecasted foreign currency-denominated sales.
Date of designation (Date of designation of existing foreign currency liability or Date of designation of new foreign currency liability at inception)
Type of hedge Cash flow Hedge
Hedging instrument Interest-bearing foreign currency liability on the balance sheet (US$…..)
Hedged item The highly probable foreign currency revenue on the date of designation US$……. matches the outflow on the hedging instrument on a monthly basis. (tabulation of inflows to be done)
Hedged period Monthly expected (say, US$) revenue (tabulated as above)
How “hedge effectiveness” will be assessed As the cash flows of the underlying and the hedging instrument occur at similar times, changes in cash flows attributable to the risk being hedged are expected to be completely offset by the instrument.
How “hedge ineffectiveness” will be measured Effectiveness will be measured by using the offset method of testing.

The company shall consider the time value of money of the Hedge item to make it comparable to a Hedging instrument, which is subject to amortised cost (a present value measurement).

In accordance with paragraph 6.5.11 of IFRS 9, the lower of the cumulative gain or loss on the hedging instrument (borrowing) and the cumulative change in fair value of the hedged item (revenue) is recognised through other comprehensive income in a separate component of equity.

[Though there is no 80-125 principle prescribed under Ind AS 109, Company A will have to document a logical range, beyond which Company A will not apply hedge accounting. Say in the above example, if the result of effectiveness was 72 per cent, then it would be subjective on the Company to adopt hedge accounting]

 

COMPLETED BY: ______________________________DATE: ____________

 

J. Conclusion

 

a. Achieving the hedge objective with a non-derivative instrument is a cost-efficient way of hedging exposures while also addressing P&L volatility from reporting perspective.

 

b. Hedge accounting can be done even with mismatch in cashflows between hedge instrument and its designated underlying, using NPV approach.

 

c. Company’s results, that are reflective of its stated risk management policy have higher reliability and acceptability levels amongst its stakeholders.

Restatement of Financial Statements — Auditor’s Considerations

INTRODUCTION

 

Events leading to the breakup of large accounting giants, corporate failures, and regulatory actions are evidence of financial reporting irregularities. Many of these irregularities involved restatement of financial statements due to error. Financial statements are prepared by the management as per the applicable accounting framework and GAAP to meet the expectations of various stakeholders. Schedule III to the Companies Act, 2013 requires companies to disclose the comparative period amounts as well in addition to current period numbers to ensure comparability between the periods presented.

The incidence and extent of restatements in various high-profile companies have created an image that the accounting process has failed more often than it really has. As per the ‘2021 FINANCIAL RESTATEMENTS – A TWENTY-ONE-YEAR REVIEW issued by Audit Analytics1’, the number of restatements filed increased significantly to 1,470, due to Special Purpose Acquisition Companies (SPAC) restatements. Excluding SPAC restatements, there was a 10 per cent year-over-year decrease. As per this study, revenue recognition had been the top issue in each of the past three years. Some of the examples include a change in the method (policy) of revenue recognition from over the period of time to the point of time, restatement originating from a failure to properly interpret sales contracts for rebate, return or resale clause, and reporting increase/decrease in revenue.

This article deals with the framework for restatement and auditor’s reporting considerations with respect to retrospective restatements to financial statements, i.e., in relation to misstatements identified in a prior period and considerations in auditing adjustments to comparative information in financial statements audited by predecessor or successor.


1   2021_Financial_Restatements_A_Twenty-One-Year_Review.pdf
(auditanalytics.com). The Audit Analytics Restatement database covers SEC
registrants who have disclosed a financial statement restatement in electronic
filings.

 

RESTATEMENT FRAMEWORK

 

Restatement is permissible under Indian Accounting Standards notified under section 133 of the Companies Act, 2013 (Act). While AS 5, notified under Companies (Accounting Standards) Rules, 2006, does not permit restatement, Ind AS 8, Accounting Policies, Changes in Accounting Estimates and Errors, permits restatement. AS 5 requires correction of prior period items by either including them in the determination of net profit or loss for the current period or to show such items in the statement of profit and loss after the determination of current net profit or loss.Material prior period errors need to be corrected in accordance with Ind AS 8. Ind AS 8 defines retrospective restatement2  as correcting the recognition, measurement, and disclosure of amounts of elements of financial statements as if a prior period error had never occurred. Ind AS 8 requires an entity to correct material priorperiod errors retrospectively in the first set of Ind AS financial statements approved for issue after their discovery by:

(a)    restating the comparative amounts for the prior period(s) presented in which the error occurred; or

(b)    if the error occurred before the earliest prior period presented, restating the opening balances of assets, liabilities and equity for the earliest prior period presented.


2   Reference – Ind AS 8 on Accounting

Policies, Changes in Accounting Estimates and Errors and Educational Material
covering Ind AS 8, Accounting Policies, Changes in Accounting Estimates and
Errors. The Educational Material provides guidance by way of Frequently Asked
Questions (FAQs) and illustrations explaining the principles enunciated in the
Standard
.

 

‘Material information’ is defined in Ind AS 8 as information if omitting, misstating, or obscuring it could reasonably be expected to influence the decisions that the primary users of general-purpose financial statements make on the basis of the financial statements, which provide financial information about a specific reporting entity. Materiality depends on the nature or magnitude of information or both. An entity assesses whether information, either individually or in combination with other information, is material in the context of its financial statements taken as a whole.Determination of materiality is a matter of professional judgement, and reference needs to be made to the standards and other guidance issued by the ICAI. Financial statements may not be restated for immaterial errors. Financial statements may also be restated due to material reclassification or for common control business combinations, as explained in Appendix C of Ind AS 103, Business Combinations.

The Act does not provide for restatement (except as stated above under Ind AS); it contains specific provisions for revision of the financial statements under sections 130 and 131 of the Act. It is discussed later in the article.

 

RESTATEMENT IN OFFER DOCUMENT UNDER SEBI REGULATIONS

 

The Securities and Exchange Board of India (SEBI) Issue of Capital and Disclosure Requirements (ICDR) Regulations, 2018 (as amended from time to time) is the regulatory framework which governs the various aspects of public issues, including IPO. It lays down a set of guidelines relating to conditions for various kinds of capital issues. In terms of the SEBI (ICDR) Regulations, 2018, the company is required to submit a Draft Red Herring Prospectus (DRHP or Offer letter). One of the important processes involved in this activity is the preparation of restated financial statements. An issuer company is required to prepare the restated consolidated financial information in accordance with Schedule III to the Companies Act, 2013 for a period of three financial years and a stub (interim) period (if applicable) in tabular format. The restated consolidated financial information should be based on audited financial statements and required to be audited and certified by the statutory auditors who hold a valid certificate issued by the Peer Review Board of the Institute of Chartered Accountants of India.The Regulations also require adjustment of audit modifications/qualifications, which are quantifiable or can be estimated in the restated financial information in the appropriate period. In situations where the qualification cannot be quantified or estimated, appropriate disclosures should be made in the notes to account for explaining why the qualification cannot be quantified or estimated.

ICAI has issued the Guidance Note on Reports in Company Prospectuses, which provides guidance to the practitioners/auditors in case of engagements which require them to issue their reports on financial information related to the prospectuses for the issue of securities by the companies. As per the aforesaid Guidance note, applicable reports/ certificates should be issued considering the accounting standards (Ind AS or Indian GAAP, as the case may be) used for the preparation of restated financial information.

It is the responsibility of the management to prepare restated financial statements in accordance with Ind AS 8 or to give effect to the common control business combination transaction or where the company is planning for IPO. The auditor is required to evaluate whether the restatement has been done in accordance with the applicable framework and evaluate reporting implications in case of deviation from the framework. The next section deals with the auditor’s responsibilities in case of restatement of the financial statements.

AUDITOR’S RESPONSIBILITIES IN CASE OF RESTATEMENT

SA 710 (Revised) on Comparative Information—Corresponding Figures and Comparative Financial Statements deals with the auditor’s responsibilities regarding comparative information in an audit of financial statements. An auditor expresses an opinion on the current period financial statements and does not refer to the comparative information in the opinion (that is, on the corresponding figures). Typically, financial reporting frameworks in India use the corresponding figures approach for general-purpose financial statements.  EXAMPLES OF PRIOR PERIOD MISSTATEMENTS WOULD INCLUDE

  • Arithmetical error in the calculation of an accounting estimate or valuations.
  • Revenue recognition errors.
  • Incorrect application of an accounting policy, such as inventories carried at NRV instead of lower of cost and NRV.
  • Inadequate or incorrect disclosures required by applicable accounting standards, e.g., incorrect comparatives disclosures for discontinued operations and assets held for sale.
  • Incorrect capitalisation of an expenditure.

 

AUDITOR’S CONSIDERATIONS — KEY PROCEDURES IN CASE OF PRIOR PERIOD MISSTATEMENT

The auditor is required to check compliance with the applicable financial reporting framework, i.e., whether the financial statements include the comparative information required by the applicable financial reporting framework (e.g., comply with requirements of Schedule III of the Companies Act, 2013) and whether such information is appropriately classified. Auditor to evaluate whether the comparative information agrees with the amounts and other disclosures presented in the prior period; and whether the accounting policies reflected in the comparative information are consistent with those applied in the current period or, if there have been changes in accounting policies, whether those changes have been properly accounted for and adequately presented and disclosed.If the auditor becomes aware of a possible material misstatement in the comparative information while performing the current period audit, the auditor is required to perform additional audit procedures as are necessary in the circumstances to obtain sufficient appropriate audit evidence to determine whether a material misstatement exists. If the auditor had audited the prior period’s financial statements, the auditor is required to follow the relevant requirements of SA 560, Subsequent events. For example, if the matter is such that had it been known to the auditor at the date of the auditor’s report, may have caused the auditor to amend the auditor’s report, the auditor will be required to discuss the matter with management and, where appropriate, those charged with governance; determine whether the financial statements need amendment and, if so, inquire how management intends to address the matter in the Financial Statements.

If the management amends the financial statements, the auditor will be required to either issue a new or revised auditor’s report as per SA 560. If management does not take the necessary steps and does not amend the financial statements in circumstances where the auditor believes they need to be amended, the auditor is required to notify management/ those charged with governance, that the auditor will seek to prevent future reliance on the auditor’s report. If, despite such notification, management or those charged with governance do not take these necessary steps, the auditor will be required to take appropriate action to seek to prevent reliance on the auditor’s report.

AUDITOR’S REPORTING

Modified opinion issued for the prior period:

If the auditor’s report on the prior period, as previously issued, included a qualified opinion, a disclaimer of opinion, or an adverse opinion and the matter which gave rise to the modification is unresolved, the auditor will be required to modify the auditor’s opinion on the current period’s financial statements.The following is an illustration of qualified reporting wherein the auditor refers to both the current period’s figures and the corresponding figures3:

“Because we were appointed auditors of the Company during 20XX, we were not able to observe the counting of the physical inventories at the beginning of that period or satisfy ourselves concerning those inventory quantities by alternative means. Since opening inventories affect the determination of the results of operations, we were unable to determine whether adjustments to the results of operations and opening retained earnings might be necessary for 20XX. Our audit opinion on the financial statements for the year ended 31 March, 20XX was modified accordingly. Our opinion on the current period’s financial statements is also modified because of the possible effect of this matter on the comparability of the current period’s figures and the corresponding figures.”

However, if the matter which gave rise to the modified opinion is resolved and properly accounted for or disclosed in the financial statements in accordance with the applicable financial reporting framework, the auditor’s opinion on the current period need not refer to the previous modification.

UNMODIFIED OPINION ISSUED FOR THE PRIOR PERIOD

If the auditor obtains audit evidence that a material misstatement exists in the prior period financial statements on which an unmodified opinion has been previously issued, the auditor shall verify whether the misstatement has been dealt with as required under the applicable financial reporting framework. For example, non-compliance with ‘material’ presentation or disclosure requirements in Schedule III in the previous year may require a restatement of financial statements of the current year as required by Ind AS 8 with adequate disclosures. This will require professional judgement.

3   Refer Illustration 2, SA 710 – Corresponding figures..

When the prior period financial statements that are misstated have not been amended, and an auditor’s report thereon has not been issued in accordance with the requirements of SA 560, “Subsequent Events”, but the corresponding figures have been properly dealt with as required under the applicable financial reporting framework and the appropriate disclosures have been made in the current period financial statements, SA 710 states that the auditor’s report may include an Emphasis of Matter paragraph describing the circumstances and referring to, where relevant, disclosures that fully describe the matter that can be found in the financial statements (refer SA 706).

However, if that is not the case, the auditor shall express a qualified opinion or an adverse opinion in the auditor’s report on the current period’s financial statements, modified with respect to the corresponding figures included therein.

ILLUSTRATIVE EXAMPLES — EMPHASIS OF MATTER PARAGRAPH FOR RESTATEMENT

“We draw attention to Note 3 to the consolidated financial results, which describe the impact of the restatements related to the non-recognition of deferred tax liabilities on the revaluation of certain property, plant and equipment and the reclassification of the amount of freight recovered from customers disclosed under ‘Other Expenses’ to ‘Revenue from Operations’. Our opinion is not modified in respect of this matter.”“We draw attention to Note 4, more fully described therein, of the Statement regarding certain errors in the consolidated financial information of the previous year/earlier years which have been rectified during the current year by way of restatement of the comparative financial information in respect of deferred tax liability on business combination, performance incentive and recognition of right of use assets. Our opinion is not modified in respect of this matter.”

COMMUNICATION WITH THE PREDECESSOR AUDITOR

The occurrence of a restatement implies not only that an irregularity or error has occurred earlier but also that it was detected in the current year. SA 710 requires that if the auditor concludes that a material misstatement exists that affects the prior period financial statements on which the predecessor auditor had previously reported without modification, the auditor shall communicate the misstatement with the appropriate level of management and those charged with governance and request that the predecessor auditor be informed. The board of directors are certainly responsible for overseeing the audit and adequacy of internal controls. The audit committee should be informed in all such cases and necessary action to be taken by the company.

 AUDIT CONSIDERATIONS WITH RESPECT TO THE RESTATEMENT OF COMPARATIVE INFORMATION DUE TO COMMON CONTROL BUSINESS COMBINATIONS

Where the comparative information has been restated pursuant to a common control business combination, the auditor needs to evaluate whether such business combination is in accordance with generally accepted accounting principles, including Ind AS 103.However, if the common control business combination is not accounted for as per the applicable accounting standard but accounted for in accordance with the Scheme approved by Court/NCLT, the auditor is required to verify that the financial statements adequately disclose such fact, e.g., Schedule III/ section 129(5) to the Companies Act, 2013 prescribes certain disclosures if the financial statements do not comply with the accounting standards. Where necessary disclosures have been made, an  Emphasis of Matter4 may be included in the audit report of the current year to describe the resultant deviation in sufficient detail.

ILLUSTRATIVE EXAMPLES OF RESTATEMENT — IND AS 103

“Note XX to the accompanying Statement, which describes the restatement of comparative previous periods presented in the Statement by A Ltd.’s management pursuant to the Composite Scheme of Arrangement and Amalgamation, approved by National Company Law Tribunal. A Ltd. has given accounting effect to these schemes from 31 March 20XX (closing business hours), being the appointed date of the said schemes as prescribed under Ind AS 103 Business Combinations, since the scheme of the merger will prevail over the applicable accounting requirements. Our opinion is not modified in respect of the above matter.”

4   Paragraph A4 of SA 706 and FAQ 29 of Implementation Guide on Reporting Standards issued by ICAI.

 

 REVISION OF FINANCIAL STATEMENTS

 

Section 131 of the Companies Act, 2013 deals with the provisions for the voluntary revision of Financial Statements and Board Report in certain circumstances. The directors of any company can opt to revise its financial statements and/or directors’ report after obtaining approval of the Tribunal when such financial statements and/or directors’ report are not in compliance with specified provisions of the Act. For example, in case of fraud or mismanagement, re-opening or recasting of financial statements becomes important for reflecting a true and fair view of the accounts. This section was introduced after the occurrence of the Satyam case in India, where recasting of accounts was mandated. One may argue that retrospective restatement of comparative amounts for the prior periods presented on account of prior period errors does not tantamount to revision of financial statements and, consequently, does not attract the provisions of section 131 of the Act. However, this is a legal matter.

BOTTOM LINE

Auditors play an important role in enhancing the stakeholder’s confidence in financial statements, and therefore, it is imperative that the auditor complies with the mandatory requirements while dealing with the restatement of financial statements. Material restatements often go together with material weakness in internal controls over financial reporting, and auditors should consider this aspect while opining on the financial statements. In rare cases, a financial restatement also can be a sign of fraud, e.g., intentional error. Such restatements may signal problems that require corrective actions.

Watchdog – Whether Placed Under Statutory Watch!!

INTRODUCTION

 

In the course of their professional duties, chartered accountants, company secretaries and cost accountants are governed by the professional norms laid down in the relevant statutes overseeing their conduct. Thus, chartered accountants are governed by Chartered Accountants Act, 1949. Similarly, company secretaries are governed by Company Secretaries Act, 1980. The cost accountants are governed by Cost and Works Accountants Act, 1959.

 

Whenever these professionals are questioned as regards their professional conduct, the disciplinary forum adjudicates on their conduct in terms of the disciplinary mechanism laid down under the respective statutes mentioned above.

 

In several court matters, the professional against whom there was a charge of gross professional misconduct punishable under the statute governing him, there was always a convenient defence explored by the professional.

 

Often, the principles decided by English Judiciary came to the rescue of the professional and saved him from punishment. Thus, in respect of the charge of professional misconduct by a chartered accountant in respect of the gross negligence in his professional work relating to the audit of accounts of a business, defence was based on the age-old golden tenet “the auditor is not a bloodhound; he is merely a watchdog”.

 

Despite being equipped with such a golden defence tenet emerging from English Judiciary, chartered accountants have been punished in many cases for gross negligence in their professional duties. This is done by invoking the disciplinary mechanism provided under the Chartered Accountants Act and related regulations.

 

With the evolution of technology, increasing volume of commerce, and business and cross-border transactions, chartered accountants have come to assume greater responsibilities. As auditors, they are also expected to report on the business enterprise’s non-compliance with a host of other laws applicable to complex business transactions.

 

Two recent amendments made by the Central Government in the Prevention of Money Laundering Act (PMLA) appear to have stirred up a hornets’ nest and have caused anxiety to chartered accountants. A reading of the amendments notified under PMLA appears to give the impression that the watchdog – now, is placed under statutory watch!! Whether such an impression is correct is the subject matter examined in this article.

 

RECENT PMLA AMENDMENTS – PARAMETERS, NEED AND IMPLICATIONS

 

Amendments have been made in PMLA by two notifications, one dated 3rd May, 2023 and the second dated 9th May, 2023 issued by the Central Government in the exercise of its powers under section 2(1)(sa)(vi) of PMLA. Section 2(1)(sa) defines “person carrying on designated business or profession”. Under the residuary clause (vi) of section 2(1)(sa), the Central Government has the power to include further categories in the definition of a person carrying on designated activities.

 

In oral discussions, many chartered accountants have apprehended frightful consequences of these two amendments. Hence, it is necessary to analyse the parameters and implications of these amendments, as follows.

 

PARAMETERS OF THE AMENDMENTS

 

In terms of the notification dated 3 May 2023, the financial transactions carried out by a practicing chartered accountant, a practising company secretary or a practising cost accountant which are carried out on behalf of his client in the course of his profession in relation to the following activities are now regarded as an activity for the purpose of section 2(1)(sa).

 

  • buying and selling of immovable property;
  • managing money, securities or other assets of client;
  • management of bank, savings or securities accounts;
  • organisation of contributions for creation, operation or management of companies;
  • creation, operation or management of companies, limited liability partnerships or trusts, and buying and selling of business entities.

 

By another notification dated 9th May, 2023 issued by the Central Government, the following activities have been notified as an activity for the purpose of sub-clause (vi) when carried out by a person in the course of his business on behalf of or for another person.

 

  • acting as a formation agent of companies and limited liability partnerships;
  • acting as (or arranging for another person to act as) a director or secretary of a company, a partner of a firm or a similar position in relation to other companies and limited liability partnerships;
  • providing a registered office, business address or accommodation, correspondence or administrative address for a company or a limited liability partnership or a trust;
  • acting as (or arranging for another person to act as) a trustee of an express trust or performing the equivalent function for another type of trust;
  • acting as (or arranging for another person to act as) a nominee shareholder for another person.

 

It has been clarified in the said notification that following four activities are not to be regarded as an activity for the purposes of sub-clause (vi).

 

(i)    any activity carried out as part of any agreement of lease, sub-lease, tenancy or any other agreement or arrangement for the use of land or building or any space and the consideration is subjected to deduction of income-tax under section 194-I of Income-tax Act, 1961; or
(ii)    any activity carried out by an employee on behalf of his employer in the course of or in relation to his employment; or
(iii)    any activity carried out by an advocate, a chartered accountant, cost accountant or company secretary in practice, who is engaged in formation of a company to the extent of filing a declaration required under section 7(1)(b) of Companies Act, 2013 [to the effect that all requirements of Companies Act and the rules made thereunder in respect of registration and matters precedent and incidental thereto have been complied with]; or
(iv)    any activity of a person which falls within the meaning of an ‘intermediary’ as defined in section 2(1)(n) of PMLA. Section 2(1)(n) defines “intermediary” to mean –
(a)    a stock-broker, share transfer agent, banker to an issue, trustee to a trust deed, registrar to an issue, merchant banker, underwriter, portfolio manager, investment adviser or any other intermediary associated with securities market and registered under section 12 of the Securities and Exchange Board of India Act, 1992; or
(b)    an association recognised or registered under the Forward Contracts (Regulation) Act, 1952 or any member of such association; or
(c)    intermediary registered by the Pension Fund Regulatory and Development Authority; or
(d)    a recognised stock exchange referred to in section 2(f) of the Securities Contracts (Regulation) Act, 1956.

 

NEED FOR THE AMENDMENTS

 

The immediate need for the two amendments was reportedly dictated by the pending assessment of the Financial Action Task Force (FATF) which is due in November 2023. India was last assessed by FATF in 2010. After 2010, the next FATF assessment was postponed due to the Covid pandemic. As a pre-cursor to such mandatory assessment, the government appears to have amended the money-laundering rules to widen the scope of reporting obligations of persons carrying on designated business or profession.

 

IMPLICATIONS OF THE AMENDMENTS

 

On a review of the aforementioned two notifications, the following implications are perceived.

 

A “Reporting Entity”

 

In terms of section 2(1)(wa) of PMLA, a person carrying on a designated business or profession is also regarded as a reporting entity.

 

Like any other reporting entity, a person carrying on a designated business or profession is also required to comply with the following obligations prescribed under the specified sections. Thus, if notification dated 3 May 2023 is held applicable to a chartered accountant in practice, he will also be required to comply with the following obligations.

 

Section Obligation
11A Verify identity of clients and
beneficial owners
12 Maintain a record of all transactions
and specified information
12A Furnish the information required by
Director of Enforcement
12AA Verify clients undertaking specified
transaction, examine ownership, financial position and sources of funds of
clients, record the purpose behind conducting specified transaction and the
intended nature of the relationship between the transaction parties.

 

B Applicability of both notifications to chartered accountants

 

From the preamble to the notification dated 3 May 2023, it is clear that a chartered accountant in practice is covered by that notification. Accordingly, he is regarded as a person carrying on designated business or profession in respect of the financial transactions carried out on behalf of his client in relation to the five activities specified in the said notification.

 

Preamble to the notification dated 9 May 2023 shows, however, that the said notification does not apply to a chartered accountant in practice. Accordingly, five activities specified in this second notification dated 9 May 2023 do not refer to any activity carried out by a chartered accountant in practice. This difference between the two notifications, one dated 3 May 2023 referring to the chartered accountant in practice and the second notification dated 9 May 2023 not referring to a chartered accountant in practice, is evident from the following.

 

(i)    The preamble to the notification dated 9 May 2023 refers to five activities “when carried out in the course of “business” on behalf of or for another person”.

 

In contrast, the preamble to the notification dated 3 May 2023 specifically refers to a chartered accountant in practice as one of the “relevant person”.

 

(ii)    Notification dated 3 May 2023 refers to certain financial transactions carried out by chartered accountant in practice “on behalf of his client in the course of his profession”.

 

So, unless the specified transaction is carried out by a chartered accountant in practice on behalf of his client, the notification would not be applicable to him.

 

In contrast, the second notification dated 9 May 2023 refers to certain specified activities “when carried out in the course of business”.

 

The dichotomy between the term “profession” in the notification dated 3 May 2023 and the term “business” in the second notification dated 9 May 2023 clearly indicates that while the first notification dated 3 May 2023 may be applied to a chartered accountant in practice in respect of specified transactions carried out by him on behalf of his client, the second notification dated 9 May 2023 cannot be applied to a chartered accountant in practice.

 

(iii)    Moreover, in the notification dated 9 May 2023 itself, a clear exception has been made for any activity carried out by a chartered accountant in practice who is engaged in the formation of a company to the extent of filing a declaration required by section 7(1)(b) of Companies Act, 2013.

 

A view may be expressed that the said exception is limited in nature and, therefore, the other activities falling outside such exception, carried out by a chartered accountant in practice are not covered by the exception.

 

This argument would not hold water because, as explained earlier, the second notification does not apply to a chartered accountant in practice. The exception made in favour of a chartered accountant in practice in the second notification dated 9 May 2023 only reaffirms the Government’s intention to exclude a chartered accountant in practice from the purview of the second notification dated 9 May 2023.

 

(iv)    As long as the chartered accountant in practice does not act on behalf of his client, he would be any way out of the purview of the notification since the words “on behalf of his client” are in the nature of a pre-condition for invoking the notification dated 3 May 2023.

 

(v)    It may be noted that assuming in a given case, amended law is held applicable, still the same would not attract penal provision under PMLA since in such case, there is no scheduled offence or the offence of money-laundering punishable under PMLA.

 

C Ambiguities

 

Certain terms and expressions used in the second notification dated 9 May 2023 are ambiguous and hence, likely to lead to controversy in their interpretation.

 

Thus, the meaning of the term “formation agent” is not clear. Accordingly, it is not clear whether consultants who assist the company in incorporation would be subject to the reporting obligations under PMLA. The expression “arranging for another person to act as” a director, partner, nominee, etc., is also not clear. It is not clear how to establish who arranges for whom.

 

While the nominee shareholding is very common, nominees could create significant obligations. Even advising clients for coordinating with directors or nominees could be covered by the amendment even though there is no formal written arrangement for such assistance. This could lead to controversies and litigation.

 

Having regard to the subjectivity and ambiguities involved in the wording, it would be worthwhile that appropriate guidance from the governing bodies is issued in consultation with the government. The same would help in monitoring illegitimate structures.

 

D Increase in the burden of professional work

 

The objective of the recent amendments in PMLA appears to be to ensure wider accountability by professionals concerned with transactions involving the proceeds of crimes.

 

The burden is now on professionals to ensure that their services are not used for suspect transactions. Indeed, the amendments would apply only to those professionals who undertake specified activities on behalf of their clients.

 

The purpose of enhanced scrutiny is to ensure that illegitimate transactions do not escape scrutiny.

 

However, when professionals have carried out the specified transactions on behalf of clients, they would be saddled with due diligence measures to verify the identities of their clients and beneficial owners as well as sources of funds. Records will also have to be maintained for a longer period. The increase in the cost of such compliances would be burdensome for small and medium-sized chartered accountants.

 

Persons acting as or arranging for another person to act as a director or secretary of a company or partner of LLP, providing a business or registered office address for a company or an LLP or a trust would also be liable under the PMLA as reporting entities. Here, too, as long as the same is not done on behalf of or for another person there should be no cause for anxiety.

 

The initial reading of the notification shows that the new regulations would trigger multiple new compliances for professionals as reporting entities, such as, monthly reports to FIU-IND, KYC of clients with the Central KYC Registry. It may be meaningful that guidance is issued by Government or the ICAI, ICSI to impart clarity on any exceptions or relaxations for professionals.

 

CONCLUSION

 

The amendments in PMLA were long called for to meet the challenges posed by various forms of money laundering and funding of terrorist activities. For this purpose, it was decided to extend the scope of reporting requirements under PMLA to the persons engaged in financial transactions and specified activities for and on behalf of others.

 

Indeed, the scope of applying the amendments to chartered accountants in practice appears to be limited and is confined only to transactions carried out on behalf of clients.

 

Accordingly, in other cases, the watchdog, though apparently placed under statutory watch, should have no reason to worry as the nature and extent of due diligence required to be exercised by him in such other cases would not undergo any change even after the two recent amendments in PMLA.

Applicability of Deferred Provisions in The Icai Code of Ethics- Fees, Tax Services, and Non-Compliance of Laws and Regulations

INTRODUCTION

The 12th edition of the ICAI Code of Ethics, effective from July 1, 2020, is divided into three volumes. However, certain provisions in Volume-I were deferred due to the prevailing situation caused by Covid-19. The Institute of Chartered Accountants of India (ICAI) decided to make these deferred provisions applicable from October 1, 2022, with certain amendments. This article discusses provisions of Fees-relative size, Tax Services to Audit Clients, and Responding to Non-Compliance of Laws and Regulations (NOCLAR) applicable to members in practice and service.

1.  Fees – Relative Size-

The provisions regarding fees and relative size in the Code of Ethics aim to address threats to independence that may arise when the total fees received by a firm from an audit client represent a significant proportion of the firm’s total fees. This situation can create self-interest or intimidation threats, which may compromise the professional accountant’s judgment and behaviour.

Self-interest threat refers to the risk that external factors, such as financial interests or incentives, could unduly influence the professional accountant’s objectivity and judgment. Intimidation threat, on the other hand, arises when there are perceived pressures or attempts to exert undue influence, leading the accountant to act in a biased manner.

These threats also emerge when the fees generated by an audit client represent a substantial portion of the revenue for a particular partner or office within the firm. To mitigate such threats, one example of a safeguard is to diversify the client base of the firm, reducing dependence on a single audit client.

The purpose of these provisions is to offer guidance on implementing safeguards to mitigate threats that arise in these circumstances and protect the independence of auditors. To ensure transparency and accountability, the Code requires disclosure to the Institute under specific circumstances.

If an audit client is not a public interest entity, and for two consecutive years, the total fees received by the firm and its related entities from that client represent more than 40% of the firm’s total fees, the firm must disclose this fact to the Institute. For audit clients classified as public interest entities, the disclosure threshold is set at more than 20% of the firm’s total fees.

However, there are exceptions to this provision. If the total fees of the firm, including fees received through other firms in which the member or firm is a partner or proprietor, do not exceed twenty lakhs of rupees, this requirement does not apply. This exception is applicable to all audit clients, including public interest entities.

Additionally, another exception exists for the audit of government companies, public undertakings, nationalized banks, public financial institutions, and cases where auditors are appointed by the government or regulators.

It is crucial to note that if the fees continue to exceed the specified thresholds for two consecutive years, the firm must disclose this information to the Institute annually.

Regarding the disclosure to the Institute, the Ethical Standards Board (ESB) will define the reporting framework, including the format and timeline. Members will be required to provide an undertaking or declaration regarding their independence, strengthening their commitment to independence.

ESB will also establish a mechanism to address the disclosure, potentially including mandatory peer reviews or other forms of quality review.

It is also imperative at this moment, to know the meaning of certain terms used herein-

a)    Public Interest Entity (PIE)

  •     The Volume-I of Code of Ethics refers to the term ‘Public Interest Entity’ wherever there is enhanced requirement of Independence.

 

  •     PIE is defined as:

(i)    A listed entity; or

(ii)    An entity:

  •     Defined by regulation or legislation as a public interest entity; or

 

  •     For which the audit is required by regulation or legislation to be conducted in compliance with the same independence requirements that apply to the audit of listed entities. Such regulation might be promulgated by any relevant regulator, including an audit regulator.

 

  •     For the purpose of this definition, it may be noted that Banks and Insurance Companies are to be considered Public Interest Entities.

 

  •     Other entities might also be considered by the Firms to be public interest entities because they have a large number and wide range of stakeholders. Factors to be considered include:

 

  •     The nature of the business, such as the holding of assets in a fiduciary capacity for a large number of stakeholders. Examples might include financial institutions, such as banks and insurance companies, and pension funds.

 

  •     Size.

 

  •     Number of employees.

b)    Audit Client

An audit Client refers to an entity in respect of which a firm conducts an audit engagement. When the client is a listed entity, the audit client will always include its related entities. When the audit client is not a listed entity, the audit client includes those related entities over which the client has direct or indirect control.

Audit engagement refers to a reasonable assurance engagement in which a professional accountant in public practice expresses an opinion whether financial statements are prepared, in all material respects (or give a true and fair view or are presented fairly, in all material respects), in accordance with an applicable financial reporting framework, such as an engagement conducted in accordance with Standards on Auditing. This includes a Statutory Audit, which is an audit required by legislation or other regulation.

c)    Independence

Independence is linked to the principles of objectivity and integrity. It comprises:

(a)    Independence of mind – the state of mind that permits the expression of a conclusion without being affected by influences that compromise professional judgment, thereby allowing an individual to act with integrity, and exercise objectivity and professional skepticism.

(b)    Independence in appearance – the avoidance of facts and circumstances that are so significant that a reasonable and informed third party would be likely to conclude that a firm’s, or an audit team member’s, integrity, objectivity, or professional skepticism has been compromised.

Overall, the provisions on fee-relative size aim to maintain independence by addressing threats that can arise from significant dependence on a particular audit client, ensuring objectivity, integrity, and professional judgment in the auditing profession.

2.    Responding to Non-Compliance with Laws and Regulations (NOCLAR) –

The Non-Compliance with Laws and Regulations (NOCLAR) is a set of guidelines introduced for professional accountants to help them respond appropriately in situations where their clients or employers have committed acts of omission or commission contrary to prevailing laws or regulations. It is the ethical responsibility of the accountant to not turn a blind eye to such matters and serve the public interest in these circumstances. Examples of laws and regulations which this section addresses include those that deal with:

  •     Fraud, corruption and bribery.

 

  •     Money laundering, terrorist financing and proceeds of crime.

 

  •     Securities markets and trading.

 

  •     Banking and other financial products and services.

 

  •     Data protection.

 

  •     Tax and pension liabilities and payments.

 

  •     Environmental protection.

 

  •     Public health and safety.

It may however be noted that the above list is not exhaustive and is only illustrative. It is important to note that the accountant is not expected to have a level of knowledge of laws and regulations greater than that which is required to undertake the engagement.

For Professional Accountants in Service (Section 260):

NOCLAR is applicable to senior professional accountants in service who are employees of listed entities. These refer to Key Managerial Personnel and are directors, officers or senior employees who can exert significant influence over the acquisition, deployment, and control of the employing organization’s resources. Such individuals are expected to take actions in the public interest to respond to non-compliance or suspected non-compliance because of their roles, positions, and spheres of influence within the employing organization.

The professional accountant is expected to obtain an understanding of the matter if he becomes aware of non-compliance or suspected non-compliance. This includes understanding the nature of the non-compliance or suspected non-compliance, the circumstances in which it has occurred or might occur, the application of relevant laws and regulations, and the assessment of potential consequences to the employing organization, investors, creditors, employees, or the wider public.

Depending on the nature and significance of the matter, the accountant might cause, or take appropriate steps to cause, the matter to be investigated internally. The accountant might also consult on a confidential basis with others within the employing organization or Institute, or with legal counsel. If the accountant identifies or suspects that non-compliance has occurred or might occur, he shall discuss the matter with his immediate superior and take appropriate steps to have the matter communicated to those charged with governance, comply with applicable laws and regulations, rectify, remediate or mitigate the consequences of the non-compliance, reduce the risk of re-occurrence, and seek to deter the commission of the non-compliance if it has not yet occurred.

The accountant shall determine whether disclosure of the matter to the employing organization’s external auditor, if any, is needed. He shall assess the appropriateness of the response of his superiors, if any, and those charged with governance, and determine if further action is needed in the public interest. The accountant shall exercise professional judgment in determining the need for, and nature and extent of, further action, considering whether a reasonable and informed third party would conclude that the accountant has acted appropriately in the public interest.

NOCLAR does not address personal misconduct unrelated to the business activities of the employing organization or non-compliance by parties other than those specified in paragraph 260.5 A1. Nevertheless, the professional accountant might find the guidance in this section helpful in considering how to respond in these situations. In relation to non-compliance that falls within the scope of this section, the professional accountant is encouraged to document the matter, the results of discussions with superiors and those charged with governance and other parties, how the superiors and those charged with governance responded to the matter, the courses of action considered, the judgments made, and the decisions taken. The accountant must be satisfied that he has fulfilled his responsibility.

For Professional Accountants in Practice (Section 360):

NOCLAR is applicable to Professional Accountants in public practice if he/she might encounter or be made aware of non-compliance or suspected non-compliance during Audit engagements of entities the shares of which are listed on a recognised stock exchange(s) in India and have a net worth of 250 crores of rupees or more. For this purpose, “Audit” or “Audit engagement” shall mean a reasonable assurance engagement in which a professional accountant in public practice expresses an opinion whether financial statements give a true and fair view in accordance with an applicable financial reporting framework”.The applicability of Section 360 will subsequently be extended to all listed entities, at the date to be notified later.

Professional Accountant when encountering or becoming aware of NOCLAR is required to assess the laws and regulations that generally have a financial impact as well as laws and regulations that are related to the operations of the Audit client. Some laws and regulations in this category may be fundamental to the operations of all or virtually all entities even if they do not have a direct effect on the determination of material amounts and disclosures in the entities’ financial statements. Examples include laws against fraud, corruption, and bribery. PAs are expected to recognize and respond to NOCLAR or suspected NOCLAR in relation to those laws and regulations if they became aware of it.

Other laws and regulations in this category might be relevant to only certain types of entities because of the nature of their business. Examples include environmental protection regulations for an entity operating in the mining industry, regulatory capital requirements for a bank, laws and regulations against money laundering, and terrorist financing for a financial institution etc. PAs who provide professional services that require an understanding of those laws and regulations to an extent sufficient to competently perform the engagements are expected to be able to recognize NOCLAR or suspected NOCLAR in relation to those laws and regulations and respond to the matter accordingly.

A professional Accountant is only expected under the Code to have a level of knowledge of laws and regulations necessary for the professional service for which he was engaged. When he/she might encounter or be made aware of non-compliance or suspected non-compliance during the course of Audit Engagements, he/she shall obtain an understanding of the matter of legal or regulatory provisions governing such non-compliance or suspected non-compliance (nature of the act and the circumstance) and discuss with management, may seek views of the legal counsel. The professional accountant shall advise the management/ those charged with governance to take timely action (rectify, remediate, mitigate, deter, disclose)

If the professional accountant becomes aware of non-compliance or suspected non-compliance in relation to a component of a group, he/she shall communicate the matter to the group engagement partner unless prohibited from doing so by law or regulation. The accountant shall assess the appropriateness of the response of management and, where applicable, those charged with governance (timely response, appropriate steps taken by the entity, etc. consider withdrawing from engagement) and determine whether to disclose the matter to the appropriate authority if there is a legal requirement for the same.

The professional accountants shall document the matter, the result of the discussion with management or those charged with governance, and the action taken.

3. Tax Services to Audit Clients-

Sub Section 604 of Volume-I of the Code of Ethics outlines the guidelines and considerations for auditors regarding various tax services provided to audit clients. The section highlights potential threats that may arise during the provision of these services and emphasizes the importance of adopting appropriate safeguards to ensure independence and objectivity.The tax services generally include-

a) Tax Return Preparation-

Tax return preparation is generally considered a low-risk job, as it involves the analysis and presentation of historical information under existing tax laws. Additionally, tax returns undergo review and approval processes by relevant tax authorities. As such, the provision of tax return preparation services to audit clients is typically not a significant threat to auditors’ independence.

b) Tax Calculations for Accounting Entries-

The preparation of tax calculations for the purpose of accounting entries poses a self-review threat. To mitigate this threat, auditors may use professionals who are not part of the audit team and ensure the presence of an appropriate reviewer. It is important to note that auditors should not prepare tax calculations for current and deferred tax liabilities/assets that are material to the financial statements on which the firm will express an opinion. However, they may review the tax calculations prepared by the client.

c) Tax Planning and Other Tax Advisory Services-

Tax planning and other tax advisory services might create self-review or advocacy threats. To address these threats, auditors may engage professionals who are not members of the audit team and have an appropriate reviewer, independent of the service, review the audit work. Furthermore, auditors must refrain from providing tax planning and other tax advisory services when the effectiveness of such advice relies on a particular accounting treatment or presentation in the financial statements that will materially impact the audited financial statements.

d) Tax Services Involving Valuations-

Engaging in tax services involving valuations can introduce self-review or advocacy threats. Appropriate safeguards may be implemented, such as involving professionals who are not part of the audit team and having an independent reviewer who is not involved in providing the service. If a tax valuation is performed to assist an audit client with tax reporting obligations or for tax planning purposes, and the valuation’s outcome directly affects the financial statements, the requirements and application material stated in Subsection 603 of the Code of Ethics related to valuation services should be followed.

e) Assistance in the Resolution of Tax Disputes-

Assisting in the resolution of tax disputes may create self-review or advocacy threats. In such cases, auditors may adopt appropriate safeguards. However, auditors must refrain from acting as advocates for the audit client before a court or providing assistance, if the amounts involved are material to the financial statements on which the firm will express an opinion. It’s worth noting that, for the purposes of this subsection, “Court” excludes a Tribunal.

Thus, the three provisions of Volume-I of the Code of Ethics which were newly introduced and were deferred from 1.7.2020 till 1.10.2022 due to the situation prevailing due to covid-19 and also to make members aware of the provisions for better adoption and implementation are now applicable, with certain modifications, and these are obligatory upon members to comply with. The provisions of NOCLAR guide the accountant in assessing the implications of the non-compliance and the possible courses of action when responding to non-compliance or suspected non-compliance. The provisions outlined in Sub Section 604 of Volume-I of the Code of Ethics are crucial for auditors providing tax services to audit clients. By recognizing potential threats and implementing appropriate safeguards, auditors can maintain their independence, objectivity, and ethical integrity while providing tax-related services. These guidelines aim to uphold professional standards and ensure the reliability of audit opinions on financial statements.

Likewise, the provisions of Fees Relative size are significant in addressing self-interest and intimidation threats resulting from continued over-reliance on one Audit client for fees.

It may also be relevant to note that the Volume-I of the Code of Ethics has been issued as a guideline of the Council. The non-compliance with the guidelines will be deemed as professional misconduct in line with the provisions of the Chartered Accountants Act, 1949. The Code contains requirements and application material to enable professional accountants to meet their responsibility to act in the public interest. The requirements of the sections of the Code establish general and specific obligations on the professional accountants to comply with the specific provision in which “shall” has been used. The Requirements are designated with the letter “R” in the Code. Professional accountants require to comply with the requirements of the Code.

Audit Documentation – The Evidence Of Audit

There is an old saying in Hindi, that reflects the importance of documentation 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.

The relevance of documentation is so high for the auditors, that it is usually said that the work not documented is not done. The audit documentation acts as evidence for the auditor to demonstrate that the audit was performed in accordance with the provisions of the Companies Act, Standard on Auditing, and various other guidelines issued by the Institute of Chartered Accountants of India (ICAI), from time to time.

However, in the current complex environment, performing audit procedures and documenting them is not an easy task to perform. The audit team is now expected to be more vigilant and require to apply a greater degree of professional skepticism while planning and performing the nature, timing, and extent of audit procedures, and as such the expectation of high-quality audit documentation has also increased to a greater extent.

Per the Standard on Auditing, the audit documentation is not limited only to the extent of documenting the verification of samples that are selected by the auditors, but it is also requires to include the evaluation and conclusion of all the possible factors that can have an implication on the financial caption. The audit documentation is expected to be so comprehensive that it should be self-explanatory to the reviewer.

Keeping in view the increasing relevance of audit documentation and the inadequacies in audit documentation highlighted by the regulators, ICAI has issued an Implementation Guide to Standard on Auditing 230, Audit Documentation, in December 2022, wherein the ICAI has provided guidance on the various frequently asked questions with respect to the audit documentation.

The objective of this article is also to highlight certain documentation aspects for the critical areas of audit that can assist the auditors in ensuring robust audit documentation and avoid common review findings from the regulators to a certain extent.

INDEPENDENCE, CLIENT AND ENGAGEMENT EVALUATION

The independence of audit firm is one of the initial steps that the audit firms need to ensure before accepting the appointment as a statutory auditor of a company. An audit firm is required to assess and document, how it has ensured independence with reference to the proposed audit client, in accordance with the requirements of the Code of Ethics issued by the Institute of Chartered Accountants of India (ICAI), and the relevant provisions of the Companies Act.As part of its documentation, the audit firm should maintain independence declarations from all of its employees and also the independence evaluations and their conclusions with a date and time stamp, with respect to its existing and prospective audit engagements, to demonstrate that all the compliances were done in a timely manner.

Similarly, the client and engagement evaluation should also be documented keeping in mind the requirements of SQC 1, which should be able to demonstrate the assessment of whether accepting a new client or an engagement from a new or an existing client may give rise to an actual or perceived conflict of interest, and where a potential conflict is identified, evaluation of whether it is appropriate to accept the client and the engagement.

The documentation for the above evaluations should be maintained by the audit firm, with a date and time stamp to demonstrate that they are performed in a timely manner.

AUDIT PLANNING

Audit planning is a comprehensive process and requires the audit team to exercise significant professional judgment to determine the nature, timing and extent of audit procedures required to complete the audit, and as such it is critical that these professional judgments are adequately documented.For instance, the determination of audit materiality is one of the most important steps in audit planning that require significant professional judgement, and as such it is imperative that its documentation is robust. The audit team should ensure that a detailed analysis for all the critical aspects of determination of audit materiality like the selection of appropriate benchmark, the percentage used for performance materiality, materiality levels for particular classes of transactions, account balances, and disclosures, etc. are adequately documented in the audit file.

Similarly, detailed documentation demonstrating all the critical aspects of audit planning like, audit procedures to address the client and engagement risks identified during client and engagement evaluations and previous financial statements, selection of account and related assertions, areas of significant management estimates, timing and extent of audit procedures, team size, work allocation, audit timelines, etc. should also be maintained in the audit file, as part of audit planning.

The above documentation should also contain the evidences of review by significant engagement partner, evidences for consultation from audit partners who audit clients in the similar industry, and the quality control partner, if any.

SIGNIFICANT AUDIT RISK AREAS

As part of audit planning and at the time of audit execution, audit team usually identify audit risk areas that are significant to audit. The audit team should ensure that while they document an audit area as significant audit risk in the audit file, they should also document the rational for identifying it as significant risk, the related assertions that are subject to risk and the audit procedures designed and performed to address the risk of related assertions, adequately. For example, if the revenue is identified as significant audit risk area, the audit team should document the factors that has resulted its identification as significant audit risk, the type of risk i.e., if it’s a fraud risk, financial statement level risk or assertion level risk, the audit procedures designed and performed to address the risk, i.e. if Completeness is identified as the assertion that is subject to risk, audit procedures that are performed to address the completeness should be documented, the conclusion of audit procedures performed and if there are any adverse findings, its implications on the financial statements and the audit report.The audit team should also ensure that there is sufficient evidence in the audit file that demonstrates the timely preparation and review of audit documentation at various levels. For example, in case the auditor is using any software to maintain the audit documentation, there should be a functionality to demonstrate the preparer and reviewer signoffs along with name, date and designation. In the case of physical files, it should be physically signed by the preparer and reviewer along with name, date, and designation.

SUBSTANTIVE AUDIT PROCEDURES

The documentation of test of details usually includes the details of the samples and the relevant parameters tested; however, the documentation should also include details like, procedures performed to ensure the completeness and accuracy of the information provided by the client from which samples are selected, sample selection methodology, the audit assertions that are getting addressed with the audit procedure, compliance of applicable Standard on Auditing, for example, SA 620 ‘Using the work of an expert, and related Accounting Standard, for example, Ind AS 19 / AS 15 on employee benefits, date and name of the preparer and reviewer of the audit work paper, testing conclusion, and implications on the financial statements and the audit report in case there are exceptions identified.Similarly, in the case of substantive analytical procedures, the documentation should clearly state the source of input data, the expectation the audit team is trying to build and the range of acceptable variation.

INVOLVEMENT OF SUBJECT MATTER EXPERTS (SMEs)

Audit clients and audit teams often involve SMEs like actuaries, legal counsels, tax experts, valuers, etc. to quantify and obtain comfort on the management judgment of various estimates and disclosures made in the financial statements, such as valuation of financial assets, employment benefits, contingent liabilities, taxes, etc. While documenting the audit procedures performed for these financial captions, the audit team should ensure the documentation and verification of a few of the important aspects related to the involvement of SMEs that includes their competency assessment i.e., if they are professionally qualified to provide the services, their level of experience, their independence declarations for the audit client, etc., audit procedures performed to validate the address and email ids of SMEs where direct confirmations has been obtained, audit procedures performed to validate the methodology and assumptions used by SMEs, minutes of meetings with SMEs, etc.

 

IMPORTANCE OF CHECKLIST

It is often seen that audit teams fill various checklists like Checklists for Accounting Standard, Standards on Auditing, Schedule III, Companies Act, etc. These checklists are filled in with the objective to ensure, that all the applicable compliances have been audited and documented by the audit team. However, these are usually long checklists that flow in hundreds of pages and are often filled near the closure of the audit, when all the required audit procedures are already performed and reviewed. This practice of filling the checklist at the end may not assist the audit team in achieving the desired objective of filling the checklist. It will be more prudent to fill out any such checklist and document it along with their related audit areas. For example, a checklist related to Accounting Standard on investments should be filled and documented along with the related audit documentation, so that both the preparer and the reviewer can identify the gaps in a timely manner. Similarly, checklists related to Standard on auditing that are relevant to independence, engagement formalities, etc., should be filled once they are done and are ready for the reviewer to review.Appending requirements of applicable auditing and accounting standards in the respective workpapers, along with the responses that how they have been complied with will make the documentation watertight and will provide greater comfort to both the preparer and the reviewer.

ICAI has released various such checklists like Indian Accounting Standards (AS) : Disclosures Checklist (Revised November, 2022), Accounting Standards (AS) : Disclosures Checklist (Revised October, 2022), E-Booklet on Sample Checklist on SAs, which should be referred and used by the audit firms.

MAPPING OF AUDIT DOCUMENTATION TO FINANCIAL STATEMENTS

At times it happens that the audit team performs the audit procedures, on all the significant audit areas that were identified for audit but at the time of assembling the audit file some of the documentation is missed to be filed or is missed to be covered in the audit. As a practice, a working paper should be prepared by the audit team wherein all the financial captions that were identified for audit have been referenced to their related audit workpapers along with the location where these workpapers are filed. The workpaper so prepared should be reviewed by the senior audit team members and audit partners before the issuance of the audit opinion, to ensure that all the required audit procedures are performed and related audit workpapers are in the file.

 

AUDIT OPINION

Issuance of the audit report is the final step for the completion of an audit, however, in cases where there are modifications in the audit report it becomes very critical for the auditor to document the factors that resulted into a modified opinion and an assessment concluding the basis of modification i.e., qualified opinion, adverse opinion, or a disclaimer of opinion.While preparing the above documentation the audit team should ensure that all the adjusted and unadjusted audit differences as identified during the audit, and as documented in the respective work papers are summarized adequately, and an assessment has been performed and documented assessing the implication of these audit differences, both on the main audit report and the audit report on internal controls with reference to financial statements.

Similarly, adequate documentation should be maintained for assessing the key audit matters that in auditor’s opinion are required to be reported in the audit report, the audit team should also ensure that the key audit matters and the audit procedures performed to address them are adequately cross-referenced to the related work papers and coincide with the audit risk areas identified during the audit planning stage and thereafter.

Further, there should be sufficient audit evidence in the file that the document so prepared is reviewed by the engagement partner and the quality control partner, if any, before the issuance of the audit opinion.

SUBSEQUENT MODIFICATIONS IN THE AUDIT DOCUMENTATION

As per SA 230, only administrative changes can be made to audit documentation after the date of the auditor’s report, at the time of the assembly of the final audit file, and should not involve the performance of new audit procedures. Examples of administrative changes include, removing review notes, Removing or replacing incorrect cross-references within the engagement files, accepting revisions in Word documents when the track changes functionality was used, sorting, collating and cross-referencing working papers, etc. However, adding signoffs to the audit work papers represents a change that is not administrative because the documentation did not meet requirements i.e., reviewer did not sign and date the work paper to evidence his or her review at the right time.Further, circumstances may arise that require changes or additions to audit documentation that are not administrative in nature after the date of the auditor’s report. In such scenarios, the audit team should document the explanation describing what information was added or changed, date the information was added and reviewed, the name of the person who prepared and reviewed the additional information, circumstances encountered and the reasons for adding the information, new or additional audit procedures performed, any new audit evidence obtained and conclusions reached, and its effect on the auditor’s report. The Implementation Guide to Standard on Auditing 230, Audit Documentation, has covered this aspect in a greater detail.

CONCLUSION

In the recent review reports of various review authorities like NFRA, QRB, FRRB, etc. we can observe that their observations are related to audit documentation that is inadequate to demonstrate the adequacy of the audit procedures performed and evidences obtained, that means that while the audit team might be performing the audit procedures with full diligence, they are not documenting it adequately so as to cover all the aspects of audit, for example, inadequate documentation related to materiality, untested population or financial captions, checklists demonstrating compliances of all the requirements of applicable laws and regulations, evidences of timely reviews and signoffs, rational for modification in audit documentation post issuance of the audit opinion, etc.There are two primary reasons that I can visualize that contribute significantly to the inadequate documentation i.e., lack of training and inadequate time and resources. I strongly believe that if the audit firms can train their resources adequately, in light of the recent developments, and deploy adequate resources and follow timelines that are reasonable to achieve, the observations from regulators will significantly reduce.

Internal Financial Controls over Financial Reporting (ICFR) and Reporting Considerations

Assessment and reporting of internal financial controls over financial reporting is a vital responsibility of the auditor. The Companies Act, 2013 introduced Section 143(3)(i) which requires statutory auditors of companies (other than the exempted class of companies) to report on the internal financial controls over the financial reporting of companies. Globally, an auditor’s reporting on internal controls is together with the reporting on the financial statements and such internal controls reported upon relate to only internal controls over financial reporting. For example, in the USA, Section 404 of the Sarbanes Oxley Act of 2002, prescribes that the registered public accounting firm (auditor) of the specified class of issuers (companies) shall, in addition to the attestation of the financial statements, also attest the internal controls over financial reporting. The objective of Internal Financial Control (IFC) testing is to assist the management in evaluating and testing the effectiveness of financial controls that are in place to mitigate the risks faced by the Company and thereby achieve its business objectives.

The Institute of Chartered Accountants of India (ICAI) has issued Guidance Note on the Audit of Internal Financial Controls over Financial Reporting (‘Guidance Note’). The Guidance Note covers aspects such as the scope of reporting on the IFC, essential components of internal controls, technical and implementation guidance on the audit of the IFC, illustrative reports on the IFC, etc.

The auditor needs to obtain reasonable assurance to opine whether an adequate internal financial controls system was maintained and whether such internal financial controls system operated effectively in the company in all material respects with respect to financial reporting only, along with the audit of financial statements.

WHAT IS INTERNAL FINANCIAL CONTROL (IFC)?

Clause (e) of sub-section 5 of Section 134 explains the meaning of internal financial controls as “the policies and procedures adopted by the company for ensuring the orderly and efficient conduct of its business, including adherence to company’s policies, the safeguarding of its assets, the prevention and detection of frauds and errors, the accuracy and completeness of the accounting records, and the timely preparation of reliable financial information.”

RESPONSIBILITY OF STAKEHOLDERS

Company Management Auditors Audit committee/
Independent Director
Board of Directors
• Create and test the framework of internal controls.

• IFC (including operational & compliance).

• Control documentation.

• Focus on internal controls, to the extent these relate to
financial reporting.• Auditor’s responsibility is limited to the evaluation of
‘Financial reporting controls’ and to preparing IFC Audit documentation.
• Would like to see a robust framework that is aligned with
acceptable standards.• Review & question the basis of controls, design &
ongoing assessments.
• Would rely on the assessment & view of the audit
committee.• It may ask for additional information.

LEGAL REQUIREMENTS

Relevant clauses Requirements Applicability
Directors’ Responsibility Statement: Section 134(5)(e) Directors’ Responsibility Statement should state that the
directors have laid down internal financial controls to be followed by the
company and such controls are adequate and were operating effectively.
Listed companies.
Section 143(3)(i) – Auditor’s Report The auditor’s report should state the adequacy and operating
effectiveness of the company’s internal financial controls.
All companies except private companies with turnover of less
than Rs. 50 crores as per the latest audited
MCA vide its notification dated 13th June 2017 (G.S.R.
583(E)) amended the notification of the Government of India, In the Ministry
of Corporate of Affair, vide No G.S.R. 464(E) dated 05th June 2015 providing
an exemption from Internal Financial Controls to certain private companies.
financial statement or which has aggregate borrowings from
banks or financial institutions or body corporate at any point of time during
the financial year less than Rs. 25 crores.
Section 177(4) – Audit Committee Audit Committee may call for the auditor’s comments on
internal control systems before their submission to the board and may also
discuss any related issues with the internal & statutory auditors and the
management of the company.
All companies having an Audit Committee.
Schedule IV Independent Directors The independent directors should satisfy themselves on the
integrity of financial information and ensure that financial controls &
systems of risk management are robust and defensible.
All companies.
Board Report: Rule 8(5)(viii) of the Companies (Accounts)
Rules, 2014
Board of Directors to report on the adequacy of internal
financial controls with reference to financial statements.
All companies

The Guidance Note states that though the Standards on Auditing (SA) do not address the auditing requirements for reporting on IFC, certain portions of the SAs may still be relevant. The procedures prescribed in the Guidance Note are supplementary in that the auditor would need to consider for planning, performing and reporting in an audit of IFC–FR under section 143(3)(i) of the Companies Act, 2013. The audit procedures would involve planning, design and implementation, operating effectiveness, and Reporting. The auditor should report if the company has adequate internal control systems in place and whether they were operating effectively at the balance sheet date.

REPORTING CONSIDERATIONS.

Circumstances when a Modification to the Auditor’s Opinion on Internal Financial Controls over Financial Reporting are required:

The auditor should modify the audit report on internal financial controls if –

a. The auditor has identified deficiencies in the design, implementation or operation of internal controls, which individually or in combination has been assessed as a material weakness.

b. There is a restriction on the scope of the engagement.

The auditor should determine the effect of his or her modified opinion on internal financial controls over financial reporting have, on his or her opinion on the financial statements.

Additionally, the auditor should disclose whether his or her opinion on the financial statements was affected by the modified opinion on internal financial controls over financial reporting. Based on the results of audit procedures, which may include testing the effectiveness of alternative controls established by the management, the auditor should evaluate the severity of identified control deficiencies.

A deficiency in internal control exists if a control is designed, implemented, or operated in such a way that it is unable to prevent, or detect and correct, misstatements in the financial statements on a timely basis; or the control is missing.

EXAMPLES OF CONTROL DEFICIENCIES:

Deficiencies in the Design of Controls – Inadequate design of internal control over the preparation of the financial statements being audited.

Failures in the Operation of Internal Control – Failure in the operation of effectively designed controls over a significant account or process, for example, the failure of control such as dual authorization for significant disbursements within the purchasing process.

Significant Deficiencies – Controls over the selection and application of accounting principles that are in conformity with generally accepted accounting principles.

Material Weaknesses – Identification by the auditor of a material misstatement in the financial statements for the period under audit that was not initially identified by the entity’s internal control, identification of fraud, whether or not material, on the part of senior management; errors observed in previously issued financial statements in the current financial year;

The auditor should also consider additional considerations as mentioned below while reporting:

a) Evaluation of control not operating effectively on account of the hybrid mode of working and absence of the concerned person in the office.

b) Identify alternate controls.

c) Company’s ability to close the financial reporting process in time.

d) Perceived opportunity for fraudulent financial reporting or misappropriation of assets may exist when an individual believes internal control could be circumvented, for example, because the individual is in a position of trust or has knowledge of specific weaknesses in the internal control system.

Circumstances when a Modification to the Auditor’s Opinion on Internal Financial Controls Over Financial Reporting are required:

Effect of a modified report on internal financial controls over financial reporting on the audit of financial statements:

A modified report on internal financial controls over financial reporting does not imply that the audit report on financial statements should also be qualified. In an audit of financial statements, the assurance obtained by the auditor is through both internal controls and substantive procedures. Hence, substantive procedures are to be performed for all assertions, regardless of the assessed levels of material misstatement or control risk. Further, as a result of substantive procedures, if sufficient reliable audit evidence is obtained and if it addresses the risk identified or gains assurance on the account balance being tested, the auditor should not qualify the audit opinion on the financial statements.

For example, if a material weakness is identified with respect to customer acceptance, credit evaluation and establishing credit limits for customers resulting in a risk of revenue recognition where potential uncertainty exists for the ultimate realisation of the sale proceeds, the auditor may modify the opinion on internal financial controls in that respect. However, in an audit of financial statements, the auditor when performing substantive procedures obtains evidence of the confirmation of customer balances and also observes that all debtors as of the balance sheet date have been subsequently realised by the date of the audit, the audit opinion on the financial statements should not be qualified, though the internal control deficiency exists.

[e.g.- Refer to Mahanagar Telephone Nigam Limited1 -Consolidation Report for 31st March 2022, where ICFR Report is qualified as material weakness is being identified in Capitalisation, Provisions, Reconciliations but overall, it does not impact the auditor’s opinion on the ‘Consolidated Ind –As financial statement’ of the Holding Company.]


1. https://www.bseindia.com/bseplus/AnnualReport/500108/77259500108.pdf

The management relies on its internal financial controls for the preparation of financial statements, whereas the auditor tests controls as well as carries out substantive procedures to opine on financial statements. For companies that prepare and publish unaudited financial information (such as listed entities), internal controls related to the preparation of financial statements determine the company’s ability to accurately prepare such information. In such cases, even if an audit report on financial statements is unmodified, it does not give any indication of whether unaudited interim financial information prepared by the company is reliable or not. Therefore, if the report on internal financial controls over financial reporting is modified, the auditor needs to consider the effect of such modification in his review of interim financial information for the subsequent period.

An unmodified audit opinion is not a guarantee of error-free financials but is rather the conclusion by an auditor – using audit procedures and professional judgement that are reasonable to the circumstances – that the statements are fairly presented.

Inter-play between substantive procedures and operating effectiveness of internal controls:

Even if the operating effectiveness of internal controls is predominantly determined by testing controls, findings from substantive procedures carried out as part of an audit of financial statements also affect the auditor’s conclusion on the operating effectiveness of internal controls. The auditor needs to consider, inter alia, the risk assessment used to select substantive procedures, findings of illegal acts and related party transactions, management bias in making estimates and selecting accounting policies and the extent of misstatements detected by substantive procedures.

FINANCIAL STATEMENTS CLOSE PROCESS (FSCP)

Though internal controls over financial reporting are required for each type of transaction, FSCP is a significant process for which internal controls need to exist. Though there is no definition of FSCP, usually it refers to the process of how transactions are recorded in the books of account and the preparation, review, and approval of interim or annual financial statements including required disclosures therein.

Similar to carrying out the audit of internal controls related to all types of transactions, an auditor needs to perform a walkthrough of FSCP to understand the risks of material misstatements and related controls, including relevant IT controls.

Example of separate modified (qualified/adverse) audit report for an audit of internal financial controls over financial reporting

Nature
of Industry/Name of the Company
Opinion
in Main Audit Report FY 21-22
Opinion
in IFCR Reporting
Material
Weakness
NEL Holdings South Limited2

– Standalone-

Adverse Qualified • Granting of unsecured advances for acquiring various immovable
properties.• Compliance with the provision of the Companies Act• Obtaining year-end balance confirmation certificates in respect of
trade receivables, trade payables, vendor advances, advances from customers
and other advances.

• To ascertain the realizable value of Inventory and also does not have
a documented system of regular inventory verification.

• Ascertaining tax assets/liabilities and payments of statutory dues
including Income Tax and Goods and Service Tax and other relevant Taxes.

• Maintaining the details of pending litigations and ascertaining
corresponding financial impact to report on the contingent liability of the
Company.

• Ascertain and maintain employee-wise ageing
details of the salary payable and other employee
benefit expenses like gratuity payable.
Imagicaaworld Entertainment Limited – Standalone3 Adverse Adverse • Preparation of Financials on Going Concern.

• Impairment testing.

Reliance Infrastructure Limited –
Standalone4
Disclaimer Disclaimer • Evaluating about the relationship, recoverability and possible
obligation towards the Corporate Guarantees given.
Hindustan Construction Company Ltd.

-Consolidation5

 

Qualified Qualified • Compliance with the provisions of section 197 of the Companies Act,
2013 relating to obtaining prior approval from lenders for payment/ accrual
of remuneration exceeding the specified limits.• Internal financial system with respect to assessment of recoverability
of deferred tax assets were not operating effectively.

2 https://www.bseindia.com/bseplus/AnnualReport/533202/73138533202.pdf
3 https://www.bseindia.com/bseplus/AnnualReport/539056/74434539056.pdf
4 https://www.bseindia.com/bseplus/AnnualReport/500390/73190500390.pdf
5 https://www.bseindia.com/bseplus/AnnualReport/500185/76791500185.pdf

The Companies Act does not spell out or specify any particular framework to be followed while establishing an Internal Financial Control System, but the Guidance Note provides detailed guidance. Therefore, the first and foremost duty of auditors regarding Internal Financial Controls over Financial Reporting is to see and get satisfied with the framework set in place as specified in the Guidance Note and as declared in the Directors’ Responsibility Statement duly vetted by the Audit Committee and independent directors, are fool-proof, infallible and watertight. To achieve that, a checklist of internal controls is to be installed for each area so that the adequacy of controls is ensured in all respects. Further for companies to which ICFR is not applicable but have control deficiencies, the auditor will have to ascertain and apply professional judgment whether any modifications are required to be reported. Internal controls may change or fail to be performed, or the processes and procedures for which the controls were created may change, rendering them less effective or ineffective. Because internal controls are effective only when they are properly designed and operating as intended, it is of huge importance to determine the quality of internal control’s performance over a period of time. In scenarios, where ICFR is applicable for the first time or ICFR is applicable to the company and is not implemented by the company or there are no adequate controls, the auditor will have to assess and conclude whether modification or disclaimer of opinion in reporting is required.

Audit Trail under the Companies Act, 2013

The term ‘Audit trail’ has not been defined in the Companies Act, 2013 (Act) or the Companies (Accounts) Rules, 2014 (“Accounts Rules”), It implies a chronological record of the changes that have been made to the data. The Ministry of Corporate Affairs (“MCA”), in its continuing drive to improve transparency and reinforce the integrity of financial reporting, has amended the Accounts Rules requiring companies to ensure that the accounting software used to maintain books of accounts has the following features and attributes:

  • Records an audit trail of each and every transaction;
  • Creates an edit log of each change made in the books of account along with the date when such changes were made;
  • Ensuring that the audit trail is not disabled.

The Companies (Audit and Auditor) Rules, 2014 (“Audit Rules”) have been correspondingly amended wherein auditors are now required to report, as part of the auditor’s report (in the section ‘Report on Other Legal and Regulatory Requirements’, as to whether,

(a)    the accounting software used by the company being audited has the feature of recording audit trail (edit logs),

(b)    the audit trail feature was operational throughout the financial year and had not been “tampered” with and

(c)    such audit trails have been retained for the period as statutorily prescribed.

The MCA has notified that the aforesaid amendments will be effective from April 1, 2023, which implies that the accounting software employed by companies will need to be compliant with the Accounts Rules from FY 2023-24 onwards. The requirement was initially made applicable for the financial year commencing on or after the 1st day of April 2021, however the applicability was deferred to the financial year commencing on or after April 1, 2022 and thereafter to April 1, 2023.

The relaxations by way of deferment of the Accounts rules twice by the MCA ought to be leveraged by the companies to assess whether the accounting software has the requisite functional parameters and attributes which would be considered as being compliant with the Accounts Rules and where necessary, engage with their service providers to ensure compliance.

In today’s environment, accounting software used for maintaining books of accounts is hosted and maintained in India or outside India, on-premises or on the cloud, or through subscribed Software as a Service (SaaS) application. Also, there are multiple other software or infrastructure elements involved in processing end-to-end transactions like Enterprise Resource Planning (ERP), Web Portals, Applications, use of End User Applications like Excel, Email Systems, Mobile Applications, Ticketing Applications, Consolidation Solutions, and others.

Considering the requirements detailed above and the said complexities involved, it is important to understand the challenges and aspects which require careful consideration both by the companies as well as by the auditors. The amendments to the Accounts Rules and Audit Rules (collectively referred to as “Rules”) could be relevant as an absolute audit trail that would be critical to establishing accountability and may act as an impediment to the falsification and manipulation of accounting records. However, the Rules are in certain respects ambiguous, and this may lead to divergence in the interpretation and application of the Rules by auditees and auditors. The objective of this article is to outline the aforesaid aspects which require clarity, enhanced responsibilities of the management and the auditor, and to discuss key implementation challenges.

APPLICABILITY OF RULES

Section 128 read with Rule 3 of The Companies (Accounts) Rules, 2014 prescribes books of accounts etc. to be kept by the company. These are applicable to all the companies registered under the Companies Act, 2013. The reporting requirements for the auditors have been prescribed for the audit of financial statements prepared under the Act. Accordingly, auditors of all classes of companies including section 8 companies would be required to report on these matters. As per Companies (Registration of Foreign Companies) Rules, 2014 the provisions of Audit and Auditors (i.e., Chapter X of the 2013 Act) and Rules made there under apply, mutatis mutandis, to a foreign company as defined in Companies Act, 2013. Accordingly, one may take a view that reporting requirements would be applicable to the auditors of foreign companies as well.

WHAT IS AN ‘AUDIT TRAIL’?

The term ‘audit trail’ can be defined as a chronological sequence of the history of a particular transaction, tracking who created/changed a record, what record, what time etc. Audit trails amongst others may help in investigating frauds, system breaches etc. and can be considered an essential tool of monitoring for organisations. Many organisations use it today as well because it is critical for certain applications. However, all businesses or organisations may not be fully equipped or invested in best-class IT systems. Also, the cost of these IT systems does not involve only one-time costs. They also include expensive upgrades, security systems, etc.

So, what is the change for those companies which are already using audit trails? The change is that companies which earlier had a choice of deciding what type of IT systems to use depending on their needs and also a choice on deciding the type of data which they needed an audit trail for, now have limited choices.

AUDIT TRAIL – EXCLUSION AND INCLUSIONS?

The Rules do not specify the fields or data sets for which audit trails are required to be maintained. In relation to a transaction, data would comprise two types:

  • transactional data (e.g., amount, accounting date, ledger accounts, narration for the transaction)
  • data pertaining to the recording of the transaction (e.g., the identity of the user accounting for the transaction or the time on which the transaction was posted).

The companies would need to ensure that the audit trail captures changes to each and every transaction; changes that need to be captured may include the following

  • when changes were made,
  • who made those changes,
  • what data was changed,

For example, if a transaction is deleted or edited, apart from logging information about who effected the deletion/edit, the audit trail may include sufficient information to either view or trace the transaction which had been deleted. This aspect may be clarified by the MCA or the ICAI.

BOOKS OF ACCOUNT – FOR AUDIT TRAIL

Section 2(13) of the Companies Act 2013 defines Books of Account as below:

“Books of account” includes records maintained in respect of—

i.    all sums of money received and expended by a company and matters in relation to which the receipts and expenditure take place;

ii.    all sales and purchases of goods and services by the company;

iii.    the assets and liabilities of the company; and

iv.    the items of cost as may be prescribed under section 148 in the case of a company which belongs to any class of companies specified under that section

It is a very broad definition which encompasses every record maintained in respect of financial statements. So, inventory records, production records, expense records, asset records etc. would be part of books of account and would need to be covered and for which audit trail would need to be maintained.

ACCOUNTING SOFTWARE – COVERAGE

The term ‘software’ has not been defined in the Act or in the Rules. It may be noted that any software used to maintain books of account will be covered within the ambit of these rules. For e.g. if sales are recorded in a standalone system and only consolidated entries are recorded on a monthly basis into the General Ledger ERP, the sales system may also have an audit trail. The companies as well as auditors would need to evaluate whether such systems would also be covered within the meaning of the term accounting software. Accordingly, it appears that any software that maintains records or transactions that fall under the definition of Books of Account as per section 2(13) of the Act will be considered accounting software for this purpose. MCA or ICAI may clarify this matter.

MANAGEMENT RESPONSIBILITIES

In order to demonstrate that the audit trail feature was functional, operated and was otherwise preserved, a company may have to design and implement specific internal controls (predominantly IT controls) which in turn, would be evaluated by the auditors, as appropriate. A company may leverage its existent internal control systems and processes to design internal controls around the audit trail.

The management will be responsible for compliance with the requirement of the rules including to:

  • identify the records and transactions that constitute books of account under section 2(13) of the Act;
  • identify the software i.e., IT environment (including applications, web portals, databases; Interfaces, or any other IT component used for processing and or storing data for the creation and maintenance books of accounts
  • ensure such software have the audit trail feature;
  • ensure that the audit trail captures changes to each and every transaction recorded in the books of account;
  • ensure that the audit trail feature is always enabled (not disabled);
  • ensure that the audit trail is appropriately protected from any modification; and
  • ensure that the audit trail is retained as per statutory record retention requirements.
  • ensure that controls over maintenance and monitoring of the audit trail and its feature are designed and operating effectively throughout the period of reporting.

In the case of accounting software supported by service providers, the company management and the auditor may consider leveraging independent auditors’ report of a service organisation, if available (e.g., SOC 2/SAE 3402, Assurance reports on controls at a service organisation) for compliance with audit trail requirements.

It is important for the companies to discuss and evaluate the applicability of the rules pending issuance of guidance from the MCA or the ICAI.

AUDITOR’S REPORTING REQUIREMENTS 

Globally, no similar reporting obligation exists for the auditors and accordingly, it becomes imperative that MCA or ICAI prescribe specific guidance to enable the auditor to obtain assurance and report accordingly under these requirements.

Unlike reporting on internal financial controls, the provisions require the auditor to report that the feature of recording audit trail (edit log) facility has “operated throughout the year for all transactions recorded in the accounting software”.

The auditor would be expected to verify the following:

  • whether the trail feature configurable (i.e., if it can be modified)?
  • whether the feature enabled/operated available throughout the year and not tampered with?
  • whether all transactions1 recorded in the software covered in the audit trail feature?
  • whether the audit trail been preserved as per record retention requirements?

1. Proviso to Rule(1) of Companies (Accounts) Rules 2014 prescribes requirement of audit trail only in the context of books of account by stating that accounting software should be capable of creating an edit log of “each change made in books of account.” The auditors’ responsibilities have been prescribed for “all transactions recorded in the software”

Considering the amendment has been made to the Rules, the non-compliance with the mandatory provisions would imply contravention with the provisions of the Companies Act, 2013. Further, based on procedures performed the auditor may evaluate the reporting implications in case of non-compliance and consider the requirements specified in Standards on Auditing 250, Consideration of Laws, and Regulations in an Audit of Financial Statements. In respect of the audit trail following could be the expected scenarios:

Management may maintain an adequate audit trail as required by the law.

Management may not have identified all records/transactions for which an audit trail should be maintained.

The accounting software does not have the feature to maintain an audit trail, or it was not enabled throughout the audit period.

Scenarios mentioned against (ii) or (iii) may indicate non-compliance with the requirements prescribed in the rules resulting in the inclusion of a modified comment by the auditor against this clause. ICAI may issue guidance on this aspect.

REPORTING UNDER CLAUSE (G) OF RULE 11 VIS-À-VIS SECTION 143(3)(I)

Section 143(3)(i) of the Act, where applicable under the provisions of the Act, requires the auditor to state in his audit report whether the company has an adequate internal financial controls system in place and the operating effectiveness of such controls. Reporting on internal financial controls is not covered under the Standards on Auditing and no framework has been prescribed under the Act and the Rules thereunder for the evaluation of internal financial controls. Guidance in this regard was specified vide Guidance Note on Audit of Internal Financial Controls Over Financial Reporting.

Accordingly, where the feature of the audit trail has not operated throughout the year, the auditor would need to evaluate and perform further testing/examination as may be required to conclude the wider impact on the reporting implication.

However, the mere non-availability of an audit trail may not necessarily imply failure or material weakness in the operating effectiveness of internal financial control over financial reporting. ICAI may guidance on this aspect.

PRESERVATION OF THE AUDIT TRAILS

Section 128(5) of the Act requires books of accounts to be preserved by the companies for a minimum period of eight years. Since the requirement of an audit trail has been made effective from April 1, 2023, it seems that the provision of audit trail retention will apply from April 1, 2023, onwards.

The auditor is also required to report whether the audit trail has been preserved by the company as per the statutory requirements for record retention. Considering this reporting requirement, the auditor is expected to perform appropriate audit procedures to assess if the logs have been maintained for the period required and are retrievable in case of a need.

WRITTEN REPRESENTATIONS FROM THE MANAGEMENT

The auditor will be required to obtain written representations from management acknowledging management’s responsibility for establishing and maintaining adequate controls for identifying, maintaining, controlling, and monitoring of audit trails as per the requirements on a consistent basis.

AUDIT DOCUMENTATION

The auditor may also document the work performed on the audit trail such that it provides a sufficient and appropriate record of the basis for the auditor’s reporting requirement; and evidence that the audit was planned and performed in accordance with this implementation guide, applicable Standards on Auditing and applicable legal and regulatory requirements. In this regard, the auditor may comply with the requirements of SA 230 “Audit Documentation” to the extent applicable.

TIMELY PLANNING AND ABILITY OF COMPANIES TO INVEST IN SUCH SOFTWARE SYSTEMS

Since the rules are applicable with effect from April 1, 2023, onwards, it is important for companies to monitor the implementation of the amended rules. Long-term maintenance of audit logs can prove challenging for many organizations because it can occupy extensive storage space that may not be readily available in desktop applications. Also, with the amendment made in the Account Rules about the mode of keeping books of account and other books and papers in electronic mode, companies are required to keep back-up of books of account and other relevant books and papers maintained in electronic mode (including at a place outside India) in servers physically located in India on daily basis, instead of periodic basis. Existing software might not be able to support it. It may not be easy to reconstruct the database transaction order if the old software doesn’t have an audit trail.

WAY FORWARD

Considering that compliance with the amended rules will require significant efforts for the companies, it would be advisable for Companies to keep an eye out for any guidance from the MCA and/or the ICAI in this regard. At the same time, enabling audit trails may not be a simple task for companies that use simple accounting software, which typically doesn’t have an audit trail functionality. Companies may have to effect significant changes to their existing software or implement a different software altogether.

Apart from the compliance by the companies, the auditors of the company are required to report on the audit trail feature of the accounting software. Therefore, auditors will need to consider the extent of efforts required in testing an audit trail as part of their planning activities and the extent of audit procedures. The auditor may also discuss with those charged with governance/audit committee/ board of directors about the new reporting requirements and the possible reporting implications.

Other Information – Auditor’s Responsibility beyond Financial Statements

INTRODUCTION

As we have evidenced over the years, information included in the Annual Reports of the companies is increasing year after year. Such information is used by users of financial statements for their analysis and decision-making. Therefore, the “Other Information” is a fundamental part of the Annual Report. Such “Other Information” may have also been used as a part of the audit work such as evaluation of going concern assumption, various transactions reported in CARO related to loans, etc. For example, CARO requires auditors to report on loans granted by the company. Such information shall also form a part of the Board’s report which is Other Information included in the Annual Report. Similarly, there could be legal or regulatory matters discussed in Other Information which may be part of key audit matters in the auditor’s report.

The audit report includes a section titled “Other Information”. This section describes the management’s and auditor’s responsibilities relating to Other Information and the outcome of the audit procedures carried out on such Other Information. Standard on Auditing (SA) 720 (Revised)The Auditor’s Responsibilities Relating to Other Information describes the reporting responsibilities on such Other Information by the auditor in his / her audit report. This aims to enhance the credibility of financial statements.

This article discusses certain specifics about reporting by the auditor on such Other Information.

Other Information section in an audit report

In this section, the auditor states:

–    Management’s responsibility of Other Information

–    Identified Other Information received prior to the audit report date and for a listed entity, expected to be received thereafter

–    That the audit opinion does not cover Other Information

–    Auditor’s responsibility for Other Information

–    If information is received prior to the audit report date, whether the auditor has identified any material misstatement of Other Information to report

APPLICABILITY TO PRIVATE COMPANIES AND NON-CORPORATE ENTITIES

The audit report on financial statements of private companies or unlisted companies also needs to include a section titled “Other Information” if any such information is received by the date of the audit report. Further details regarding the distinction between listed and unlisted entities are discussed in the below paragraphs.

In the case of unlisted non-corporate entities, auditors would not be in a position to report on Other Information because many a times such entities do not prepare annual reports whereas, by definition, Other information refers to information included in an entity’s annual report. Therefore, SA 720 (Revised) requires reporting on Other Information in the case of unlisted corporate entities only.

ELEMENTS OF OTHER INFORMATION

Other Information is a defined term in SA 720 (Revised). It is defined as “Financial or non-financial information (other than financial statements and the auditor’s report thereon) included in an entity’s annual report.” The SA further explains that the Annual Report may be referred to as such or may be referred to by any other name. The legal environment or custom may require the entity to report to owners, the information on the entity’s operations and financial statements. Such a report is considered as an Annual Report which may be a single document or a set of documents. Usually, the Annual Report contains a Management Report, Chairman’s statement , Corporate Governance Report, etc. All of this information are elements of Other Information.

Such Other Information may contain various aspects related to the entity and its operations. For example, it may contain information about the company, Chairman’s statement may include business- related relationships and specifics related to contracts entered into with key suppliers or customers, segment-wise performance of the company, market presence of the company, what are the risks that the company is expected to face, what opportunities it foresees in the market in the future year, information about human resources, sustainability disclosures and report thereon, new products the company plans to launch, so on and so forth. Over the years, the volume of such information is increasing. Such information may be in quantitative form or narrative form. All this information is other than the financial statements and is part of Other Information.

However, if there are any reports published outside the Annual Report to meet the needs of a specific group of users, such reports usually will not meet the definition of Other Information such as Diversity Report, various reports filed with government agencies and Registrar of Companies, etc. If any of such reports are included in the Annual Report itself, then those will meet the definition of Other Information and will be scoped in SA 720 (Revised).

OBTAINING OTHER INFORMATION

Before reporting, the auditor should discuss with the management which documents comprise annual report. Based on such discussion, the auditor should make arrangements with the management to obtain such information in a timely manner and before the date of the audit report, if possible. Such documents should be the final version of the information going to be included in the Annual Report. This can be done by appropriately wording the audit engagement letter. The Audit Committee and Board of Directors should be requested to review the Other Information.

IDENTIFICATION OF OTHER INFORMATION IN THE AUDIT REPORT THAT IS SCOPED AS PART OF THE AUDIT

The audit report identifies Other Information so that the reader can understand what has been scoped by the auditor as Other Information. Usually, the audit report includes a sentence for such identification as “The other information comprises the information included in the Company’s annual report, but does not include the standalone financial statements and our auditor’s report thereon.” However, SA 720 (Revised) clarifies that it does not apply to preliminary announcements of financial information or securities offering documents, including prospectuses.

AUDITOR’S RESPONSIBILITY FOR OTHER INFORMATION

The auditor is not required to “audit” the Other Information. He auditor is required to only read Other Information to consider whether there is a material inconsistency between the Other Information and the financial statements. This ensures that the credibility of the audited financial statements is not undermined by material inconsistencies between the audited financial statements and Other Information. The auditor’s procedures would include:

–    Reading the Other Information to ensure consistency with financial statements and information obtained as part of the audit

–    Comparing the Other Information or ratios with the financial statements and auditor’s understanding of the entity

–    Checking clerical accuracy with the data presented in the financial statements

–    Obtaining a reconciliation with the information included in the financial statements, if required. For example, the Other Information may include revenues for specific key products whereas financial statements shall include the total revenue of the entity. The product-wise revenue should reconcile with total revenue in the financial statements by excluding the revenue related to the products that are not included in Other Information. Another example could be the bonuses paid to the key management team of the entity, which are included in the statement of profit and loss along with salaries and bonuses of all the employees in the entity.

If there is a material inconsistency, it may indicate that either there is a material misstatement in the financial statements or in the Other Information. Either of such a situation undermines the credibility of financial statements and the auditor’s report thereon. In such cases, economic decisions of the users of the financial statements will be affected.

Upon reading of Other Information for the purpose of identifying any material inconsistencies, if the auditor becomes aware of any apparent material misstatement of fact, the auditor should discuss the matter with the management.

The auditor is not required to “identify” and settle material inconsistencies or material misstatements of fact in Other Information. However, he auditor may become aware that such Other Information includes material inconsistency or material misstatement. In such cases, the auditor should not be allowing the audited financial statements to be included in the document that contains such materially false or misleading Other Information or material omission of fact. The auditor should discuss the matter with the management and request the management to rectify the inconsistency in Other Information or not to include such information as part of the Annual Report in which financial statements are being included.

DATE OF THE AUDIT REPORT AND ANNUAL REPORT MAY BE DIFFERENT

The auditor should agree with the management on the timing of availability of the final version of the information that will be included in the Annual Report, so that he / she can discharge the responsibility towards it as casted by SA 720 (Revised). Such information should be in the near final draft stage and written representation to this effect should be obtained from the management.

Other Information obtained till the date of the audit report

The auditor is required to report on the Other Information obtained until the date of the audit report. If the auditor expects to receive such information after the audit report date, then the auditor is required to state so in the audit report in he case of a listed entity. In the case of an unlisted entity, though it is not mandated in SA 720 (Revised), it states that the auditor may consider it appropriate to do so. It provides an example of a situation when management is able to represent to the auditor that such Other Information will be issued after the date of the auditor’s report.

No Other Information was obtained till the date of the audit report

Even if no Other Information is obtained till the date of the audit report, the auditor is required to state such a fact in the audit report of a listed entity. In the case of an unlisted entity, if no Other Information is available to the auditor at the date of the audit report, he auditor is not required to report anything on the “Other Information” through the auditor’s report. Thus, even if reporting on Other Information is applicable for unlisted entities, such reporting is triggered only if part or all of such Other Information is obtained before the date of the audit report. Other Information obtained after the date of the audit report is discussed below.

Other Information obtained after the date of the audit report

When all or part of Other Information is made available to the auditor after the date of his audit report, in case of both listed and unlisted entities, auditor’s responsibility under SA 720 (Revised) continues i.e., the auditor needs to read such other information to ensure that it does not contain any material misstatement. In such cases, the auditor should obtain written representation from the management that such Other Information will be provided to the auditor before it is issued so that the he can fulfill his duties.

STATUTORY REPORTS AND OTHER INFORMATION

The Annual Report contains certain reports required to be included as per law, for example, Board’s Report. All such statutory reports which are required to be included in the Annual Report are elements of “Other Information”.

The Annual Report may contain certain information that the entity provides voluntarily. Such information also forms part of “Other Information” within the scope of SA 720 (Revised).

THE SUMMARY REPORT INCLUDED IN ANNUAL REPORT AND A DETAILED REPORT IS PLACED OUTSIDE

There may be situations where a summary of the report is included in the Annual Report giving reference to the detailed report placed outside such as on the website, etc. For example, entities may prepare a Business Responsibility and Sustainability Report in detail but provide only the summary in its Annual Report and give a link to the detailed report.

If such a detailed report is required to be part of the Annual Report, it is considered as part of “Other Information” irrespective of its placement. However, in other cases, a mere reference to such a report will not bring it in the scope of “Other Information”.

INCONSISTENCY BETWEEN INFORMATION ON THE WEBSITE AND INFORMATION OBTAINED AS PART OF THE AUDIT

SA 720 (Revised) clarifies that when other information is only made available to users via the entity’s website, the version of the other information obtained from the entity, rather than directly from the entity’s website, is the relevant document for the auditor under the SA.

EXAMPLES OF MATERIAL MISSTATEMENTS OF FACTS IN OTHER INFORMATION

As part of his audit work, the auditor receives a plethora of information regarding the entity, its environment, its operations and products, etc. Some of the examples where Other Information contains material misstatements of facts could be:

–    As part of the impairment analysis, the auditor has been provided with future cash flow projections for value-in-use calculation made by the management. But Management Discussion and Analysis included in Annual Report gives materially different projections about its future years.

–    Corporate Governance Report in the Annual Report includes reference to whistle-blower complaints received during the year. However, the auditor was not provided any information on such events during the audit process.

Similarly, when the audit opinion is modified, i.e., the financial statements contain or may possibly contain material misstatement, the Other Information included in the Annual Report would also carry such material misstatement. In such situations, the Other Information section in the audit report shall also include auditor’s remarks about material misstatements in Other Information.

CONCLUSION

Unlike other auditing standards which focus on the audit of financial statements, SA 720 (Revised) discusses the auditor’s responsibility for the information that is outside financial statements. Therefore, the auditor needs to ensure that such information is appropriately identified in the audit report and the auditor has discharged his / her duty in respect of such Other Information along with the audit of financial statements. The Institute of Chartered Accountants of India has also issued an implementation guide on SA 720(Revised). It deals with various aspects and possible situations that the auditor may face while reporting on Other Information.

Guidance for Executing Audit of Small and Medium Enterprises by Small and Medium Practitioners

INTRODUCTION

Auditing is a process of reviewing the financial transactions of the entity, verifying records for the transactions which are material, assessing the risks of material misstatements based on the overall samples selected and then giving an assurance to the readers of the audited financial statements that they reflect the true and fair view of the affairs of the entity.

The process of auditing requires going through various types of documents like payment vouchers, purchase invoices, sales invoices, expenses invoices, receipt records, bank statements, contracts and agreements entered into by the entity which has a bearing on the financial results, filings for regulatory compliances, assessments/demands under various statutes, maintenance of records as per various regulations, etc.

Challenge lies in documenting the audit process for SME entities. The primary reason for this challenge is that the organisational structure is lean and majority of the decisions are centralised with a few persons managing the business. Sometimes, decisions are taken off the cuff during informal meetings and there may be no official documents for the process followed for decision making. Further, there may be explanations provided which may be genuine and convincing, however they would not be recorded in any form. The auditors of these SME entities are also Small and Medium Practitioners (SMPs) who may not have professional staff with adequate exposure to elaborate documentation and process flow experience.

It is with this background that this article has been conceived to provide some insights on the importance of documenting the audit work carried out during the year and thereby ensuring that the auditor is not caught on the wrong foot during any scrutiny of the audit either due to some wrongdoing by the auditee or during the random selection by the peer reviewer.

It is rightly said “What is not documented is not audited”

PROCESS OF COLLATING AUDIT EVIDENCE

One should understand the different types of audit evidences which can be used. The evidence collection methodology will vary depending upon the purpose for which it is sought. However, here are some of the most commonly used forms of evidence.

1. Physical Verification

This entails confirming the existence of assets and/or their condition. This type of examination is the major source to obtain audit evidence on fixed assets and inventory.

Auditor should ensure to carry out physical verification of fixed assets as well as inventory on test check basis and keep the working sheets of such physical verification countersigned by the personnel of the auditee.

It must also be ensured to take all the working sheets of the physical verification carried out by the personnel of the auditee and have a reconciliation of the same with the accounting records as part of the audit working papers.

2. Confirmations

Whenever there are balances of vendors, customers and banks whose correctness has to be established by the auditors in the financial statements, the auditor should place reliance on confirmations from such third parties.

It is always possible that all the balances for which confirmations are called for may not be matching with the balances in the auditee’s books of accounts. In such cases, the auditor should ensure to obtain reconciliation and be satisfied with the reasons for the reconciliation and document the same.

3. Documentary evidence

There may be transactions in current times which are negotiated over emails. Further, there may be the authorisation of the transactions on the documents moving between the parties. In such cases, the auditor should ensure to vouch and trace parts of the documents to take comfort in the genuineness of the transactions for the auditing procedure.

4. Analytical procedures

At the macro level to verify the true and fair representation of financial statements, auditors usually use these procedures by performing their own calculations.

An example can be relating to working out material consumption. Here auditor may compare the prices of the material consumed against the average price of such material throughout the year which may be available from the public domain. This will provide comfort that there is no inflated consumption.

For quantitative consumption, inquire about the quantum of materials which are required for the sale of different items manufactured or if the entity maintains a Bill of Material then obtain the same. Extrapolate the total consumption of various materials which are required for producing the items sold or in inventory. Compare the same against the consumption of various materials as per the financial records in quantity. If the variation is not material then the auditor can take comfort in the consumption-related financial data.

This process of analytical procedures can be applied using various ratios and formulas for working out variances and then seeking explanations from the management for such variances.

The entire process as well as findings should be well documented as part of audit documentation.

5. Oral evidence

Normally at the commencement of the audit, auditors will typically interrogate company executives regarding business operations and also from their past audit experience design the auditing procedures to be performed and the extent of checking to be carried out in various areas of audit.

6. Accounting Systems

This typically serves as a source of auditing evidence. It allows the auditor to access financial reporting documents and anything interconnected with financial statements.

Audit staff should be trained to document the internal flow of documents within the accounting system and their authorisations before it gets finally recorded in the accounting system. There should be a record of the selection of the entries which have been checked from various registers or ledgers in the accounting system. They should also record the selection criteria and the materiality considered for selection based on the size and nature of transactions audited.

7. Re-performance

For the purpose of testing internal controls in financial reporting, the auditor should walk through a limited number of transactions in each category of the business cycle getting recorded in the financial statements. This will enable them to test the controls which have been set by the entity and also identify shortcomings in key internal control processes.

This will act as additional support in carrying out an audit through sampling basis considering the level of controls in operation and the comfort which can be derived by the auditors based on their walk-through.

8. Observational Evidence

When there are fewer layers of operational personnel in SME entities, auditors would have to rely on observational skills too. They should take notes of how the entity processes some of its work. They should specifically observe how the entity goes about handling operations, policies, and protocols to find weaknesses.

This will enable the auditor to understand the business of the entity as well as structure its audit plan in a better manner.

BENEFITS AND NATURE OF DOCUMENTATION

Documentation will ensure better planning and make effective supervision and review possible. It results in clarity of thoughts and expressions and evidence of work performed and compliance with Standards.

Here are some extracts reproduced from ICAI’s Peer Review Manual 2020, which can serve as a guiding light for SMP’s documentation compliance –

Audit documentation is very important in the areas of quality control of the audit. Audit documentation should be prepared in such a manner that other auditor who is not involved with the audit engagement previously can understand the work that he performs when he reviews the documents.

The general guidelines which can be adopted by the audit firm for the preparation of working papers are:

a) Clarity and Understanding

b) Completeness and Accuracy

c) Pertinence

d) Logical Arrangement

e) Legibility and Neatness

f) Safe and retrievable

g) Initial and Date

h) Summary of conclusions

WHAT INFORMATION MUST DOCUMENTS PROVIDE?

The following is the key information that should be a part of the audit documentation:

(a) The nature, timing and extent of the audit procedures performed to comply with the SAs and applicable legal and regulatory requirements.

(b) The evidence that the auditor obtains, the procedures that they use for testing and the result of testing should be properly and clearly documented in the audit working papers. This is to ensure that the reviewer could easily perform the quality review and to prove that the relevant Standards are implemented.

(c) The auditor should clearly document significant matters related to financial statements, their ethics, as well as their process, during the audit.

(d) Testing or sampling requires auditors’ use of their professional judgment and it is important to document these judgments.

Further, the ICAI has issued SA 230 – “Audit Documentation” which should be read in conjunction with other Standards on Auditing (SAs) having a bearing on documentation.

There is guidance for the maintenance of the Permanent Audit File and Current Audit File. This article addresses the process of audit documentation for SME clients by SMPs.

PERMANENT AUDIT FILE

A permanent audit file contains those documents, the use of which is not restricted to one time period and extends to subsequent audits also, e.g. Engagement letter, Communication with the previous auditor, Memorandum of Association, Articles of Association, Organization structure, List of directors/partners/trustees/bankers/lawyers, etc.

During each year’s audit, there may be some developments which shall have bearing or reference for more than one time period in the future. Accordingly, it should be ensured to update the permanent file with such further documentation. Examples of such changes which would need updating permanent file are changes in Articles of Association, Joint Venture agreement, long term supply contract, change in KMPs/directors, etc.

The following table illustrates the contents of a permanent file:

Title Information
Contained
Engagement
  • Letter of Engagement
  • Correspondence with the retiring auditor
    (NOC)
Constitution
  • Copies of Memorandum and Articles of
    Association in case of corporate entities or
  • Partnership agreement in case of
    partnership firm or
  • Act, Regulation, byelaws, trust deeds, as
    applicable under which the entity functions
Background
and Organisation Structure
  • Nature and history of the business
  • Profile of ownership
  • Registered office details
  • Management structure
    including organisation chart
  • Industry specification with reference to client’s size, economic
    factors affecting the industry, seasonal fluctuations and demands
Background
and Organisation Structure
  • Facility locations, plant capacity, owned
    or leased, age, capital expenditure budget, etc. Products specifying diverse
    ranges along with classification
  • Purchase volumes, main suppliers, policies
  • Inventory norms, inventory levels during the last five years and
    related ratios.
  • Sales volumes including exports, main customers, methods of
    distribution, pricing policies, credit policy
  • Personnel showing numbers, analyses by departments or function,
    method of remuneration, contracts, union agreements, HR policy
  • Copy of audited financial statement for the previous five years,
    if it exists.
  • Study and evaluation of internal controls
  • Significant audit observations of past
  • Statistical information showing 5 years comparison of performance
    indicators (major accounting ratios) Industry Statistics.
Systems
(for larger Audits, this section could be held on a separate file)
  • Details of methods of accounting including cost accounting, flow
    charts, specimens of accounting documents, code structure and list of
    accounting records
  • EDP-systems security, source code security, authorisation and
    backup policy
Contracts,
agreements, Minutes
  • Leases agreements photocopies/ extracts of the same
  • Title deeds inspected annually by an auditor
  • Royalty agreements
  • Minutes of continuing importance such as Directors’ meetings,
    Members’ meeting
Group
  • Group structure – subsidiaries, associates
  • Joint venture
  • Names of auditors
Other
professional advisor’s list
  • Bankers
  • Solicitors
  • Investment Analysts
  • Registrars
  • Credit Rating Agency
Miscellaneous
  • Details of other client information of a permanent nature

CURRENT AUDIT FILE

A current audit file contains those documents relevant to that time period of audit. The Current Audit File comprises of one or more files, in physical or electronic form, meaningfully arranged containing the records that comprise the audit documentation for a specific engagement.

The auditor should ensure that the file is providing evidence that the engagement was carried out in accordance with the basic principles mentioned in SA 200- Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with Standards on Auditing.

The following table illustrates the contents of an audit file:

Title Information
Contained
Engagement
  • Acceptance of annual reappointment
Accounts
  • Copy of draft financial statement
  • Copy of final signed financial statement
Reports
and Final Papers
  • Copies of all draft and final reports issued to the client
  • Correspondence with other auditors and experts
  • Comments received from client and letter of  representation
  • Observations on accounts and points carried forward to next year
  • Final journal entries
  • Company accounts checklist – directors’ report
  • Audit completion report
Audit
Plan
  • Planning programme
  • Time and cost summary
  • Briefing notes
  • Copy of planning letter to client
  • Points carried forward from the previous year
Balance
sheet, statement of profit and loss account and cash flow statement audit –
systems testing
  • Lead schedules/ Notes
  • Audit programmes
  • Detailed working papers and conclusions
  • Company accounts and Accounting Standards, if any, checklists
  • Queries raised and explanations received
  • Third-party confirmations and certificates
  • Weaknesses identified and a copy of the letter of  weaknesses sent to the client
Accounts
preparation
  • Schedules/ Notes
  • Trial balance
  • Cross-reference to audit work performed
Audit
Programme
  • Audit procedure (compliance and substantive)
  • Detailed working papers and conclusions
  • Queries raised and explanations received
Extracts
from minutes relating to accounting
  • Directors’ meetings
  • Members’ meetings
  • Audit committee meetings
  • Investment and other Board committee meetings
Statistical
information
  • Performance indicators collected which have a bearing on the
  • extent, nature, and timing of substantive tests

ASSEMBLY OF AUDIT FILE

The audit firm shall have adequate policies and procedures to ensure compliance with SA 230 in respect of the assembly of files. The final audit file is required to be assembled within 60 days after the date of the Auditor’s Report. However, after the assembly of the file, no document should be added or deleted subject to exceptional circumstances wherein the auditor shall mention the specific reasons for making them and when and by whom they were made and reviewed.

GENERAL EXAMPLES OF DOCUMENTS TO BE MAINTAINED

Some of the examples of documents which shall be maintained by an audit firm for an audit engagement are as follows:

Miscellaneous
– Others
1  Audit engagement letter (with reference to
SA 210)
2  Opening and closing trial  balance
3 Last year’s signed financial
statement
4 List of various
registrations obtained under other laws
5 List of Branches
Direct Tax
Reporting
6 Copy of computation of
income of last year
7 Summary
of disallowances to be made and allowances as per section 43b of I T Act
8 Deferred
tax working
9 Form 26AS
10 Advance tax payment challans
Indirect Tax
Reporting
11 Applicability of GST
12 Applicability of Customs
13 Respective returns copy
14 Respective challans copy
15 Respective
order status, if any
16 Reconciliation
statement of turnover declared and booked, wherever required
 Company Law
17  Shareholding pattern
18  List of Directors
19  List of KMP
20  Register extracts of transactions with
related parties
21 Minutes
of meetings
Compliance Under
Allied Laws
22 PF
payment challans and returns copy, if any
23 Profession
tax payment challans  and returns copy,
if any
24 ESIC
payment challans and returns copy, if any
25 LWF     payment challans and returns copy, if
any
26 SEBI
compliances

CONCLUSION

The basic aim of this article is to drive through the importance of documenting the findings throughout the journey of the audit. It also strives to provide an insight into the different ways in which comfort can be drawn by the auditor to arrive at the conclusion of the financial statements to be true and fair. These processes and documentation will also act as safeguards against any regulatory proceedings and protect the auditor from adversities of fines and penal consequences. This exercise also acts as a reference check of the process followed during the audit as well it acts as a lighthouse for the audits of the future years. All in all it increases the efficiencies in the audit process and enables the audit firm to scale up the audit quality maturity model.

The Transformative Power of Artificial Intelligence (AI) In Audit

Artificial Intelligence (AI) has brought about radical change in various industries, and the field of audit is no exception. As businesses grapple with large volumes of complex data, auditors face the challenge of delivering accurate and insightful assurance services efficiently. In this digital era, AI presents a transformative solution, enabling auditors to harness the potential of technology to enhance their capabilities and elevate the value they bring to clients. This article explores the impact of AI in the audit profession and highlights its potential to reshape the future of assurance. In each section, references to popular AI audit tools are given. Readers can go through them and make appropriate uses to enhance the quality of audit assurance.

UNDERSTANDING AI IN AUDIT

At its core, AI refers to the simulation of human intelligence in machines, enabling them to learn from experience, interpret data and make informed decisions. AI in audit encompasses various technologies, such as machine learning, natural language processing, robotic process automation and data analytics. These components work together to augment the auditing process, driving greater efficiency and accuracy.

Traditionally, audits have relied on sampling techniques to assess financial data and detect errors or irregularities. AI complements these methods by analysing entire data sets rapidly and comprehensively. Moreover, AI’s ability to learn from patterns in data allows auditors to uncover insights that may have otherwise remained hidden.

AI’S ROLE IN DATA ANALYSIS

One of AI’s most significant contributions to the audit profession lies in data analysis. Auditing involves examining vast amounts of financial and operational data to assess a company’s financial health and compliance with relevant regulations. Manual analysis of such data is not only time-consuming but also prone to human error.

AI-powered audit tools are proficient at processing and interpreting large datasets with remarkable speed and precision. By automating data analysis, AI empowers auditors to focus on interpreting results, identifying patterns and making informed decisions based on data-driven insights. This data-centric approach enhances risk assessment, improves the accuracy of audit conclusions and enhances the overall quality of audits.

Furthermore, AI algorithms are adept at identifying anomalies and potential fraud in financial data, reducing the risk of financial misstatements going unnoticed.

AI Tool for Ratio Analysis
https://www.readyratios.com/features/
 
ENHANCING AUDIT SAMPLING TECHNIQUES

AI’s influence on audit sampling techniques is a significant step towards continuous auditing. Instead of conducting periodic audits based on sampling, continuous auditing employs real-time data analysis to provide ongoing assurance.

With AI-powered sampling, auditors can analyse entire datasets more frequently, eliminating the need for selective sampling. Larger datasets improve the reliability of audit conclusions and help auditors detect irregularities or potential risks more effectively. By embracing continuous auditing, businesses gain access to timely insights, enabling proactive decision-making and risk mitigation.

Use case: A retail chain with multiple locations is subject to regular financial audits. Historically, the auditors used sampling techniques to review a portion of the company’s transactions. However, by adopting continuous auditing with AI-powered sampling, auditors can now analyse real-time data from all locations simultaneously. This provides the management team with ongoing assurance and helps them quickly address any potential irregularities, ensuring better risk management and compliance.

AI Tool for Data Analysis
MICROSOFT EXCEL — Data analysis tools — Sampling

AUTOMATION OF ROUTINE TASKS

AI’s automation capabilities have immense potential to streamline audit processes. Many routine tasks that previously demanded significant human effort and time can now be automated with AI tools.

Tasks such as data entry, reconciliation and transaction testing can be handled efficiently by AI-powered software, freeing auditors from repetitive and mundane activities. As a result, auditors can redirect their efforts towards higher-value tasks, such as data analysis, risk assessment and client interaction.

Automation not only increases audit efficiency but also reduces the likelihood of errors and inconsistencies, thereby enhancing the overall quality of audit services.

Use case: A large auditing firm faces the challenge of repetitive tasks during its annual audit of a manufacturing company. These tasks involve reconciling vast amounts of transaction data, which consumes significant time and resources. By integrating AI-based Robotic Process Automation (RPA) tools into their audit process, the auditors automate data entry, reconciliation and transaction testing. This allows the audit team to focus on higher-value activities, such as verifying complex financial arrangements and offering valuable strategic advice to the manufacturing company.

AI TOOLS FOR ROBOTIC PROCESS AUTOMATION (RPA)

https://www.automationanywhere.com/rpa/robotic-process-automation

https://www.automai.com/rpa-robotic-process-automation/

https://www.blueprism.com/

AI AND PREDICTIVE ANALYTICS

Predictive analytics is a powerful application of AI that empowers auditors to go beyond historical data and anticipate future trends and risks. By analysing historical financial data and relevant market indicators, AI can offer valuable insights into a company’s future performance and potential areas of concern.

For auditors, predictive analytics aids in audit planning and strategy development. By identifying high-risk areas in advance, auditors can tailor their audit procedures to address specific challenges effectively. Additionally, auditors can provide clients with proactive advice and recommendations, helping them make informed business decisions.

Use case: An investment bank hires auditors to assess the risk associated with its portfolio of mortgage-backed securities. By leveraging AI-powered predictive analytics, the auditors analyse historical financial data, economic indicators and market trends. This empowers them to identify potential risk areas and forecast the performance of the securities in different market scenarios. The investment bank uses these insights to adjust its investment strategy, mitigating potential risks and maximising returns for its clients.

AI Tool for Predictive Analytics
Download Power BI Desktop from the Official Microsoft Download Center

ADDRESSING CHALLENGES AND ETHICAL CONSIDERATIONS

While AI presents significant opportunities for audit professionals, it also comes with its set of challenges. Implementation of AI-powered audit tools requires investment in technology, training and infrastructure. Ensuring data privacy and security is crucial, as AI systems process sensitive financial information.

Ethical considerations surround the reliance on AI for decision-making. Auditors must strike the right balance between leveraging AI’s capabilities and exercising their professional judgment. Human intervention remains essential to interpret AI-generated insights and make final audit determinations.

Use case: A financial services firm adopts AI-powered audit tools to enhance its internal controls and risk management processes. However, the firm faces challenges in maintaining data privacy and security due to the sensitive nature of the financial information involved. To address this, the auditors work closely with the firm’s IT and cybersecurity teams to implement robust data protection measures, ensuring that AI-generated insights are accessible only to authorised personnel.

THE FUTURE OF AI IN AUDIT

The future of AI in audit is promising and dynamic. As technology continues to evolve, auditors will witness even more sophisticated AI solutions that can handle increasingly complex audit engagements.

Opportunities for auditors to upskill and adapt to technological advancements will be essential to harness the full potential of AI. Collaboration between auditors and AI technologies will be paramount, as humans and machines work in tandem to deliver comprehensive and insightful audit services.

Use case: A leading global audit firm invests in research and development to stay at the forefront of AI advancements. They develop and deploy cutting-edge AI solutions that can analyse complex financial instruments and transactions. With the support of AI, auditors can now perform audits with increased accuracy and efficiency, significantly reducing the time needed for compliance while offering more value-added services to their clients. One may refer to the Audit Data Analytics Guide published by the AICPA.

CONCLUSION

AI has already begun transforming the audit profession, and its impact will only intensify in the years to come. AI empowers auditors to perform more accurate and efficient audits, delivering greater value to clients and stakeholders. By embracing AI responsibly and aligning it with their professional expertise, auditors can navigate the digital landscape successfully and secure a prosperous future for the audit profession. As AI-driven audits become the norm, auditors will continue to evolve into strategic advisors, leveraging technology to fuel innovation and ensure financial trust in a technology-driven world.  

How Certified Enterprise Risk Managers Can Make a Crucial Contribution to the Success of New Business Projects?

We take and manage risk to seek reward and achieve objectives. All projects involve risk, some more so than others, but risk should be understood as meaning uncertainty, which covers both threats and opportunities. Inbuilt into every project planning process should be the creation of a project Risk Management Plan (RMP), or a subset of the project management plan, to define how the project team will take and manage risk. An RMP should be put together by a project risk coordinator, who is appointed early in the project’s life by the project manager as the project team structure is being defined. Whether the risk coordinator is a full-time or part-time role on your project depends on the project’s nature and size. Many high-risk large projects employ a full-time risk manager. Whether it is a full or part-time role, the coordinator needs to liaise with all project disciplines and be the glue ensuring that managing risk is done cohesively and collaboratively, not in functional silos. If your organisation has a central risk function, they should support the risk coordinator. They can provide guidance for the RMP and perhaps include them in any risk champions’ network to provide mentoring and skills development.

THE PLAN

Risk managers need to include four critical elements in the RMP. First, set out how all disciplines/ teams on the project will manage risk in a coordinated and common way, focusing on achieving project objectives. Second, specify roles and responsibilities for taking and managing risk. That includes defining a governance structure to oversee this activity, including deliverables for phase and gate reviews. Third, articulate how the management of risk will be embedded into the rhythm of everyone’s activities, as part of the team’s culture. And finally, describe how you will leverage your organisation’s knowledge and resources, such as central personnel, lessons learned from other teams, templates, tools and techniques. The team environment and culture is a defining influence on how a project team takes and manages risk. It is important to ensure that people’s attitudes and behaviours to risk are aligned with the objectives of the project, and that team members are clear on what is expected of them. The team’s understanding of its risks must be consistent with how these risks are being communicated and discussed with the project’s parent organisations and other stakeholders. At the earliest possible time – this should be described in the RMP – the risk coordinator should assist the project leadership team in applying recognised good practices to ensure a healthy environment and culture. The IRM’s practical framework for establishing and maintaining a healthy team environment and culture is helpful here (Risk culture, resources for practitioners is free and can be downloaded from the IRM India Affiliate website at https://www.theirmindia.org/thoughtleadership)

RISK APPETITE

A risk appetite statement is a good way to define your propensity for taking different types of risk. The use of risk appetite is common in some sectors, particularly finance. It is used sparingly in many sectors, if at all. Defining your risk appetite for your project, and agreeing it with key stakeholders, can play a useful role in informing people where your focus needs to be. A project that needs to take risks to achieve ambitious financial objectives will have higher appetite and tolerance ranges for financial risk, for example, than a project which is financially risk averse.

Establishing and communicating a clear risk appetite fits naturally with establishing the right team environment and culture to manage risk. Risk appetite is most effective when it is either created by the team or guided by the project’s parent organisation, and then integrated into how the project team collaboratively evaluates and manages their risks across all disciplines. When risk appetite is being considered during regular reviews and daily activities, it has established itself as a valuable tool for decision-making and to measure performance against objectives – of which, more later. When the right team environment and culture is in place, and your appetite for risk is understood, taking and managing risk should be ingrained into everyday activities. It leads to the proactive anticipation of risk and measuring the cost-benefit of actions, and having the resilience to respond in the best way possible to risk events should they occur. Prioritisation of risk is important. Many of us are familiar with an “impact x likelihood = rating” method to prioritise risks into a “risk matrix heat map” and/or a risk register. Using a risk matrix – the levels in which will be influenced by your risk appetite – to prioritise risks, and displaying these risks in a heat map, is a good starting point. But additional factors should also be considered to improve the quality of prioritisation and focus

CRITICAL CONTROLS AND TOOLS

Prioritising risks helps us focus on the prioritisation of controls. Having the right controls in place to manage risks, rating control effectiveness and testing controls is a fundamental part of risk management. Controls must be proportionate to the risks that are faced so that effort is focused on what matters most. Controls rated as “critical” are those that have the largest effect on managing the risk. They are the most important controls to focus on and to have appropriate assurance in place, for example, through functional, internal and perhaps external audits. The RMP should describe a risk toolkit, perhaps provided by your organisation’s risk team, of techniques and tools that will help the team. The toolkit should complement the processes already used by all disciplines on the project. Typically, tools will include an IT risk tool, which can be anything from a shared risk register, to a comprehensive source of knowledge for all risks and controls. Most tools are likely to help teams to manage their risks, events, incidents and audits in an online, collaborative and efficient way that is better than using document versions. But they should also include risk workshops, for example, that are planned, structured and run by a facilitator. They can be planned into the project schedule for key milestones. Discipline-specific workshops, always with a few people from outside the discipline, should be held when required. One simple way of helping keep the project on track is to create a risk card. It is a modest but useful tool to provide to team members. It is a double-sided and laminated card – A4 or letter size – that summarises the key points of your culture, your risk appetite, your risk prioritisation process, and how the management of risk is measured. Laminating them makes a difference. Many team members will pin them to their desks and use them in future team reviews.

MEASURE IT

Continuously improve your performance by measuring what is working and what is not. You can measure the management of risk and not let it go unseen if you weave your measurements into people’s regular activities. There are two useful ways of measuring the management of risk. The first measures the cost of controls and actions to manage risks, and their effect on project outcomes. You can establish an accurate estimate of the cost of controls when the right people are in the room. Ask the question during your reviews. When you monitor how well controls are contributing towards project performance, you can demonstrate their financial value, whether they are safety controls, design controls or others. The second, is to measure the cost of managing risk against risk appetite performance and project outcomes. By using your risk appetite to guide your decisions, you can track performance against risk appetite metrics over time – such as safety metrics, financial, schedule, supply chain metrics and others. This can in turn be mapped to the success towards achieving good outcomes.

LESSONS

Risk managers can play an important role in educating people in their organisation about project failure and success. Earning the IRM’s certification in Enterprise Risk Management is a great way to consolidate and then use, capture and share knowledge and lessons learned of how you have managed risk, for your own benefit, and so that others in your organisation learn from your project’s experiences.

NASA, for example, turns their capture of risk knowledge into knowledge-based risks, which are freely shared and disseminated. Your knowledge repository, structured in an appropriate way, will provide people with a valuable information source before and during their projects. Your RMP should include how you will run knowledge capture sessions, such as peer assists (seeking knowledge before activities commence), after action reviews (quick-fire learning during activities), and retrospectives (postimplementation lessons learned). Incorporating these activities into the risk management schedule will produce a rich source of information for the entire business. Taking the time to plan, implement and monitor good practices to take and manage risk increases the likelihood of achieving project objectives. Taking the time to measure your management of risk, and ensuring knowledge is shared, allows you to tangibly demonstrate the cost-benefit of your activities.

[This article was originally featured in IRM’s Enterprise Risk Magazine and is reprinted with permission for the benefit of our readers]

Technology : The New Audit Team Member

The rapid growth that we are witnessing is the result of the massive digitization of operations to achieve qualitative outputs with less time and effort.

The same concept applies to the audit profession as well. Auditors can deal with business transactions that are complex and voluminous while going digital. Regulators also use technology to achieve better compliance through quality assurance services.

The auditors have nearly no option but to use digital audit tools and techniques, to deal with complex and voluminous transactions, and provide superior assurance services in less time and with less effort. There are various digital tools presently available in the market that can be used by the auditors throughout the audit life cycle i.e., starting from evaluation and documentation of prospective client and audit engagements, audit planning, execution, and completion.

The Audit Quality Maturity Model (AQMM) and its implementation guide that has been recently released by ICAI in February 2022, have also emphasized that the adoption of digital audit tools and new-age technologies, can significantly help auditors to improve their level of maturity.

The objective of this article is to discuss the relevance of digital tools and techniques, and how the auditor can use them at different stages of audit to ensure effective planning, execution, and completion of audit engagements.

CLIENT EVALUATION

SQC 1 requires that the firms should obtain such information as it considers necessary, before accepting an engagement with a new client when deciding whether to continue an existing engagement and when considering acceptance of a new engagement with an existing client. Also, where issues have been identified, and the firm decides to accept or continue the client relationship or a specific engagement, it should document how the issues were resolved.

In order to meet the above requirement, the firm may choose to do the evaluation of client acceptance and continuation in a digital format, wherein different enquiries, which in the firm’s view are required to be made before accepting or continuing a new or existing client, and can be defined in the tool, may be in in the form of a questionnaire or templates that are required to be filled for the assessment, and wherein the necessary evidences can be attached or uploaded to support the assessment and conclusion. For example, the firm may design a questionnaire that includes relevant questions with respect to the client’s background, its related entities, the geographies in which it has its operations, any litigations against it, if the client has political influence or has a high public profile, etc., all such questions and their responses along with the supporting documents can be captured through google forms or by using any audit management or practice management software, with restricted access.

In this manner, the firm will not only ensure the proper evaluation and documentation of client acceptance and continuation, but it will also be able to demonstrate the compliance of applicable professional and ethical requirements, prescribed by the Institute of Chartered Accounts of India (ICAI), to the regulators, as and when required.

ENGAGEMENT EVALUATION

Similar to client evaluation, SQC 1 also requires audit firms to conduct engagement evaluation in order to assess whether accepting an engagement from a new or an existing client may give rise to an actual or perceived conflict of interest, and where a potential conflict is identified, evaluate whether it is appropriate to accept the engagement and document the conclusion thereof.

The above evaluation can only be done, if a comprehensive database is maintained for all the audit and non-audit clients having details like names of all the related entities i.e., holding, subsidiaries, associates, joint ventures, etc., along with the list of services provided by the firm, to these entities. This database becomes more critical when the firm operates within a network of firms or has offices at various geographical locations.

The firms should use tools that can maintain relationship trees for each and every client along with the list of ongoing and completed services provided to these clients and which can also assist to evaluate and document the conflict of interest, and rationale for accepting an engagement.

The firm should also need to obtain and maintain independence declarations from all of its employees with respect to its existing and prospective audit engagements, from time to time so that any potential independence issues can be identified, and mitigating steps can be taken in a timely manner, to avoid any potential non-compliance.

Firms can obtain and store such declarations by using digital forms having relevant questionnaires that are required to be responded to by the employees to confirm their independence, with respect to the audit clients of the firm. A master list of all the audit clients should also be maintained over the intranet or circulated through emails to all the new and existing employees, from time to time.

These digital tools usually assist firms to keep a record of all such evaluations and their conclusions for a longer period in the electronic format with a date and time stamp, which also assist regulators to ensure that all such compliances were done in a timely manner.

AUDIT PLANNING

Planning is the most crucial and time-consuming activity for any audit engagement, as it involves significant deliberations with respect to the resources to be involved, the timing and extent of various audit procedures that are required to be performed by the team, and the review milestones, so that the engagements can be completed within the required timeline.

It is very important to ensure that all the relevant matters with respect to the audit engagement like financial statement level risk, fraud risk, audit approach, materiality, significant accounts, sampling technique, data analytics, involvement of experts, resourcing, timelines, etc., have been discussed and deliberated upon, amongst the senior audit team members and partners, and are documented and stored in such a way that it is easily accessible to all the audit team members.

To achieve the above objective, the audit firm can use standard digital templates or audit management tools that can provide dedicated sections for evaluation and documentation of each aspect of audit planning, whether in the form of a checklist or specifically designed forms that cover all the relevant guidance of the applicable Standard on Auditing (SA). It is important to note that such tools or digital forms should give read-and-write access only to partners and designated audit team members and read-only access to other audit team members.

AUDIT EXECUTION

In order to perform a quality audit, the auditor needs to ensure effective analysis of the client’s data, so that it can be converted into useful information and can be used with professional skepticism while performing the audit.

At times considering the size and complexity of operations and the IT environment in which the client operates, it is not possible to analyze the required data without the use of automated data tools. These data tools assist the audit team in analyzing voluminous and complex data based on the pre-defined parameters that are relevant for the audit. A few examples of the analysis that can be performed for clients that operate in an ERP environment are as under:

– Data analytics for internal controls: Analysis of data flow from purchase requisition to payment, wherein the audit team can analyze the chronology of transactions and also their respective preparers and approvers. With this analysis, the audit team can easily assess the effectiveness of internal controls as compared to the workflow and authorization metrics defined by the organization and report the exceptions to the management.

– Sampling: Selection of samples for vouching from the data population can also be performed with the use of data analytic tools. These data tools allow the audit team to input key parameters that the audit team wants to consider for sample selection. For example, materiality, risk rating of account caption, number of samples to be selected, type of samples to be tested i.e., random, or high-value transactions, expected error, tolerable error, confidence level, etc. The algorithm defined in the data tool takes into account all these inputs given by the audit team and selects the samples accordingly.

– Journal vouchers (JV) analysis: These data tools also assist auditors to analyze JVs which are considered to be the most error-prone accounting vouchers in the ERP environment. The auditor can run an analysis to identify JVs exceeding and below specific amounts, JVs passed during odd working hours and during the weekends, the highest number of JVs passed by a single user, JVs passed using the employee IDs who left the organization, JVs passed by the senior management personnel, etc.

– Account-specific analysis: Data analysis on a specific risk area can also be performed using data analytic tools. For example:

  • Analysis of employee, vendor, and customer master for the identification of duplicate accounts with common inputs like PAN, Aadhar number, GST Number, Bank account number, etc.
  • Analysis of sales and purchase register for the identification of duplicate invoices, high-value debit, credit notes, etc.
  • Re-computation of income or expenses like interest, sales incentives, rents, etc. using the key parameters defined in the underlying policies, agreements, or other documents.
  • Analysis of bank account statements to identify frequent payments that are of very nominal values, payments that are of specified values or less than the approval thresholds, for ex- ending with 999, and high-value transactions.

It is worthwhile to mention that all the above analysis can produce reliable results only when the underlying data is complete and accurate, and as such IPE (Information produced by the entity) testing is of greater relevance, in these cases.

Also, before using any of the data analytic tools the auditor must ensure the authenticity and reliability of the results these data tools produce i.e., the auditors need to obtain an assurance from the vendor that the algorithm used in its tools is producing complete and accurate results.

At times, it becomes very difficult for auditors to convince clients to share the entire database with the audit team so that a detailed analysis can be performed and as such it is very important for the audit firms to explain the Board of Directors and Audit Committee, at the time of audit planning or the audit appointment, the audit methodology adopted by the firm, the various digital tools that the firm uses to carry out the audit, the objective of using these tools, and how their extensive usage can bring audit efficiencies and provide better audit comfort to the audit team and the management.

MONITORING AUDIT PROGRESS

In the audit execution process, audit teams continuously obtain evidences that either supports the audit assertions assigned to the account caption or reports an exception, for example, the exceptions may indicate a control failure, a material misstatement in the account caption, a risk that was not previously perceived by the audit team, a non-compliance of law, etc., whatever the case may be, the more important aspect here is how the audit team keeps a track of all these evidences and testing results, and evaluate if the evidences are conclusive or further audit procedures are required to be performed, to draw conclusions

A review mechanism is the best way to assess the appropriateness and adequacy of these evidences, however, in order to do so, the reviewer must be informed, on a timely basis, about the progress of the audit and the exceptions identified.

In the present environment, the above exercise is done manually by the majority of the audit firms, however, with the growing digitization, few of the audit firms have created a digital environment through which audit progress, documentation of evidences and review thereof is done on a real-time basis, and thus assist audit firms to evaluate and discuss exceptions with audit team and management, and make the required changes in the audit plan and procedures, in a more frequent and timely manner.

AUDIT COMPLETION

Audit completion is the last stage of audit wherein the audit engagement partner along with the senior audit team members ensure that the adequate audit procedures have been performed on all the significant account captions that are identified during the planning or execution stage and sufficient appropriate audit evidences have been obtained to support the audit opinion. Further, the audit team also needs to ensure that audit risks and other audit issues that are identified during the audit have been adequately addressed and reporting implications if any are captured in the audit report.

To ensure the above, the audit team needs to perform a series of checks and balances to ensure that nothing has been left out. The above completion activity can be done in a more robust and time-effective manner if an audit management tool can be used from planning to completion of the audit, and that can provide reports highlighting exceptions at every stage of the audit. Some of the common instances of exception reports may include:

– Control testing not documented for all the accounts or related assertions selected at the planning stage.

– Audit procedures on all the significant accounts or related assertions not documented.

– Engagement-specific risks identified at the planning stage are not documented and concluded.

– The financial implications of the total identified misstatements are more than audit materiality.

– The total of untested or non-significant accounts, if material.

– Required checklist for Standard on Auditing, Accounting Standard, Schedule III, etc., not filled and documented.

– Audit evidences of significant areas are not marked as reviewed by the engagement partners.

– Audit procedures for identified fraud risks that have not been documented; etc.

TRAINING AND IMPLEMENTATION

Though from the above discussion it can be construed that using digital audit tools in the audit life cycle will bring significant audit efficiency and better audit quality for both the audit firms and their clients, yet an inappropriate implementation of any such tools or inadequate training to audit staffs, may refrain audit firms to reap all these benefits to their full extent.

Audit firms while selecting and implementing these tools need to be very cautious and should ensure that the workflow and features of the tool coincide with the audit methodology and infrastructure of the firm. For example, if an audit firm is selecting an audit tool that require a strong computer processor to do the required analysis and a strong internet bandwidth to provide remote access to the multiple team members, the audit firm need to consider whether the computer system (desktop/laptop) provided to the audit staffs are competent enough to handle these tools and the internet bandwidth the firm uses is strong enough to provide the seamless connectivity.

Similarly, audit firm needs to ensure that adequate training sessions are offered by the vendors of these tools so that all the audit staff can be adequately trained and use these tools seamlessly. Also, dedicated technical support must also be ensured for any technical issues, that may be encountered by the audit team while performing the audit.

AUDIT MANAGEMENT AND DATA ANALYTIC TOOLS

There are a number of audit management and data analytic tools that are presently being offered by various companies in India. Some of these tools are also recommended by ICAI as part of its capacity-building initiatives for small and medium size practitioners. Below are the web addresses for a few of such tools:

Purpose of tools Web address
Audit management https://www.teamleaseregtech.com/product-services/audit-management-software/
Audit and practice
management
https://simplifypractice.com/
Audit and practice
management
https://papilio.co.in/icai.html
Audit management and
data analytics
https://anyaudit.in/
Audit management and
data analytics
https://assureai.in/
Audit and practice management https://www.myaudit.co.in/
Data Analytics https://idea.caseware.com

Audit tools that are recommended by ICAI, can be accessed at http://cmpbenefits.icai.org/. Many of these software companies are either offering these tools with 1 to 5 years of free usage period or at a discounted price to the members of ICAI.

CONCLUSION

There is a possibility that initially, some of the small and medium size practitioners may find the selection and implementation of an audit tool to be a complex, cumbersome and expensive process, however, once it is appropriately implemented and adopted by the audit team as part of their auditing tool, the benefits that the audit firms can derive from it, are immense. Further, in the present economic environment it is not feasible for audit teams to conduct audits of organizations that are operating in a far more complex digital environment with voluminous transactions and achieve the desired level of audit comfort and robust documentation, by using the traditional audit methodologies, and as such the adoption of digital tools and techniques, is the need of the hour for all the audit practitioners.

Ind AS 20 and Typical Government Schemes in India – Part II

[Part – I of this article published in November, 2022 BCAJ covered various aspects of Ind AS 20. In this concluding part, the author covers how certain typical Government schemes/ programs work, how they fall within the definition of “Government Assistance” and how the same should be recognized and disclosed.]

GOVERNMENT GRANTS/ ASSISTANCE
In India, due to structural issues coupled with the inefficiencies in implementing various programs on their own, the Government has recognized the need to develop multiple underdeveloped or remote locations through private participation. Additionally, to seize the opportunity in global economy/ trade, foreign investments, and earn higher foreign exchange from exports, the Government has thought it apt to promote a few activities. Consequently, governments have launched various benefits/ facilities/ schemes from time to time. These benefits/schemes have proven to be “beneficial” for the Government in terms of meeting their twin objectives, one towards fulfilling their obligation towards the public at large; and second towards achieving the long-term objective of developing remote/ under-developed regions through the creation of employment and ancillary industries with more prominent operating entities establishing their shops.  Such schemes/ benefits have also helped private sector entities get some cash/ resources from the Government or concessions to reduce the cost of their investments / working capital and cheap labour at remote locations to reduce recurring/variable costs.

In general, the schemes/ benefits/ facilities provided by the Government do not result in the actual movement of money but are like either deferral of collection of dues from entities or forgoing the dues from the entity. Deferral of dues from the entity is nothing but allowing such entities to use funds they ought to have paid for the granted deferral period and, consequently, support working capital finance by the Government. The foregoing/ deferral of dues by the Government is a transfer of resources from the Government to the entity. It is recognized as “duties/taxes foregone” while presenting budgets.

Many times, even within the commercial world, where decisions are made for the evaluation of different projects with an element of government scheme/ benefit/ facility, such entities do give cognizance to such schemes/ plans/ benefits in arriving at business decisions. This also supports the view that Government Assistance should get recognized.

Let us see how few typical Government Schemes/Programs work, how they fall within the definition of “Government Assistance” and how the same should be recognized and disclosed.


INTERNATIONAL FINANCIAL SERVICE CENTRE (“IFSC”) IN GIFT CITY
The Government of India has an ambitious plan to invite global financial services companies to set up their regional centres in India and make the country one of the essential Financial Hubs globally. The activities on the same started way back in 2008, but material steps began in 2015-16 with the IFSC declaring a multi-service Special Economic Zone. Subsequently, over time and learning more about the requirements from global players in financial sectors, the law affecting the operations of IFSC kept on improving year after year. Now, we have a more structured law on the IFSC.

An operating unit/ entity in IFSC is treated differentially by treating the same (artificially) as operating/functioning “outside India” even though physically located within India. Such legislative artificial projection creates a difference between entities carrying on similar activities outside and within the IFSC. Therefore, a regulatory framework for IFSC is nothing but “an action” by the Government which, through various “exemptions”, creates a specific situation which allows units in IFSC to enjoy “certain benefits” not available to entities carrying on similar operations outside IFSC. The legislative framework is a conscious effort (intended) by the Government “to give economic benefit” to the entities investing and operating from such IFSC. Hence, IFSC squarely falls within the ambit of “Government Assistance”. However, the economic benefits are measurable and can be recognized as a benefit under the relevant Ind-AS framework, and the Standard requires careful evaluation. It will be relevant to understand that the Government has carved out “exemption” for entities operating from the IFSC against making laws not applicable as, generally, all laws are applicable across India. As the schemes have been designed as “exemptions” these further call for the considered view that the IFSC largely works as a Scheme/ Program intended to give an economic benefit. Hence, the benefit derived by the entity in terms of savings on duties or taxes, which such units ought to have paid otherwise, are clear benefits requiring recognition in financial statements. Similarly, any benefit in terms of upfront exemption vis-à-vis payment and subsequent claim of refund helps such entities in terms of working capital.

EPCG / SEZ SCHEMES

Export Promotion Capital Goods (EPCG) or Special Economic Zone (SEZ) unit or Software Technology Park (STP) unit schemes allow certain benefits in terms of exemptions from payment of duties. All such schemes work on different principles, but the operating unit/ entity gets benefits subject to the fulfillment of certain conditions.

Both these schemes have been examined and opined by Ind AS Technical Facilitation Group (“ITFG”) of ICAI1 as qualifying Government Grants and requiring the relevant entity to recognize the same in accordance with the prescription under the Standard. The basic premise of the opinion appears to be that the legislative enactment by the Government is “action” that intends to exempt duty which such an entity (i.e. specific to the entity or group of entities qualifying requirement) ought to have paid otherwise (i.e. resulting into economic benefit to such an entity). Under EPCG, the entity which commits itself to export goods manufactured by using imported capital goods/ equipment is allowed to import such equipment without payment of customs duty. By such an exemption, the Government compensates the entity for the component of customs duty on the import of capital goods it ought to have paid but for the exemption. Even though there is requirement of certain quantum of exports to be achieved for finished goods produced from use of such assets, the exemption is granted for one of the components of the asset (i.e. import duties). In this background, in the authors view, EPCG is a grant for capital assets. It should be accounted for basis guidance provided in the Standard at Para 17 and 18 by setting up deferred revenue in the Statement of Financial Position and recognized as income in  the Statement of Profit and Loss over the asset’s life. However, a perusal of certain published results suggests that entities have opted to recognize grants to the Statement of Profit and Loss based on the satisfaction of export obligations. This is the same divergence of prescription under the Standard with Conceptual Framework for which the project has been pending since 2006. Recognition of the revenue grants on the basis of export obligation may be appropriate.


1. ITFG has provided clarification about treatment of EPCG under Ind AS 20 vide response to Issue No. 5 to ITFG Clarification Bulletin No. 11. Further, ITFG has provided clarification on SEZ/ STP programs / Schemes as qualifying and requiring accounting as “Government Grant” under Ind AS 20 vide Issue No. 3 to ITFG Clarification Bulletin No. 17.

However, recognizing the grant to Statement of Profit and Loss based on export obligation, even for capital grants, appears to be a deviation from the prescription under Paras 17 & 18 of the Standard, even though it might be in sync with the Conceptual Framework. However, with the amendment in the Standard2 allowing measurement of non-monetary grants relating to assets at nominal value, such an option if exercised, will excuse the entity from setting up deferred revenue and related complications if the nominal value is not material.

The SEZ scheme allows the eligible entity to procure goods (capital goods or inputs other than capex) without payment of taxes and duties. The eligible entity is expected to manufacture and export the goods to enjoy the exemption. In  case of manufactured goods sold within India, as per changed regulation3, duty/ taxes claimed exempted must be paid back to the Government without any interest. A different principle applies to the SEZ scheme, but the benefits still remain. Hence, ICAI’s ITFG4 has concluded that the SEZ scheme is a “Government Grant” requiring compliance with Ind AS 20. An important point to remember is the change with respect to allowing the entity to value (i.e., on measurement point) capital grant at nominal value instead of at fair value w.e.f. 1st April, 2018 and its prospective application. Due to this, unless relevant information is not provided as required, financial statements of otherwise comparable entities may not be comparable due to different entities accounting for grants received before and after 1st April, 2018 differently.


2. Para 23 of Ind AS 20 substituted vide Notification dated 20th September 2018, permitted an entity to adopt an alternative to recognise assets at nominal value instead of fair value in case of such grant pertained to non-monetary government grant.
3. Vide Finance Act, 2021, Provisions of Customs Tariff Act, 1975 have been amended which requires SEZ units to “surrender” duty exemption in respect of CVD/ ADD availed on inputs which have been used for finished goods sold in domestic market.

4. ITFG has provided clarification on SEZ/ STP programs / Schemes as qualifying and requiring accounting as “Government Grant” under Ind AS 20 vide Issue No. 3 to ITFG Clarification Bulletin No. 17.

Further, as per the Standard today, the recognition also depends on whether the grant relates to asset or revenue. In the author’s view, when the exemption is related to a capital asset, the intention is to compensate the cost of the capital asset, even if such a capital asset is intended to be used for manufacturing goods for exports. Therefore, if the exemption enjoyed by the entity is towards the cost (including duties/ taxes) related to capital asset, such benefits / grants should be accounted for as a grant related to capital asset in contrast to considering the same as related to revenue merely due to certain condition of certain obligation (i.e., export obligation).

MANUFACTURING AND OTHER OPERATIONS IN WAREHOUSE REGULATIONS (MOOWR)
The basic premise of the Customs Act,1962 is to levy duties on goods moving out of India or coming within India. However, with the passage of time, trade evolved and many new business models were introduced. Further, globally, the regulatory landscape has changed. Under the Customs Act, any goods entering India do not suffer duties till the same are within the Custom’s area. Generally, within Custom’s area no use of such goods is permitted. However, such regulations create a bottleneck in changing business models where entities set up facilities to manufacture and export. In such business models, imported items are not intended for consumption by a person residing in such country of import but are eventually expected to get exported after manufacture. To meet such challenges, the Government has to tweak customs law to make way for some “convenience” whereby duty liabilities are either deferred or foregone. Such an act of duty deferral/exemption has been achieved either through notifications or by legislative fiction by treating / creating an artificial projection of locations as a place not within India, even if located far away from the Customs port. MOOWRs is one such example.

Under MOOWR, the specified place is considered to be a “warehouse”, and any goods will be considered as “not entered India” for levy of Customs Duty even if the goods have actually moved in India from the port to such locations. This fiction was further extended recently by permitting even the use of such imported goods without triggering duty liability. Government creates all such fiction through the law which indicates that these are in the form of “Government Assistance”. Further, when such assistance becomes measurable, it should be considered as a “Grant” and accounted for/ recognized in the financial statements accordingly.

For example, under MOOWR, if an entity is not liable to pay customs duty upfront but it is deferred till such good is moved to a person in India out of such entity/ specified location, then the Government is actually allowing or accommodating the entity with a working capital facility for the time being and allowing the use of such goods/ equipment, as the case may be. Hence, ideally, such deferral should be accounted for as an interest-free loan granted by the Government on the duty deferral component.

However, quantification of the Government Grant or otherwise will require examination of each case and nature of exemption, whether on the capital asset or input and whether intended sales are domestic or export. In case an entity has significant exports,  the  scheme can be considered as “assistance” in place of a “grant” for duty deferral on inputs when exports are exempted. Otherwise, the entity would have anyways got a rebate for duties paid on inputs on exports. However, another view that is equally possible refers to the scheme as assistance, as the liability has been deferred through statutory notion from the date of importation till the actual export of goods out of the country. However, it appears that the earlier view seems more aligned with the requirements of the Standard.


MEIS/ SEIS / RoDTEP / PRODUCTION LINKED INCENTIVE SCHEMES
The Government of India announced the Production linked incentive (“PLI”) scheme for various sectors with multiple conditions. Such incentives are computed and earned on the basis of an “incremental production/ sale.” However, they have imposed additional conditions on the investments being made. Hence, accrual of such an incentive as Government Grant requires examination of multiple conditions including “reasonable assurance” of entitlement to such Grant and the creation of “deferred income” in case the entity receives the grant but cannot fulfill the obligations.

In contrast to the PLI scheme, Merchandise Exports from India Scheme (“MEIS”) / Services Exports from India Scheme (“SEIS”) / Remission of Duties and Taxes on Export Products (“RoDTEP”) are more straightforward. They can be easily identified as revenue grants. These revenue grants can be presented as net of expenses as per the option available under the Standard. However, the relevant expenses, which the grant intends to offset, might have been booked under different headings and groupings, and identification or bifurcation of the grant amount into differential components will be difficult. These grants should be accounted for under gross basis accounting, contrary to offset against relevant expenses.

STATE GOVERNMENT SUBSIDIES UNDER STATE INDUSTRIAL POLICIES
Various State Governments, through their state industrial policies, announce various schemes for inviting industries to set up operating facilities in their states. Such policies generally have differentiated benefits based on the level of investments or job opportunities created, etc.

Some typical incentives are as under:

Stamp Duty waiver: The grant can be capital or revenue in nature depending on the waiver mentioned in the documents/ agreement or transaction.

Refund of State GST component on local sale within the state: The grant will be revenue grant.

Electricity duty exemption: The grant will a be revenue grant.

Reimbursement of a portion of capex cost: The grant will be capital grant.

Land at a concessional rate: The grant will be a capital grant.

Electrical/water line at no extra cost:  Grant can be a capital grant if otherwise entity needs to incur these costs.


CONCLUSION
The review of various published results indicates that the Standard on Government Grants has been considered as more of disclosure standard and might be true to many of such entities. However, generalising the same may not be correct as each scheme may require different treatment depending upon the facts. It is critical to understand the definition of a grant. For this, one must understand whether a particular scheme/ policy/ program / legislation really falls within the ambit of a “Government Grant” or not. Generally, recognition/ accounting and measurement of money actually received from the Government poses lesser challenge as compared to waivers or exemptions. Various Government benefits/ schemes, including the waiver of liability or obligation, need to be understood for transfer of resources from the Government to the entity or not. For the waiver of the obligation, firstly, one should examine whether there exists any obligation or not. Such an evaluation may require an entity to examine facts of the relevant scheme and applicable relevant statute. In some cases, it may also require an entity to perform comparative analysis of carrying on similar activity in different set-ups to come to a conclusion about existence of obligation or not. Once the obligation exists, then its waiver or deferral due to specific legislation or status may create “transfer of resource” from the   Government to the entity. ICAI’s ITFG has already provided guidance on SEZ/ STP and EPCG, which can be useful for entities and auditors. If an entity is availing any other scheme, then the scheme should be examined with regards to the parameters / guidance prescribed under the Standard. Further, the Standard having the prescribed differential treatment (recognition as well as measurement) for grants related to assets from grants related to revenue/ expenses, needs to look at the issue of recognition, measurement, accounting and disclosure more closely for each category of grants.

It will not be wrong to state that first of all, the nature of the grant should be identified followed by examination of fulfillment of secondary criteria required for recognition of the relevant grant, which are “reasonable assurance on meeting such conditions” and “assurance on realization of grant”.  

Considering that the Standard has prescribed differential recognition parameters (i.e., in case of grant related to asset, over life of the asset) as well as differential measurement parameters (i.e., all revenue grants at fair value as against non-monetary capital grant with option at nominal value), an entity should carry out careful and detailed examination and analysis of relevant parameters for eligibility of grant, to what it pertains (i.e. cost of asset or to compensate for some expenses or incentive to do some activity), conditions/ obligations required to fulfil to be entitled for such grant/ compensation, etc.

Separately, various schemes have conditions/requirements that are obligations that should be adequately disclosed to give the user of the Financial Statements adequate information on the nature of grant/assistance and its impact on the Financial Statements of the entity.

Apart from the schemes through which entities get monetary benefits, there are few schemes by the Government that give certain category of entities more “facility” or “convenience”. It may be a good practice to disclose such schemes or facilities or convenience as “Government Assistance” if management believes that they are material in nature as the benefit from such facilities may not be reasonably measurable and hence may not fit within definition of “Government Grant”.

Sustainability Reporting and Assurance

INTRODUCTION
Sustainability Reporting is an evolving discipline encompassing the disclosure and communication of an entity’s non-financial – environmental, social, and governance (ESG) performance and its overall impact. Over the last few years, more and more entities are preparing and disclosing their sustainability reports either under a mandate or voluntarily as per the reporting frameworks/standards provided by various standard-setting bodies/regulators. Sustainability reporting will only be useful if it is of sufficient quality, and the stakeholders understands and trust the framework.
India is one of the early adopters of sustainability reporting for listed entities amongst its various other global peers1. In 2012, requirement of Business Responsibility Report (BRR) containing ESG disclosures was introduced for adoption by listed entities. SEBI introduced the requirements for sustainability reporting in May 2021. The new report is called the Business Responsibility and Sustainability Report (BRSR), with nine principles covering both environmental and social aspects such as climate action. SEBI has mandated the Top 1,000 listed companies (by market capitalisation) to provide such disclosures from F.Y. 2022-23 onwards as part of their Annual Reports (voluntary basis for F.Y. 2021-22). The new reporting format, BRSR, aims to establish links between the financial results of a business with its ESG performance. BRSR is not merely presenting the data collected, but an approach to drive an organisation’s commitment to sustainability and demonstrate it to interested parties in a transparent manner. BRSR has evolved from the National Guidelines on Responsible Business Conduct principles issued by the MCA, which itself emanates from the UN Sustainable Development Goals. A company may adopt the practice of framing a new single BRSR Policy containing policies and implementation procedure for all the nine principles and its core elements.

1. Source: Background Material on Business Responsibility and Sustainability Reporting.

The BRSR is a notable departure from the existing BRR and a significant step towards bringing sustainability reporting at par with financial reporting. Further, companies will be able to better demonstrate their sustainability objectives, position and performance resulting into long-term value creation.
ESG and sustainability are both strategic considerations for businesses, executive teams, and investors. They both share the same goal of improving a company’s business practices to boost profits and win favour from investors, customers, and regulators – while safeguarding the environment and supporting communities.
The global discussion around ESG and sustainability reporting is evolving every day and organizations are increasingly reporting on their broader performance and impact. While climate-related information is certainly on top of minds for many stakeholders, other ESG factors i.e., social and governance are gaining prominence. Company-reported information about sustainability factors is becoming a key focus area through increased voluntary disclosures as well as through new jurisdiction-specific rules. Assurance is a key aspect in increasing trust in the quality and accuracy of sustainability information. Assurance from an independent professional coupled with enhanced standards and reporting rigor has the potential to further build trust in sustainability information. For sustainability reports to be credible, the reliability of the reports is important. Assurance on sustainability information helps enhance stakeholders confidence in the accuracy and reliability of the reported information and provides the intended users with useful data for decision making.
The objective of this article is to explain sustainability reporting and benefits of assurance on such reporting. It also covers the role of auditor when assessing the impact of climate change and corresponding disclosures in an audit of financial statements.


WHAT IS SUSTAINABILITY AND ESG REPORTING?
There is increased investors and other stakeholders focus on seeking businesses to be responsible and sustainable towards the environment and society. Therefore, the goal of sustainability reporting is to make it easier for investors, customers, employees, and other key stakeholders to understand how well companies are managing their impact on the society and the environment. Thus, reporting of a company’s performance on sustainability related factors such as socio-cultural aspects, community participation, economic sustainability, and environmental sustainability have become as vital as reporting on financial and operational performance. However, it is yet to become a regulatory enforcement for all companies in India.

The term ESG reporting is often used for communications about ESG matters through a variety of channels, including press releases, websites, social media, investor letters or presentations and submissions to rating agencies. In many cases, ESG reporting refers to a voluntary disclosure of ESG information posted on a company’s website, commonly called ESG reports, purpose-led reports, sustainability reports or CSR reports.

In a typical ESG report, a company discusses material risks and opportunities related to ESG matters and its strategies for managing those risks and opportunities. This discussion is often accompanied by quantitative metrics. For example, a company that consumes various resources, such as electricity, jet fuel and water, or creates hazardous or non-hazardous waste from its operations and business activities may discuss its impact on the environment and its plan to reduce such impact over time, often by including reduction targets over multiyear time horizons. It may also include metrics supplementing the discussion, such as greenhouse gas (GHG) emissions, energy consumption and water usage.
 
SUSTAINABILITY REPORTING FRAMEWORKS
There is no standard format for sustainability reporting, however, following types of frameworks2 are often used by various companies or entities:

Framework

Organisation

Audience

Description

Sustainable Development Goals (SDGs)

United Nations

Broad set of stakeholders

SDGs comprise 17 interlinked global goals that aim to eradicate poverty
and promote sustainable prosperity, accompanied by 169 targets. Indicators
specify the information that should be used to help measure compliance toward
each target. These goals are used by companies to shape and prioritize their
business strategies and associated reporting.

GRI standards

Global Sustainability

Standards Board

Broad set of

stakeholders

These standards are the most widely used framework to create corporate
sustainability reports targeted to a broader range of stakeholders. They
consist of Universal Standards and Topic Standards. Topic Standards are
selected based on the company’s material topics.

Recommendations of the TCFD

Financial Stability

Board

Investors,

lenders and

insurers

This framework is used to create climate-related financial disclosures
and comprises disclosure recommendations structured around the core elements
of governance, strategy, risk management metrics and targets.

Integrated Reporting

Formerly International

Integrated Reporting

Council (IIRC), now Value Reporting

Foundation which has been merged with the IFRS Foundation

Integrated reporting

focuses on how the

organization creates, preserves or erodes

value.

This principles-based framework includes seven guiding principles
applied individually and collectively for the purposes of preparing and
presenting an integrated report. The framework establishes content elements,
which are categories of information required to be included in an integrated
report.

Greenhouse Gas Protocol

World Resource Institute and World Business Council on Sustainable
Development

Corporations and their customers.

This framework is focused on accurate, complete, consistent, relevant
and transparent accounting and reporting of GHG emissions by companies and
organisations.

Stakeholder Capitalism Metrics

The world Economic Forum’s International Business Council

Broad set of stakeholders

This framework includes a universal set of metrics and recommended
dislcosures intended to lead to a more comprehensive global corporate reporting
system. It divides disclosures in four pillars

(principles of governance, planet, people and prosperity) that serve as
the foundation for an ESG reporting framework.

CDSB Framework

Climate Disclosure Standards Board

Investors

This framework sets out an approach for reporting environmental and
climate change information in mainstream reports such as annual reports or
integrated reports.

SASB Standards

SASB

Investors, lenders and insurers

The SASB provides standards for 77 industries across 11 sectors. Each
standard identifies the subset of sustainability issues reasonably likely to
impact financial performance and long-term value of a typical company in an
industry.

Other proposed frameworks and standards:

  • Setting up of new Board to issue standards on sustainability-related financial disclosures. The International Sustainability Standards Board (ISSB) has published its first two exposure drafts on IFRS Sustainability Disclosure Standards, namely, General Requirements for Disclosure of Sustainability-related Financial Information and Climate-related Disclosures. These drafts once finalized will form a comprehensive global baseline of sustainability disclosures designed to meet the information needs of investors when assessing enterprise value. The ISSB did not propose an effective date in the drafts but plans to include one in the final standard.

  • US SEC – Proposed Rules for the Enhancement and Standardisation of Climate-Related Disclosures for Investors.
  • European Union Sustainability Reporting Standards (ESRS) proposed by EFRAG.


2. CDSB, as well as VRF, which included the SASB and the International Integrated Reporting Council (IIRC), have merged into the ISSB.
BENEFITS OF INDEPENDENT ASSURANCE
It is important to understand the benefits of independent assurance on Sustainability Reporting even if this is currently not mandatory in India and companies obtain assurance on a voluntary basis. Independent assurance can provide intended users, including boards of directors, customers, suppliers, prospective employees, and other stakeholders, with increased confidence in the reliability of ESG information, making it more likely that the data will be useful for decision-making. The management may also benefit from the feedback that comes with having an independent perspective on its sustainability reporting and associated processes. Furthermore, an assurance of such information may impact a company’s rankings and ratings on sustainability indices. It is worth noting that the assurance may benefit a company’s investors and other stakeholders, even if it is not required or stakeholders haven’t requested it. A strategic approach to sustainability issues can help organisations unlock many value creation opportunities. The other key benefits of assurance include the following:
  • Positive impact on internal practices and governance.
  • Strengthens internal awareness of sustainability risks and benefits.
  • Positive influence on branding and reputation.

  • Systems, processes, and internal controls around sustainability performance improve with each assurance engagement.

  • Credibility of information about sustainability is strengthened.
  • Improvement in positions of credit, risk, regulatory and sustainability rankings.

The IAASB has issued Non-Authoritative Guidance on Applying ISAE 3000 (Revised) to Extended External Reporting Assurance Engagements to address ten key stakeholder-identified challenges commonly encountered in applying ISAE 3000 (Revised) in sustainability assurance engagements.

The IAASB3 is currently working on a project to develop an overarching standard for assurance on sustainability reporting, that would address both limited assurance and reasonable assurance; the conduct of an assurance engagement in its entirety; and areas of sustainability assurance engagements where priority challenges have been identified, and more specificity is required.


3. Source: Assurance on Sustainability Reporting | IFAC (iaasb.org)

The two key assurance standards that are widely used for providing assurance of sustainability information are:
  • Assurance Engagements Other than Audits or Reviews of Historical Financial Information – ISAE3000.
  • Accountability 1000 Assurance Standard (AA1000AS)

As per the IFAC study on ‘The State of Play in Sustainability Assurance’, 91 per cent of the companies reviewed report some level of sustainability information. 51 per cent of companies that report sustainability information provide some level of assurance on it. 63 per cent of these assurance engagements were conducted by Audit or Audit Affiliated Firms.

Who currently provides/obtains external assurance?
Companies do not obtain independent assurance on most of the sustainability information they disclose today. It is not mandatory, and companies obtain it on a voluntary basis. Assurance is most commonly obtained on the subject matter involving GHG emissions, safety, water usage and diversity of the workforce.
 
A company may voluntarily choose to obtain assurance over certain aspects of its ESG information for various reasons, including to respond to requests from investors and investment organizations, or meet expectations from other stakeholders, such as suppliers and customers or meet criteria of organizations that promote assurance, such as the GRI. These assurance reports are generally included in a corporate social responsibility report or posted separately on the company’s website.
Various organizations, such as engineering, consulting, and accounting firms, currently provide assurance-related services on Sustainability or ESG information.
A snapshot of assurance on ESG disclosures of 100 Indian companies with largest market capitalization as of March 2021 is as follows4:


4. IFAC publication – The State of Play in Sustainability Assurance – page 32.

Why to use a professional accountant for an assurance engagement?
The information reported by a company needs to be credible so that investors and other stakeholders can rely on it for their investment and other decisions. Many companies want to be perceived as leaders in or advocates for sustainability reporting by having their financial statement auditor provide assurance, which sends a message to the market regarding their commitment to such reporting.
Further, having the financial statement auditor perform such assurance engagements can drive efficiencies in the engagement because the auditor can use the knowledge obtained from the financial statement audit to plan the engagement. However, there is no requirement for a company to use its financial statement auditor.
The financial statement auditor is well positioned to perform the necessary work and provide this assurance. He also communicates a company’s commitment to the priorities, values and concerns that are important to the growing number of stakeholders interested in these matters.
ICAI has issued Exposure Draft on Standard on Sustainability Assurance Engagements (SSAE) 3000, Assurance Engagements on Sustainability Information, which is applicable to all assurance engagements on sustainability information. The draft defines terms such as engagement partner, firm (which is registered with the ICAI) and also provides for the characteristics of the engagement partner including he/she being a member of a firm that applies SQC 1, or other professional requirements, or requirements in law or regulation, that are at least as demanding as SQC 1. Accountants are already involved in monitoring, checking, and interpreting information relating to social, environmental, and economic impacts. The accountancy profession is quali?ed for providing external assurance, building on initiatives such as the IAASB Framework and ISAE 3000 and working with other disciplines. Other possible reasons could be as follows:
  • A professional accountant who provides assurance services has important skills that enhance the quality of those services. Professional accountants are in a position to apply sound judgement to a wide range of services, including assurance.

  • They follow well-established and widely recognised standards when conducting their work, which allows a consistent and more readily understandable approach to the work they perform. They are bound by a strict code of ethics and are subject to regular assessment by regulators. Their commitment to professional competence and due care requires them to offer high-quality services to businesses and to act in the public interest. Therefore, a sustainability report with an unmodified assurance conclusion from a professional accountant is seen as credible in the marketplace.
  • A professional accountant may be able to help in other ways to enhance business sustainability performance. If, for example, a company is just about to start measuring and managing its carbon footprint, it will need to think through the governance, control environment, process, and systems implications before starting.

STATE OF SUSTAINABILITY ASSURANCE IN INDIA

In India, broader legislative intent in the sustainability space has been ahead of the curve. The Companies Act 2013 requires a director of a company to act in the best interests of the company, its employees, community and for the protection of the environment.
As discussed elsewhere in this article, SEBI introduced Business Responsibility and Sustainability Report (BRSR) and replaced it with the existing BRR. The BRSR seeks disclosures from listed entities on their performance against nine principles. These nine principles echo the Sustainable Development Goals and cover both environment and social aspects such as climate action, responsible consumption and production, gender equality, working conditions, etc.
The ICAI has issued ED on SSAE 3000, Assurance Engagements on Sustainability Information as discussed above. ICAI has also issued SAE 3410, Assurance Engagements on Greenhouse Gas Statements to strengthen assurance frameworks for Non-Financial Information, equivalent to ISAE 3410 “Assurance Engagements on Greenhouse Gas Statements” issued by the IAASB of IFAC. SAE 3410 deals with assurance engagements to report on an entity’s Greenhouse Gas (GHG) statement. The objective of an engagement under SAE 3410 is to obtain either limited or reasonable assurance, as applicable, about whether the GHG statement is free from material misstatement, whether due to fraud or error. GHG statements are assured to enhance the reliability of the emissions information reported. The standard is applicable on a voluntary basis for assurance reports covering periods ending on 31st March, 2023, and on a mandatory basis for assurance reports covering periods ending on or after 31st March, 2024.
To strengthen sustainability reporting in the country, ICAI has also developed “Sustainability Reporting Maturity Model (SRMM) Version 1.05” with an objective to bring out a comprehensive scoring tool based on a report of the Committee on Business Responsibility Reporting constituted by the Ministry of Corporate Affairs (MCA) in August 2020. BRSR scoring mechanism comprises of total 300 scores, by completing the scoring of all its three sections and nine principles. Corporates can self-evaluate their current level of maturity on the SRMM, identify areas where more focus is required and then develop a roadmap for upgrading to a higher level of maturity. SRMM would allow rating agencies and assurance providers to compare the sustainable nature of Indian companies with international companies.

5. Source: ICAI Releases Sustainability Reporting Maturity Model (SRMM) Version 1.0 | IFAC

CHALLENGES IN SUSTAINABILITY ASSURANCE
There is no doubt that an attention to sustainability issues can deliver better social, environmental, and financial outcomes for companies. Companies are very likely rewarded with lower costs of capital, and their focus on sustainability can improve margins and enhance brand value. In addition, the reporting itself has some very real problems which are given below:
  • Lack of mandates and auditing standards specific to the subject matter.
  • Lack of standardisation in reporting processes and controls.
  • Desire to establish a more consistent set of procedures for assessment.
  • Uncertainty over the reliability of information.

Some of these challenges can be overcome if the regulator prescribes a well-defined framework for such assurance engagements.
Role of the Statutory Auditor – Consideration of climate-related risks in an audit of financial statements
As per the recent article on Where climate change isn’t global: auditing6 “Climate was highlighted by auditors as a challenging issue in vetting some companies’ accounts — the type of thing that required complex, subjective judgments, or that might carry the risk of misstatements. But not consistently everywhere.”

6. Source:Where climate change isn’t global: auditing | Financial Times (ft.com)

The role of the auditor is to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, to enable the auditor to report whether the financial statements are prepared and presented fairly, in all material respects, in accordance with the applicable financial reporting framework. Understanding an entity and its environment is fundamental to planning and executing an effective risk-based audit. In developing the understanding of an entity, the auditor should include the consideration of climate-related risks and how these risks may be relevant to audits.
The climate-related risks could be more relevant in certain sectors or industries, e.g., banks and insurance, energy, transportation, materials and buildings, agriculture, food, and forestry products. For example, in case of transportation sector, with the introduction of new modes of transportation, traditional transportation assets may be impaired. There is a risk of this continuing to happen as environmental technologies are continuing to develop and evolve at a fast pace. Therefore, the auditor should consider climate-related risks for all sectors.
Many investors and stakeholders are seeking information from auditor’s reports about how climate-related risks were addressed in the audit. With this increased user focus on climate change, the auditor need to be aware of, and may face, increasing pressure for transparency about climate matters in their auditor’s reports. However, the auditor’s reports must follow the requirements of applicable auditing standards.
The auditor’s report is a key mechanism of communication to users about the audit that was performed. In addition to the audit opinion, it provides information about the auditor’s responsibilities and, when required, an understanding of the matters of most significance in their audit and how they were addressed (i.e., Key Audit Matters under SA 701, for example for an entity in the energy sector, the impairment analysis for long-lived assets may be an area of significant auditor judgment that also considers the potential impact of climate change and the transition to renewable energy sources).
In some circumstances, it may warrant inclusion of an Emphasis of Matter paragraph to draw attention to disclosures of fundamental importance to users’ understanding of the financial statements. The auditor should also determine whether the entity has appropriately disclosed relevant climate-related information in the financial statements in accordance with the applicable financial reporting framework, e.g., Ind AS or Accounting Standards, when relevant before considering climate-related matters in the auditor’s report.
The auditor should also read the other information for consistency with information disclosed in the financial statements and information that may be publicly communicated to stakeholders outside the financial statements, such as management report narratives in the annual report, press releases, or investor updates. This is a requirement under ISA 720 and SA 720, The Auditor’s Responsibilities Relating to Other Information.

BOTTOM LINE
The overarching importance of sustainability reporting continues to gain momentum globally with demands from various stakeholders and substantial research and developments towards a uniform set of sustainability standards. The uniformity is not achieved yet due to lack of a common language for sustainability reporting. As reporting of sustainability information becomes the trend being observed globally, the demand for independent assurance of sustainability information is anticipated to grow as entities around the globe look to enhance the integrity of their sustainability reporting. Hence, it is imperative that auditors and assurance providers understand the current landscape and continue to monitor ongoing developments. The demand for assurance on “sustainability branded” reporting continues to grow and therefore, there is an urgent need for globally accepted sustainability / ESG assurance standards that can be used by all assurance professionals. Entities may also want to begin considering how they would gather the information and whether they would need to set up new processes, systems and controls.

Will Technology Replace Skilled Auditors?

INTRODUCTION

If data is the new oil, then a digital ecosystem is its refinery. Today, entities are using next-generation technologies more than ever, and many aspects of financial reporting and underlying processes have been digitised. As referred by the World Economic Forum, we are at the cusp of the “Fourth Industrial Revolution,” central to which is the development and adoption of automated technologies. The audit profession is also catching up with these technological developments. Building on the changes computers brought to the assurance profession, the use of advanced technologies is driving the evolution of the audit. As digital transformations speed ahead, auditors need to follow suit – the question is no longer ‘if’ the auditor needs to change; it’s ‘how fast?’

This article provides an overview of the automated tools and techniques in vogue, their myths, challenges and considerations while embarking on innovation strategy by audit firms.

AUTOMATED TOOLS AND TECHNIQUES
Audit procedures are performed using several manual or automated tools or techniques (and a combination of both). The automated tools and techniques would broadly fall into any of the following categories:

Automation

Analytics

Artificial Intelligence (AI)

Robotic Process Automation (RPA)

 

When an activity/ procedure is
performed by a tool with least human intervention. E.g., updating workpaper
with terms and conditions from a purchase agreement.

 

Evaluation of a large volume of data
to find trends and make objective decisions. E.g., margin analysis of a group
of products.

 

Teaching tools to complete tasks
requiring human intelligence. E.g., identification of unusual clauses in a
lease contract

 

Uses recorders and easy programming
language mimicking human execution of applications, usually for repetitive
tasks. E.g., auto bank reconciliation statements.

Some commonly used automated tools relate to the following:

  • General ledger analysers: These examine and analyse general ledgers through a suite of data capture and analytics tools, e.g. audit teams can look at sales invoicing activity throughout the year, the impact of credit/ debit notes and ultimately, how the invoices are settled and accordingly allow auditors to obtain a better understanding of both revenue and trade receivables. This tool uses an analytics-driven approach that enables auditors to provide better-quality, deeper insights and more client-relevant audits, as well as exercise a higher level of professional scepticism.

 

  • Anomaly detectors: These refer to a practice in which auditors detect accounting fraud by selecting samples and testing them to ensure accuracy basis their knowledge about the clients, their businesses and accounting policies. Machine learning and AI is capable of sensing anomalous entries in large databases and create visual maps of the flagged entries and the reason for their detection.

 

  • Data profiling: Data might be unstructured, i.e. not recorded as rows and columns of data, e.g. written reports and social media. Plugins of some of the automated tools simplify extraction and analysis of unstructured data to quickly generate in-depth interactive reports containing statistics and graphical representations so that auditors can make more informed decisions.

 

  • Working paper management: Working paper solutions allow team members to collaborate effectively on an engagement file in real-time, even when in different locations. Members of the audit team can work on a work paper at the same time without being concerned about different versions. These solutions also automatically roll forward the identified client data from year to year to ensure continuity and reduce workload.

 

  • Reporting considerations: These incorporate a deep understanding of the auditing standards and generate audit reports on the basis of the conclusion reached by the auditor, e.g. audit having a modified opinion is automatically aligned with the relevant requirements. Additional features can include health check functions such as the casting of financial statements, tie-out in financial statements, cross reference checks against financial statements and notes, as well as casting of the notes.

 

AUDITING IN A DIGITAL WORLD
The audit of the future would focus human interaction on high-risk transactions as opposed to highly repetitive and rules-based tasks. Interface tools could be used to automatically share information in real time with the auditor’s automated tool(s), which in turn could analyse, test and flag anomalies or issues that require the auditor’s attention. However, human insight and experience to ultimately understand the context underlying the output as well as the cause of the output would continue to be relevant. A high-level summary of how an auditor can benefit from the use of automated tools is summarised below:Planning phase

Audit planning involves establishing an overall audit strategy that sets the scope, timing and direction of the audit guiding the development of the audit plan. The audit planning phase includes the following:Materiality and scoping – RPA can be used to pull out relevant data from the financial statements of prior periods or interim financial statements and compute the materiality based on a range of benchmarks. The same techniques can be utilised to determine materiality in a continuous or real-time audit.

RPA and analytics can be applied to identify outliers or areas that have not followed the understood course of business to determine the scope and focus testing on accounts or transactions that appear to present a greater risk of misstatement.

Risk Assessment – During risk assessment, auditors normally perform variance analysis about how the current period amounts compare with the prior period amounts based on an understanding of the entity, its industry, and the current business environment. RPA can perform this activity quickly basis prior period financial statements and publicly available information.

AI can analyse board meeting/audit committee minutes to help the auditor identify additional risks, and request to provide for supporting information, as well as scheduling meetings with the relevant individuals to discuss audit matters.

Execution phase
The execution phase of an audit engagement is an intense period of activity. It broadly comprises analysing information, executing testing, making judgements, documenting work and the following:

Test of controls – The aim of tests of controls in auditing is to determine whether internal controls are sufficient to detect or prevent risks of material misstatements. Metadata3 can enhance the testing of controls by highlighting potentially higher-risk areas, for example, AI tools can analyse how many purchase invoices an individual typically approves and their usual frequency and duration, as well as the amount of time since their previous approval. If a reviewer approves a purchase invoice in 5 minutes, then depending on the complexity of the purchase and the comparability with others performing the same task, AI could highlight an outlier for testing.


3. A set of data that describes and gives information about other data.

Risk control matrix has several automated controls. BOT can be used to analyse the result against a defined rule. BOT can prepare draft report of exceptions in a predefined format. The exception report can be reviewed by the auditor and once accepted, BOT can send report for response to management. This can result in significant effort optimisation of auditor.Inventory counts – With the computer’s vision, an AI-based app can look at millions of pictures taken from cameras (whether statically mounted in a warehouse or mounted on moving drones) and identify articles. Articles that have indexing information (such as bar codes) are even easier to identify and be counted, giving the auditor the ability to obtain more coverage.

Estimates – Traditional audit techniques used to audit estimates typically include reperformance of management’s process, retrospective testing, or development of an independent estimate. An array of automation and AI techniques can be used to perform variations of these techniques e.g., warranty gets triggered in case of a failure in the products. Management may have established a model for determining the expected rate of failure of products. Using machine learning, the audit team could build an independent model to predict this likelihood based on historical product failures. The AI tool could also be trained to incorporate other relevant observable factors, such as customer profiles, point in time when product failure occurs and contractual terms. Inclusion of these factors could also enable determination of an independent warranty estimate for comparison with the entity’s estimate.

Reporting phase
After fieldwork is completed, the auditor needs to:

Prepare an audit report – Auditors normally have a repository of standard audit reports which are customised as per the facts and circumstances. A modified audit opinion might require an auditor to make varied changes to a standard audit report. An editable version of an audit report is prone to errors. An automated audit report generator helps the auditor to choose the required audit report format and instantly generate an audit report on the basis of the limited inputs from the auditor e.g., the auditor would input limited information such as name of the auditor, year-end, basis for modified opinion. The automated audit report generator ensures consistency in reporting requirements and brings efficiency in the audit process.

Prepare client communications – Standardised templates are already developed and available to the audit teams, but human effort is required to tailor them to speci?c clients. AI can extract information from the audit ?les and workpapers (e.g., auditor’s report, management representation letter, etc.).

 

MYTHS AND CHALLENGES

There are many misperceptions about automated tools. Contrary to popular belief, at present these tools are neither all-knowing nor inherently smart. Some of the myths and challenges are as follows:

Garbage in garbage out

Automated tools are only as effective as the underlying data. The accuracy of the information presented or produced by the automated tools and techniques depends on it. The old adage ‘garbage in, garbage out’ applies. The auditor would need to evaluate data integrity e.g., how to assess the reliability of data captured, whether any mid-year system change would affect the overall scope.Automated tools can give biased or bad predictions if they are trained using biased or bad data e.g., if an AI tool was trained to automatically classify documents as either ?nancial data or non-financial data, but if 90 per cent of the training documents were non-?nancial data, the tool would wrongly learn and predict most of the data as non-?nancial data.

The ‘black box’ problem

In a simple set of data, an auditor can trace and determine the cause-and-effect relationship of automated tools and techniques. When the data points become complex, tools may not be able to clearly link input factors and outcomes, and explain the cause-effect pattern. This lack of transparency or explainability creates a lack of trust in automated tools, and is perhaps the biggest challenge to the widespread adoption of some of the sophisticated automated tools.Data privacy and conndentiality

The effective use of automated tools often requires an access to large amounts of data, including conndential client data, in order to learn relevant patterns and apply them to predict or suggest an output. Not surprisingly, entities may be resistant to providing access to this high-value data and information. Auditors need to consider the risks associated with data and privacy, and design security protections commensurate with the sensitivity of the data.Not a substitute for auditors’ judgement

Automated tools fail to see the big picture e.g., the world of automated tools is restricted only to the (correct or incorrect) data to which it has access, what it has been taught and what it has been programmed to do. It does not know the nuances of the real world and can’t replace an auditor’s professional judgment. Fraud or bias can happen even when transactions processed by the automated tools seem perfectly legitimate. Auditors need to be alert to these qualitative aspects. Advanced technologies provide a wealth of information to an auditor that enables them to make a judgment. But the auditor will still be the one making that judgment.Technology is an enabler and is unmatched when it comes to identifying correlations among datasets or variables. However, it takes human insight and experience to ultimately understand the context underlying the output as well as the causation of the output relative to the inputs provided. An auditor confirms the information and determines whether it is an anomaly and, more importantly, determines what it implies or how to conclude on how appropriate the treatment of the information is. Accordingly, automated tools will not replace the need for professional judgment in auditing processes.

Widening expectation gap

These technologies have the potential to widen the expectation gap and raise the bar for the definition of an audit. With the ability to analyse a larger percentage of transactions and data, there will be an increased expectation as to what an audit achieves. 

CALL TO ACTION

Much of the growth in automated tools and techniques in some audit firms over the past few years can be put down to one factor: competition. The audit firm rotation rules have sent some of the audit firms into a technology arms race. As the technology trickles down, every audit firm, regardless of its size, needs to decide on its innovation strategy. No choice of the strategy is bad – it’s all a question of what suits a firm’s client base. Audit firms would need to balance the risks and benefits. While deciding the innovation strategy, audit firms are encouraged to:

  • Conduct an environmental scan: Firstly, look inwards. Research and analyse the firm’s current audit process to identify outdated systems that need improvements before exploring external products. This process may involve attending vendor events to learn about what new technology is available and considering how the firm can collaborate with external IT specialists.

 

  • Align with long-term strategy: Firms should identify which technology is best aligned with their strategy and consider the relevant business need, available budget and marketplace opportunities. The return on investment should be calculated, but the risk of not investing in a new technology should also be considered.

There are various options to manage the required investment, including exploring a subscription based or monthly-renewal model to manage the costs, and consider passing the costs on to clients. It can be difficult to determine which one is the best and a long-term solution. Sharing experiences with other similar firms can be mutually beneficial.

  • Formulate realistic implementation plan: A bite-sized plan should be developed so the firm can effectively manage the transition. Be strategic while identifying opportunities for automated tools and techniques. An ideal place to start is with high-benefit, low-effort opportunities. Assess the results using professional judgment, as well as any potential efficiency savings. Audit firms may determine the best option based on requirements, resources and schedule.

 

  • Adopt the Cloud: Cloud technology has become a key part of most industries. Firms with multiple offices can use the cloud to provide staff an easy way to work virtually on the same client simultaneously in different offices. The firm needs to know the service providers and where they are storing the data to track how it is being secured. There is also a need to be aware of any relevant laws and regulations, such as data protection legislation.

 

  • Identify innovation champions: Understanding who to approach in the audit firm places the firm in a better position to support tangible change and implementation of identified opportunities. The firm should identify and position a passionate team member to take the lead in implementing a new technology initiative. The technology champion will need support and guidance from the firm’s leadership to proceed with change because there may be challenges with its implementation. It may take time and effort, so patience and perseverance are prerequisites, but the benefits will far outweigh the costs.

 

  • Involve clients in technology decisions: Clients want to hear about technological developments that save time. Involving clients would create transparency and highlight a long-term vision for all involved. As the firm enhances its technology knowledge, it will further enhance trust and help introduce new permissible service offerings.

 

IN A NUTSHELL
Audit is changing at an unprecedented pace as technology continues to evolve and entities increasingly expect more. These two intersecting trends mean that auditors must continually acquire new skills and up their game to meet the rising bar on audit quality. It’s not enough to have the latest technology – auditors must be able to mine data for information that is important to clients, such as that affecting relevant risks, internal controls, and important processes, and be able to communicate it clearly. It is important to see automated tools as enablers. They will not replace the auditor; rather, they will transform the audit and the auditor’s role.

Ind AS 20 and Typical Government Schemes in India – Part 1

BACKGROUND
Indian Accounting Standard – 20 (‘Ind-AS 20’ or ‘the Standard’) prescribes guidance on accounting for and disclosure of government grants and government assistance.

Ind-AS 20 is based on IAS-20, which IASB adopted in 2001 based on draft/standard issued in 1983. As Ind-AS 20 is based on IAS-20, a standard issued before the issuance of the earlier Conceptual Framework, due to legacy reasons, IAS-20 has some inconsistency with the Conceptual Framework and for which a project was initiated in 2003. However, the said project has been deferred since then due to various reasons. Since 2006, there has been no further update on the alignment of IAS-20 with  the  Conceptual  Framework. Alignment of IAS-20 (equally applies to Ind-AS 20) with the Conceptual Framework is under consideration (as the project is deferred and not discarded) mainly on the following counts:

a) Recognition of grant as deferred credit when the entity has no outstanding obligation, and

b) Options available  with the entity which  reduce the comparability of financial statements and understate assets controlled by the entity.

In this current discussion, we will not discuss IASB’s work on the same as such, however, we will discuss some divergence and issues arising from the pendency of this project.

The Standard requires that the government grant/assistance be accounted for and/ or disclosed to ensure that the user of the financial statement can appreciate the impact of such a grant/ benefit/ assistance on the financial performance as well as future resource generation capabilities of the entity. This also helps the financial statement user while comparing the results of the entity availing such benefits/ assistance with the results of other entities in similar industries but not availing such benefits.

IMPORTANT DEFINITIONS

Government
Government refers to government, government agencies and similar bodies, whether local, national or international.

Government Assistance
Government assistance is action by government designed to provide an economic benefit specific to an entity or range of entities qualifying under certain criteria. Government assistance for the purpose of this Standard does not include benefits provided only indirectly through action affecting general trading conditions, such as the provision of infrastructure in development areas or the imposition of trading constraints on competitors.

Government Grants
Government grants are assistance by government in the form of transfers of resources to an entity in return for past or future compliance with certain conditions relating to the operating activities of the entity. They exclude those forms of government assistance which cannot reasonably have a value placed upon them and transactions with government which cannot be distinguished from the normal trading transactions of the entity.

Government Assistance is a broader term compared to Government Grant and encompasses all actions by the Government that intends to provide benefit to a specific entity or range of entities, whether measurable or not. If Government Assistance is measurable, then the same will be considered as “Government Grants” under the Standard. If benefit to an entity or a range of entities cannot be measured reasonably, then such Government Assistance will not qualify as “Government Grant”. The Standard deals with accounting and disclosure of government grants and only disclosure requirements for some forms of government assistance to which a reasonable value cannot be placed.

Fair Value measurement under Ind-AS 113 and three-level fair value hierarchies prescribed thereunder will have considerable influence over the determination of “reasonable value” and classification of Government Assistance as “Government Grant”.

Definition of Government Assistance refers to action by government designed to provide an economic benefit specific to an entity or range of entities”. It is extremely relevant and important to observe that the definition refers to an action that can include many causes that entitle an entity to receive an economic benefit. “Action” can include “Separate/ Specific legislation” or “Notification/ Circular” within existing legislation, or it can also include ad hoc act/ special order/ decree issued by the relevant authority. Additionally, for any action to fall within the ambit of “Government Assistance”, it should have two characteristics; a) designed to provide economic benefit and b) specific to an entity or range of entities.

Thus, “designed to provide economic benefit” should be understood by comparison with what such an entity would have incurred or obliged otherwise if such “action” (which includes legislation/ classification/ order, etc.) was missing.

For example, various state governments, as part of the state industrial policies, grant certain one-time monetary compensation or provide land at concessional rate or reimburses upto certain amount spent on property, plant and equipment, etc. These are economic benefits only to those “entities” that employ local employees or more female workforce, then the scheme intends to give some benefits to the entity, which otherwise is not payable by Government and not receivable by the entity engaged in similar activities even if such entity otherwise satisfies such conditions/ requirements. Hence, it can be observed that the “designed to provide economic benefit” can take different forms.

Further, “specific to an entity or range of entities” should be understood to compare the entity with a similar entity engaged in a similar business except classification/ parameters affected by such action.

Another important phrase to understand is “action”. In India, the Government through various laws has created a “deeming/ artificial legislative framework” which creates a difference between entities carrying on similar activities.

MEASUREMENT
Under the Standard, the measurement of “Grant” depends upon the classification/ nature of the grant. The same is summarized in a tabulation herein below:

From the above tabulation, it is evident that primarily all grants are required to be measured at fair value. However, in case grants related to assets, with effect from 1st April 2018, an option is available “to measure” non-monetary “Government Grant” at nominal value. However, in the case of a grant which is partially monetary and partially non-monetary, then such a grant should be measured at fair value.

Even after the amendment for non-monetary grants related to assets, the standard requires a large part of grants to be measured at fair value. Hence, the impact of Ind-AS 113 on Fair Value Measurement will become equally relevant, particularly for such Government Assistance which qualify as “Government Grant” as it will trigger a requirement for recognition as well as disclosure.

Additionally, an entity should evaluate each of the Government Schemes/ Programs closely to see whether such schemes/ programs result in a “transfer of resources to the entity” or not. It is relevant to note that the Standard itself suggests that the mode of disbursal of the grant is neither relevant for the identification of Government Assistance as “Grant” nor recognition of the grant.

Therefore, in a situation where the Government shares a certain tangible/ intangible right/ benefit or forgives any due from the entity, such a sharing of right/ valuable thing/ asset or forgiving of due is nothing but a transfer of a resource from the Government to the entity concerned.

Further, in case there is a transfer of resources by the Government to the entity (either by the way of transfer of money/ resources or by way of waiver of duty/ taxes), the value of such resource/ waiver itself will be fair value.

RECOGNITION

Recognition is another part which requires the attention of the entity. The Standard prescribes below conditions for recognition of the grant to the Statement of Profit and Loss:

a)    Recognition should be systematically over the period over which the entity is expected to incur the cost for such obligation or for which grant is being received;

b)    There is reasonable assurance that the entity will fulfil relevant conditions/ obligations; and

c)    There is reasonable assurance that the grant will be received.

In respect of a scheme for which the entity fulfils the above conditions, the entity should recognize such a grant to the Statement of Profit and Loss. However, the presentation thereof depends upon the nature of the grant.

In the below tabulation, the recognition pattern has been summarized:


DISCLOSURE REQUIREMENTS
Except for certain peculiar situations, this Standard does not cause challenge in terms of recognition. However, this Standard is extremely critical from disclosure requirements as disclosures on “Government Assistance” will help the user of the Financial Statements to understand the impact of such Government Assistance on the entity’s Financial Position as well as enable them to compare Financial Performance/ Position of the relevant entity with its competitors or over time for the same entity. Para 39 of the Standard deals with the disclosure requirements. For ready reference, critical aspects of disclosure requirements are highlighted herein below:

(a)    the accounting policy adopted for government grants, including the methods of presentation adopted in the financial statements;

(b)    the nature and extent of government grants recognized in the financial statements and an indication of other forms of government assistance from which the entity has directly benefited; and

(c)    unfulfilled conditions and other contingencies attaching to the government assistance that has been recognized.

Let us discuss the above three disclosure requirements in detail.


ACCOUNTING POLICY AND METHOD OF PRESENTATION

Accounting Policy:
The entity has to make specific disclosure about the “Accounting Policy” adopted by it in connection with the government grant and method of presentation. Ind-AS 8 provides relevant guidance on the same. Further, in case of deviation from the prescription of the treatment under the Standard, as per Para 19 to 21 of the Ind-AS 1 relating to Presentation of Financial Statements, additional information should be disclosed, including the title of Ind-AS, nature of departure and impact thereof.

Manner/ method of presentation: The entity needs to disclose the method of presentation in financial statements as well. There are two alternative presentations which are permitted;

i)    The first option is to show the grant /deferred income separately from cost/ expense/ asset to which the same relates which will lead to the recognition of income/ expenses or deferred income / asset at gross values in the Statement of Profit and Loss and the Statement of Financial Position, respectively.

ii)    The Second option is to present the grant / deferred income net off against relevant cost/ asset in the Statement of Profit and Loss and Statement of Financial Position, respectively.

iii)    Even though the option to present the grant at net amount was permitted under the Standard vide notification dated 20th September, 2018, the cash flow statement requires separate presentation in respect of grant/ expense/ asset. Apparently, the intention is to give more qualitative information regarding the nature and impact of the grant on cash flows.

Nature of extent of grant recognized in financial statements:

Nature of Grant: The entity needs to disclose the nature of the grant received from the Government. To fulfil the objective of qualitative information/ disclosure, the entity should provide information on the relevant assets/ operations or expenses to which the grant pertains/ relates, and whether such a grant is non-monetary or monetary. Disclosure on the nature of the grant should be suitable and give information on the entity’s judgement on the nature of such a grant as related to expenses or assets to better appreciate the recognition and disclosures made in the Financial Statements.

Extent of grant recognized in financial statements:
In this requirement, the Standard requires disclosure about “recognition” of the grant and not “presentation” as presentation of the grant is already captured in the first requirement of accounting policy and presentation. Hence, the entity is expected to disclose the quantum of grant recognized according to the application of recognition and measurement parameters of the Standard. Recognition refers to “income in the financial statement” or “deferred income in the balance sheet” vis-à-vis presentation, which can be ‘net after adjusting such grants against relevant expenses/ income’. Hence, where the entity follows presenting government grant at net of against relevant expenses (i.e. net amount of relevant expense remains positive after adjusting or netting off grant received in connection therewith) in Statement of Profit and Loss, no amount will appear as “Government Grant” which is “presentation.” However, the current requirement (as being discussed) refers to disclosure of “the extent of grant recognized” and consequently, the entity needs to disclose the quantum of grant “recognized” in the Financial Statements irrespective of presentation thereof as net or as gross basis. However, in case of non-monetary grants related to assets measured and recognized at nominal value, the extent of disclosure may not be material to the entity, and the disclosure of such an option for non-monetary grant related to assets should ideally suffice unless the nominal value itself is material having regard to the entity concerned.

Generally, unless the grant is recognized at nominal value or presented separately as income, it would be difficult for the user of the Financial Statements to understand the “extent of grant recognized” if the disclosure is not made in compliance with the above stated requirements.


UNFULFILLED CONDITIONS OR OTHER CONTINGENCIES
A Government grant is without consideration and provided to the entity for undertaking specific activities or transactions which Government would like to promote. Considering the fact that the Government has the most socialist obligations for spending, granting of benefits to the entities engaged in economic operations needs to be controlled closely and leakage of funds protected. Due to such reasons, the Government places conditions (generally holds suitable for all schemes/ programs of the Government) to be fulfilled by the entity to be entitled to grant/ economic benefit under the relevant scheme.

Conditions play an important role in “earning” such economic benefits from the Government. In certain situations, the Government may allow the entity to receive such economic benefits upfront before fulfilling the relevant conditions, and may put in place a mechanism for recovery of the amount already disbursed if conditions are not fulfilled. Hence, the status of fulfilment of relevant conditions and likelihood of meeting such requirements within permitted timelines plays a vital role in accounting and disclosure of such government grants.

Unfulfilled conditions may have an impact on the provision to be made under Ind-AS 37 or the possibility of reversal of “Grant” in the subsequent period. The entity is required to make relevant disclosure about the unfulfilled condition or contingencies related to the “Government Grant” recognized, or for which it is entitled to give the user of the Financial Statements a better perspective of the possible outcome or potential reversal if any. Therefore, if such a conditionality exists and remains unfulfilled at the reporting date, the entity gives appropriate information/ disclosure about the conditions / contingencies attached to “Government Grant” which is already recognized even if entitled based on management judgement.

The prescription of the Standard as discussed above is critical for concluding that the Financial Statements have been prepared in accordance and compliance with applicable Ind-AS. Deviation from such prescribed requirements should be adequately disclosed along with the reason for the deviation and why management feels that the deviation results in a better and more faithful representation of the relevant transactions and events. The requirements of reporting such deviations have been dealt with by Para 19 to 21 of Ind-AS 1 dealing with Presentation of Financial Statements.

The above background of the requirements of the Standard will be helpful for us in examining how and what reporting requirements and challenges a typical “Government Grant” presents to the entities receiving such government grants.

Note: Part II of this article will cover how certain typical Government schemes/ programs work; how they fall within the definition of “Government Assistance”; and how the same should be recognized and disclosed.

CARO 2020 – Tighter Controls Over NBFCs

INTRODUCTION

Non-Banking Financial Companies (“NBFCs”) are financial entities performing functions akin to that of a bank, except they cannot accept demand deposits, issue cheques, or notes on themselves and provide Deposit Insurance and Credit Guarantee Corporation cover. They have established themselves as an integral part of the financial system; few of the large NBFCs have even outgrown certain small banks. There are different types of NBFCs; a separate Registration Certificate is issued based on the nature of activities elected by the applicant company. The industry, until today, has played a pivotal role in financial inclusion programmes, offering various products suitable to different classes of society. In hindsight, it was also observed that it carries a huge potential to affect the public interest adversely if not regulated prudently. The regulator, over time, has taken many initiatives to minimize systemic risk and enhance the quality and coverage of compliance in the industry.

Clauses pertaining to NBFCs in CARO 2016 were one such attempt to preserve public interest, which proved to be highly successful. Hence, in the light of recent disruptions in the NBFC industry, the Revised Companies (Auditor’s Report) Order, 2020 (“CARO”) has been rolled out. This report has introduced additional clauses, entrusting Auditors to report on crucial regulatory aspects over NBFCs and those entities which undertake the business of Non-Banking Financial Activities. The other clauses also seek to closely check the Core Investment Companies (one of the many types of NBFCs). These clauses are as under:

Clause (xvi) of Companies (Auditor’s Report) Order, 2020 requires the auditor to report on the following:

(a) Whether the company is required to be registered under section 45-IA of the Reserve Bank of India Act, 1934 (2 of 1934) and if so, whether the registration has been obtained;

(b) 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;

(c) Whether the company is a Core Investment Company (CIC) as defined in the regulations made by the Reserve Bank of India, 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;

(d) Whether the Group has more than one CIC as a part of its structure, if yes, indicate the number of CICs which are part of the Group;



UNDERSTANDING THE RELEVANT REGULATORY PROVISIONS

Section 45-IA of the Reserve Bank of India Act, 1934 (“RBI Act”) pertains to the registration of the company as a Non-Banking Financial Company for conducting of a Non-Banking Financial Institution activity. However, for a detailed understanding of the implications of the Clause, it is imperative to understand certain essential regulatory provisions.

SECTION 45-IA AND RELEVANT DEFINITIONS OF THE RBI ACT

Section 45-IA(1): Notwithstanding anything contained in this Chapter (Chapter III-B of RBI Act) or any other law for the time being in force, no non-banking financial company shall commence or carry on the business of a non- banking financial institution without:

(a) Obtaining a certificate of registration
issued under this Chapter; and

(b) Having the net owned fund of twenty-five lakh rupees or such other amount, not exceeding hundred crore rupees, as the Bank (RBI) may, by notification in the Official Gazette, specify:

Provided that the Bank (RBI) may notify different amounts of net owned funds for different categories of non-banking financial companies.

Section 45 I(a): “business of a non-banking financial institution” [“NBFI activity”] means carrying on the business of a financial institution referred to in Clause (c) and includes the business of a non-banking financial company referred to in Clause (f).

Section 45 I(c): “financial institution” means any non- banking institution which carries on as its business or part of its business any of the following activities, namely:

(i)    The financing, whether by way of making loans or advances or otherwise, of any activity other than its own:

(ii)    The acquisition of shares, stock, bonds, debentures or securities issued by a Government or local authority or other marketable securities of a like nature:

(iii)    Letting or delivering of any goods to a hirer under a hire-purchase agreement as defined in Clause (c) of section 2 of the Hire-Purchase Act, 1972:

(iv)    The carrying on of any class of insurance business;

(v)    Managing, conducting or supervising, as foreman, agent or in any other capacity, of chits or kuries as defined in any law which is for the time being in force in any State, or any business, which is similar thereto;

(vi)    collecting, for any purpose or under any scheme or arrangement by whatever name called, monies in lumpsum or otherwise, by way of subscriptions or by sale of units, or other instruments or in any other manner and awarding prizes or gifts, whether in cash or kind, or disbursing monies in any other way, to persons from whom monies are collected or to any other person,

but does not include any institution, which carries on as its principal business,–

(a)    agricultural operations; or


(aa) industrial activity; or

(b) the purchase or sale of any goods (other than securities) or the providing of any services; or

(c) the purchase, construction or sale of immovable property, so however, that no portion of the income of the institution is derived from the financing of purchases, constructions or sales of immovable property by other persons;
 
Explanation – For the purposes of this Clause, “industrial activity” means any activity specified in sub-clauses (i) to (xviii) of Clause (c) of section 2 of the Industrial Development Bank of India Act, 1964;

Section 45I(f):   “non-banking   financial   company” means–

–  a financial institution which is a company;

–  a non-banking institution which is a company and which has as its principal business the receiving of deposits, under any scheme or arrangement or in any other manner, or lending in any manner;

– such other non-banking institution or class of such institutions, as the Bank (RBI), may, with the previous approval of the Central Government and by notification in the Official Gazette, specify;

UNDERSTANDING PRINCIPAL BUSINESS

RBI Press Release 1998-99/1269 dated 8th April, 1999 read with RBI Notification DNBS (PD) C.C. No. 81 / 03.05.002/ 2006-07 dated 19th October, 2006 had defined the Principal Business for identification as a NBFC as:

The company will be treated as an NBFC if its financial assets are more than 50 per cent of its total assets (netted off by intangible assets), AND income from financial assets should be more than 50 per cent of the gross income. Both these tests are required to be satisfied as the determinant factor for a company’s principal business.

The word “Financial Assets” have not been defined under the RBI regulations. However, based on general parlance and the definition of Financial Institution defined in Section 45I(c) of the “RBI Act”, loans, financing, investment in marketable securities (which includes investments in shares, mutual funds, AIFs, debentures), etc. are considered to be Financial Assets.

This is the generic test for identification of an NBFC’s requirement to be registered u/s 45-IA. Apart from the above, there are specifically prescribed businesses classified as NBFCs, irrespective of their Principal Business Criteria, such as Account Aggregator, NBFC- Peer to Peer Lending [NBFC- P2P] and Core Investment Company (CIC).

Although the business of Account Aggregator and NBFC- P2P may be conducted only on a specific license by the regulator, any company being primarily a holding company may fall under the definition of CIC.

Specific instruction for HFC:

Housing Finance Company shall mean a company incorporated under the Companies Act 2013 that fulfils the following conditions:

(i)    It is an NBFC whose financial assets, in the business of providing finance for housing, constitute at least 60% of its total assets (netted off by intangible assets). Housing finance for this purpose shall mean providing finance as stated in clauses (a) to (k) of Paragraph 4.1.16 of the HFC Directions.

(ii)    Out of the total assets (netted off by intangible assets), not less than 50% should be by way of housing finance for individuals as stated in clauses (a) to (e) of Paragraph
4.1.16 of the HFC Directions.

Note: The above-mentioned conditions shall be treated as Principal Business Criteria for HFCs and are applicable from the date of original instructions issued vide circular DOR.NBFC (HFC).CC.No.118/03.10.136/ 2020-21 dated October 22, 2020.

The activity to be understood as housing finance has been laid down in para 4.1.16 of the directions specified for Housing Finance Companies.

UNDERSTANDING CORE INVESTMENT COMPANY

A Core Investment Company has been defined in Para 2(1) of the Core Investment Company (Reserve Bank) Directions, 2016 (“CIC Directions”) as a non-banking financial company carrying on the business of acquisition of shares and securities which satisfies 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 investments 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 Trusts (InvITs) only as sponsor constitute not less than 60% of its net assets as mentioned in Clause (xviii) of sub-para (1) of paragraph 3 of CIC Directions;

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 dilution or disinvestment;

(iv)    It does not carry on any other financial activity referred to in Section 45I(c) and 45I (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 that make investments in debt/money market instruments with a maturity of up to 1 year

(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.

Para 3(xviii) of the CIC Directions: “net assets” means total assets excluding:

(i)    cash and bank balances;

(ii)    investment in money market instruments and money market mutual funds

(iii)    advance payments of taxes; and

(iv)    deferred tax payment.

Note: Companies in the Group shall mean an arrangement involving two or more entities related to each other through any of the following relationships: Subsidiary – parent (defined in terms of AS 21), Joint venture (defined in terms of AS 27), Associate (defined in terms of AS 23), Promoter-promotee (as provided in the SEBI (Acquisition of Shares and Takeover) Regulations, 1997) for listed companies, a related party (defined in terms of AS 18), Common brand name, and investment in equity shares of 20 per cent and above.

Para 3(viii) of the CIC Directions: “Core Investment Company (CIC)” means a core investment company having total assets of not less than Rs. 100 crore either individually or in aggregate along with other CICs in the Group and which raises or holds public funds.

Para 2(2) of the CIC Directions states that the directions shall not apply to a Core Investment Company, which is an ‘Unregistered CIC’ defined in para 6.

Para 6 of the CIC Directions state: CICs (a) with an asset size of less than Rs. 100 crore, irrespective of whether accessing public funds or not and (b) with an asset size of Rs. 100 crore and above and not accessing public funds are not required to register with the Bank under Section 45-IA of the RBI Act in terms of notification No. DNBS. PD.221/CGM (US) 2011 dated January 5, 2011, and will be termed as ‘Unregistered CICs’. However, CICs may be required to issue guarantees or take on other contingent liabilities on behalf of their group entities. Before doing so, all CICs must ensure they can meet the obligations thereunder as and when they arise. In particular, Unregistered CICs must be in a position to do so without recourse to public funds in the event the liability devolves, or they shall approach the Bank for registration before accessing public funds.

If unregistered CICs with asset size above Rs. 100 crore access public funds without obtaining a Certificate of Registration (CoR) from the Bank, they shall be violating Core Investment Companies (Reserve Bank) Directions, 2016.


SPECIFIC EXEMPTIONS FROM THE PROVISION OF SECTION 45-IA(1) PERTAINING TO REGISTRATION
Exemption from registration u/s 45-IA(1)(a) of the RBI Act has been provided to (Note: The below list is only pertaining to the exemption from Section 45-IA(1)(a), i.e. registration requirement. Other provisions of Chapter III-B may apply to the below-stated entities and needs to be examined on a case-to-case basis):

(i)    Any non-banking financial company which is
 
a.    providing only microfinance loans as defined under the Reserve Bank of India (Regulatory Framework for Microfinance Loans) Directions, 2022, provided the monthly loan obligations of a household do not exceed 50 per cent of the monthly household income; and

b.    licensed u/s 25 of the Companies Act, 1956 or Section 8 of the Companies Act, 2013; and

c.    not accepting public deposits as defined under Non- Banking Financial Companies Acceptance of Public Deposits (Reserve Bank) Directions, 2016; and

d.    having an asset size of less than Rs. 100 crore.

(ii)    Securitization and Reconstruction Companies (ARC) i.e. a non-banking institution which is a Securitization company or Reconstruction company registered with the Bank u/s 3 of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002.

(iii)    Nidhi Companies, i.e., a non-banking financial company notified u/s 620A of the Companies Act, 1956 (Act 1 of 1956), as Nidhi Company.

(iv)    Mutual Benefit Companies i.e. a non-banking financial company being a mutual benefit company as defined in paragraph 3(x) of Non-Banking Financial Companies Acceptance of Public Deposits (Reserve Bank) Directions, 2016.

(v)    Chit Companies i.e. a non-banking financial company doing the business of chits, as defined in Clause (b) of section 2 of the Chit Funds Act, 1982 (Act 40 of 1982).

(vi)    Mortgage Guarantee Companies i.e. notified as a non-banking financial company in terms of section 45 I (f)(iii) of the RBI Act, 1934 with the prior approval of the Central Government, and a company registered with the Bank under the scheme for registration of Mortgage Guarantee Companies.

(vii)    Merchant Banking Companies i.e. a non-banking financial company subject to compliance with the following conditions:

a. It is registered with the Securities and Exchange Board of India as a Merchant Banker u/s 12 of the Securities and Exchange Board of India Act, 1992 and is carrying on the business of a merchant banker in accordance with the Securities and Exchange Board of India Merchant Banking (Rules) 1992 and Securities and Exchange Board of India Merchant Banking (Regulations) 1992;

b.    acquires securities only as a part of its merchant banking business;

c.    does not carry on any other financial activity referred to in section 45I(c) of the RBI Act, 1934; and

d.    does not accept or hold public deposits as defined in subparagraph (xiii) of paragraph 3 of Non-Banking Financial Companies Acceptance of Public Deposits (Reserve Bank) Directions, 2016.

(viii)    Housing Finance Institutions i.e. non-banking financial companies acting as a housing finance institution as defined in Section 2 (d) of the National Housing Bank Act, 1987 [“NHB Act”](Registration requirements prescribed under the NHB Act).

(ix)    Insurance Companies i.e. a non-banking financial company doing the business of insurance, holding a valid certificate of registration issued u/s 3 of the Insurance Act, 1938 (IV of 1938); and not holding or accepting public deposit as defined in subparagraph (xiii) of paragraph 3 of Non-Banking Financial Companies Acceptance of Public Deposits (Reserve Bank) Directions, 2016.

(x)    Stock Exchanges i.e. non-banking financial companies being a stock exchange, recognized u/s 4 of the Securities Contracts (Regulation) Act, 1956 (42 of 1956) and not holding or accepting public deposit as defined in the subparagraph (xiii) of paragraph 3 of Non-Banking Financial Companies Acceptance of Public Deposits (Reserve Bank) Directions, 2016.

(xi)    Stock brokers i.e. non-banking financial companies doing the business of a stock-broker holding a valid certificate of registration obtained u/s 12 of the Securities and Exchange Board of India Act, 1992 (Act 15 of 1992) and not holding or accepting public deposit as defined in subparagraph (xiii) of paragraph 3 of Non-Banking Financial Companies Acceptance of Public Deposits (Reserve Bank) Directions, 2016.

(xii)  Alternative Investment Fund (AIF) Companies, i.e. non-banking financial companies, which act as an Alternative Investment Fund (Not trustee / AMC) holding a certificate of registration obtained u/s 12 of the Securities and Exchange Board of India Act, 1992 (Act 15 of 1992) and not holding or accepting public deposit as defined in subparagraph (xiii) of paragraph 3 of Non-Banking Financial Companies Acceptance of Public Deposits (Reserve Bank) Directions, 2016.

(xiii) Unregistered Core Investment Companies, i.e. a non-banking financial company in the nature of a Core Investment Company as stated at para 6 of the Core Investment Companies (Reserve Bank) Directions, 2016.


ROLE OF AUDITOR WHILST REPORTING
The auditor needs to perform the audit, keeping in mind the various provisions produced above, for reporting under clauses (xvi) on the NBFC and CIC. The following paragraphs further explain the practical difficulties auditor may face and measures to tackle the same.

Sub-clause (a) & (b) of Clause (xvi)

1.    As a pre-requisite, the auditor must evaluate the fulfilment of PBC for the companies undertaking any of NBFI activities. This shall enable him to form his opinion on whether the company is required to seek registration with RBI. Certain points which may be considered while determining the financial asset and financial income ratios are:

a.    Financial Assets under Ind AS, such as Security Deposits and loans to employees to advance against salary (to be considered as financial if in the ordinary lending business of the company) are to be considered as non-financial if they are not like lending.

b.    Cash/bank balances (including bank FD with commercial banks) shall not be considered as financial assets.

c.    Investments in real estate, precious metals, and other commodities are not considered as financial assets.

d.    For the calculation of financial income, it is essential to consider all the financial income emanating from the financial assets. Therefore, if an asset is classified as a financial asset, its income may be regarded as financial income unless otherwise specified in the regulation.

Note:

(i) The fulfilment of the PBC criteria is based on the satisfaction of both, financial asset ratio and financial income ratio. However, following a conservative approach, the RBI may treat a company fulfilling the financial asset criteria as NBFC because of its potential to generate financial income, which may be over 50 per cent of its total income.

Note: Deemed NBFC is a word coined for entities engaging in NBFI activity and not registered, irrespective of the activity stated as its main object clause.

(ii)  The PBC criteria needs to be evaluated even for the entities granted exemption, since it may be considered a deemed NBFC if the regulator withdraws the exemption.

(iii)  The main object clause, as stated in MOA shall not be considered while conducting the PBC test as the objective is to weed out the deemed NBFC.

Although the prescribed timeline for testing the PBC is the balance sheet date, the auditor may evaluate the actual nature of the business being conducted by the company during the entire period covered under the audit.

The PBC test checking shall be performed by the auditor irrespective of the size or net-worth requirement for registration under the Act, i.e., the RBI Act or the NHB Act read with HFC Directions of the RBI.

2.    In case of meeting the PBC test, and not obtaining registration, the auditor needs to report, against the company, as under:

a.    To the management/those charged with governance as per SA 260.

b.    CARO stating the need for registration with the regulator.

c.    An exceptional report to be submitted to the regulator for violation of the provisions of section 45-IA of RBI Act 1934 and conducting/continuing principal business of NBFI without a valid Certificate of Registration.

Note: This might affect the “fit and proper status” of the promoters, which may act as a hindrance to incorporating a regulated entity in future.

The auditor may be subject to regulatory action as stated in section 45M of the RBI Act 1934 in case of false/non- reporting of the company’s position to the regulator. The auditor shall comment that “the company is not fulfilling the Principal Business Criteria, and is not required to be registered with RBI” for substantiating not conducting NBFI activity or non-fulfilment of PBC on the conduct of NBFI activities within limits prescribed by RBI.

Note: Even if CARO is not applicable to an entity, the auditor must make exceptional reports to the regulator if the PBC test is met.

3.    The company may seek regulatory guidance on a qualification from the auditor as stated above, whereby generally the regulator advises the board to select from alternatives as below:

a.    register with the RBI, or

b.    reconfigure its assets to fall out of the criteria, or

c.    liquidate the financial assets to take financial asset ratio below 50 per cent.

Continuance of the existing business without obtaining registration shall attract penal actions as per RBI Act 1934.

In case of any unusual circumstances whereby the company meets the PBC, the regulator may consider the company’s request for not intending to engage in the NBFI activities on submission of a suo moto explanation for situation due to which the company fulfils PBC along with a corrective plan of action to rectify the defect.

4.    For registered NBFCs, the auditor needs to verify the validity of the certificate of registration issued by the RBI. The name of the stated company shall appear in the list of NBFCs on the RBI’s website. Although not addressed in CARO, the auditor needs to assess that the registered entity fulfils the PBC criteria when it holds a valid Certificate of Registration. In case of non-compliance, the auditor’s direction is responsible for reporting to the regulator in due time to take suitable action.

SUB-CLAUSE (c) & (d) OF CLAUSE (xvi) OF CARO

1.    The conditions for classification as CIC shall further be assessed keeping in mind the following points:

a.    The company shall not have any exposure, irrespective of its quantum, other than its group company.

b.    CICs are allowed to invest in money market instruments, government securities, bank deposits and specified securities as stated by the regulator from time to time.

The auditor must identify the companies in the Group, for the auditee to evaluate whether its activity is restricted to the group company. Subsequently, it falls within the criteria of CIC. The auditor shall have the same reporting responsibility as stated above since CICs are primarily NBFC’s fulfilling certain special conditions unless they avail exemption by fulfilling the conditions.

2.    There are only 62 registered NBFC-CICs in the records of RBI as on 31st July, 2022. Although the criteria for recognition as CICs may cover a large number of companies, the Certificate of Registration is not obtained for a majority of them on account of exemption from Section 45-IA to CICs (i) Not Accepting Public Funds but asset size >= Rs. 100 Crore and (ii) Asset Size < Rs. 100 Crore, irrespective of whether they accept public funds or not.

3.   The Clause places responsibility on the auditor to report the CICs in the same “group” for the records of RBI on the lateral spread of the Group. The reporting shall be done irrespective of the fact that vertical layering of the entities may comply with section 450, r.w.s. 469 of the Companies Act 2013, whereby the company is not allowed to have more than two layers of subsidiaries.

This may be to keep a check on the additional liquidity facility percolating from the holding company to its subsidiaries and for the RBI to evaluate the number of CIC structures in the NBFC environment, both registered and unregistered.

4.    A Written Representation shall be obtained from the management for the classification of entities falling within the Group and the number of CICs within the Group.

5.    For registered CICs, the auditor needs to verify the validity of the certificate of registration issued by RBI with the name of the stated company appearing in the list of CICs on the RBI’s website, and evaluate that the registered CIC shall not engage in any other activity, post- meeting the criteria, other than permitted i.e., investment in money market instruments, government securities, bonds and debentures of the group companies.

Since the company cannot have any exposure outside its group company, if at any point in time it shall have any exposure outside the Group, the company shall be tested for PBC. And on fulfilment, it may attract reporting and registration clauses as stated in points (a) and (b) of Clause (xvi) of CARO.

6.    The Clause requires the auditor to evaluate the criteria for fulfilment by unregistered CICs for availing exemption on a year-on-year basis. The auditor shall report in case of contravention of any conditions and any specific condition on the basis of which exemption is granted.

CONCLUSION

Although the NBFC industry has been consolidating from over 12,000 NBFCs only five years ago to less than 10,000 NBFCs today, the growth of NBFCs has made them an integral part of the Financial System in general and credit delivery in particular. To address the possible systemic risk on credit delivery via unregulated means, CARO 2020 substantially strengthens the reporting requirements prescribed under CARO 2016 by entrusting additional responsibility to curtail the contravention of the regulation to company auditors.

Auditors, therefore, are required to conduct the audit with utmost care and diligence, now more than before. An in-depth knowledge and constant upskilling on the auditee’s regulatory environment is essential, especially since, in the case of NBFCs, the industry and its regulations have been immensely dynamic in the recent past.

Identification of Related Parties and Significance of Related Party Transactions

INTRODUCTION
Related party transactions have always been under the scanner of various regulators. Recently, SEBI fined a large group for taking loans from a financial institution, which was its related party, in violation of SEBI regulations and not disclosing such related party transactions. SEBI also recently amended the definition of a related party by widening it to include certain large shareholders and requiring shareholders’ approval for material related party transactions (in terms of value or as a percentage of turnover). Once the party is identified as a related party, there are certain compliances for the company to follow, including provisions relating to approval and voting for such transactions. The Companies Act, 2013 (the Act) provides definition of the term ‘Related party’ u/s 2(76). On the basis of this definition, there are various compliances required under the Act for transactions with related parties. Schedule III to the Act, which prescribes disclosures required in the financial statements of a Company, also requires certain disclosures related to shareholding of promoters, changes in their shareholding during the year, loans or advances in the nature of loans granted to promoters, directors, key management personnel and the other related parties either severally or jointly with any other person, etc. Accounting Standard 18 and Ind AS 24 also define related party relationships.

There are differences in the definition of related party under the Companies Act and accounting standards. For listed entities, SEBI Regulations also define related parties which has additional relationships as compared to Companies Act and accounting standards. For examples, two companies with common director are related parties from the perspective of Companies Act and SEBI, but those may not be related parties under accounting standards.

Therefore, entities need to interpret this term on the basis of all the regulations that apply to them i.e., SEBI (in case of a listed entity), Companies Act (in case of a company) and relevant accounting standard (based on accounting standard framework applicable to the entity). Due to various regulatory requirements applicable to the entities, they are required to identify their related parties and transactions with them during the period. From the auditor’s perspective, such transactions are considered to carry a higher fraud risk due to the nature of relationship.

In this article, we look at the regulatory framework in respect of related party transactions and certain issues while applying the related requirements along with company’s and auditor’s perspective of implementing and auditing these compliances.

REGULATORY FRAMEWORK

Companies Act, 2013

For companies, there are various sections in the Act that aim to ensure that the company’s interest is protected in such transactions. For example,

– Section 185 relates to provisions for giving loans to directors,

– Section 186 restricts the amount of loan or investment a company can make,

– Section 177 requires approval of audit committee for related party transactions,

– Section 188 requires consent of the Board of Directors for specified transactions,

– Section 192 requires approval of members for certain non-cash transactions with directors, etc.

Companies (Auditor’s Report) Order, 2020 requires the auditor to report on transactions covered under the above sections of the Act. The Companies Act, 2013 also provides for the manner in which the directors are required to disclose their interest in the transaction. Failure to do so attracts penalties for such a director. The Companies Act, 2013 defines the term ‘related party’, but does not provide definition of ‘related party transactions’. However, Section 188 lists certain types of transactions. To protect the interest of the members, specified related party transactions under the Companies Act, 2013 require shareholders’ approval.

ACCOUNTING STANDARDS

To achieve a true and fair view of the financial statements, disclosure of related party transactions and their terms is also considered as one of the necessary components. Therefore, accounting standard framework also defines related party relationships, and prescribes disclosures to be made in the financial statements for such transactions, with certain exemptions for government-related entities. With such disclosures, the users of the financial statements understand the impact of such transactions on the overall financial statements. However, accounting standards framework does not establish any recognition or measurement requirements for related party transactions. Such transactions are recognized and measured based on the requirements of the respective accounting standards. For example, if the parent company issues ESOPs to the employees of the subsidiary, the subsidiary shall record the transaction as per accounting standard applicable to ESOPs.

Accounting Standard (AS) 18 and Ind AS (Ind AS) 24 define related parties. Such parties could be other body corporates, individuals or employee benefit plans. However, there are differences in the definition of related party under AS 18 and Ind AS 24.  Definition in Ind AS 24 is wider in scope as compared to AS 18 in terms of close members of the family, key managerial personnel (KMP), control, joint control and significant influence, etc. Ind AS 24 also covers certain relationships  not covered under AS 18 such as joint ventures of the same venturer, joint venture and associate of the same party, certain post-employment benefit plans, parties providing KMP services, etc. Under Ind AS 24, post-employment benefit plans are related if those are for the benefit of employees of either the reporting entity or any entity related to reporting entity. It does not require any influence or control being exercised over such a plan for covering it as a related party.

However, some of the indirect relations may or may not be covered in the definitions of the applicable standard. Therefore, one needs to carefully evaluate the definition of a related party. For example, if A is a joint venture of B, and C is an associate of B, then A and C are related parties of each other under Ind AS 24.  However, C is not a related party of any other associate that B may have (fellow associates). Though this gives somewhat unexpected answer, but due to complexity of relationships, some of such indirect relationships may not get covered in the definition.

Major customers or suppliers are also not considered as related parties under the accounting standards, though in such business relationships, the transactions will have effect of the relationship on the performance of the entity as compared to the transactions with an unrelated party.

Control relationships (e.g., parent, ultimate parent, etc.) gain more importance in the disclosures for which the accounting standards require names of such related parties to be also disclosed. Such control may be with an individual in a promoter-controlled company. Disclosure of names of these parties is required even if there are no transactions with them.

While applying the accounting standards, entities need to understand the appropriate interpretation of certain requirements of the relevant accounting standard. Some of such requirements of Ind AS are discussed below.

WHO ARE KMPs UNDER IND AS 24?

Directors

Directors hold fiduciary capacity vis-à-vis the company. Therefore, they are not expected to use company’s assets or their power for personal gains. As they hold such a position, certain directors are considered as related parties of the company. Ind AS 24 defines KMP as persons having authority and responsibility for planning, directing and controlling the activities of the entity. With this definition, executive directors of the company will usually be covered since they carry such authority and responsibility. The definition also includes any director, whether executive or otherwise. Therefore, even non-executive directors who have such authority and responsibility are KMPs of the company.

CFO, Financial Controller, etc.

Will other senior management personnel such as CFO, Chief Marketing Officer, Chief Legal Officer, Financial Controller, etc. be covered as KMPs under Ind AS 24? There is no one answer here that fits all. KMPs are not restricted to directors. Other senior management members also may be KMPs. The company needs to evaluate their roles and determine whether they have the above-mentioned authority and responsibility or not. It is not the designation but the role that the individual plays that determines whether he / she is a KMP or not.

Members of Strategy Board

In some companies, the Strategy Board assists the Board of Directors to set the overall strategy for the company, and  also implements such a strategy. In such cases, members of the Strategy Board are also KMPs. Similarly non-directors who are responsible for key planning, directing and controlling key activities, such as treasury, investments, etc. can also be KMPs in cases of companies which have such functions as key operating functions.

Therefore, all directors may not be KMPs and KMPs need not be only directors.

KMPs for a group

The group consists of a parent and one or more subsidiaries. Each component of the group would have its own KMP, but the question is who are KMPs for the group as a whole. For example, an investment company invests in a subsidiary which is an operating company. In such case, KMPs of the subsidiary company will also be KMPs of the group because subsidiary contributes significantly to the group’s results.

Non-individual KMPs

Given that the definition of KMP does not restrict to individuals; non-individuals, such as another entity, that provides the functions as given in the definition of KMP, is also a related party as KMP for the reporting entity. For example, investment funds may have investment managers as KMPs which are entities and not individuals.

Once an individual is identified as a KMP, the scope of identification of related parties also expands to close members of that person’s family and certain related parties of such a close member of that person’s family.

TRANSACTIONS WITH KMPs

Accounting standards require specific disclosures for transactions with KMPs including specific elements of their remuneration. Usually, in practice, such disclosures are made on an aggregate basis, and not for each KMP. Though materiality is an overarching principle for making disclosures, sometimes it is incorrectly used by considering only quantitative measurement for not making such disclosures. However, one needs to consider qualitative aspects as well of such disclosure required by the accounting standard.

RELATIONSHIP PERIOD

Another interesting issue is what is the scope of requirement if the relationship ceases or new relationship gets established during the reporting period. Whether related parties should be considered as at the year end? Though accounting standards do not explicitly cover this matter, relationships should be considered during the period, and not only at the year end. Transactions taking place after cessation of relationship are not considered as related party transactions.

RELATED PARTY TRANSACTIONS
Once related parties are identified, the next step is to identify related party transactions. AS 18 and Ind AS 24 both provide the definition of related party transactions. Both accounting standards explicitly clarify that transactions for which no price is charged are also covered in related party transactions. Accordingly, if the KMP of a holding company is also a KMP of its subsidiary company, for which no remuneration is paid by the subsidiary company, services received from such a KMP is also a related party transaction for the subsidiary and provision of services is a related party transaction for the holding company. In another example, if employees of subsidiary are used by the holding company for which no charge is made by the subsidiary company, transaction should be disclosed by both the companies as related party transactions.

SEBI REGULATIONS

For listed entities, Securities and Exchange Board of India (SEBI) has included certain compliance requirements in its SEBI (Listing Obligations and Disclosure Requirements) Regulations. These regulations prescribe approval mechanism and require disclosure of specified transactions which are transactions between the listed entity and the related party. The investors obtain better perspective of the performance of the company, and their interests are protected through these requirements. This mechanism also helps  monitor funds movement between the listed entity and the related party.

In SEBI regulations, certain related party transactions are identified as material when they exceed the specified threshold given in Regulation 23(1). However, there are certain interpretational issues while applying such thresholds to the transaction such as what constitutes a transaction on which such limits are to be applied, whether group of related transactions are treated as a single transaction, etc. The definition of related party is revised in the regulations and the revised definition applies from 1st  April, 2023. The revised definition refers to purpose and effect of the transaction. In practical scenario, determining the purpose and effect of the transaction is going to be a challenge.

COMPANY’S PERSPECTIVE

Internal controls framework

Companies need to design and implement internal controls framework around:

–    Identification of related parties.

–    Approval process of related party transactions.

–    Accounting of related party transactions (especially when those are not at arm’s length).

–    Disclosure of related party transactions in the financial statements.

Such internal controls should be tested for their operating effectiveness throughout the year.

AUDITOR’S PERSPECTIVE

Audit of a related party transactions is always a challenge for the auditor. The skepticism for such transactions is set at higher limits for the auditor. The auditor needs to understand business rationale for such transactions. When such rationale is lacking, it may not meet the ‘smell test’ and would require additional audit procedures to be carried out to fulfil auditor’s responsibility and understand impact of such transactions on the financial statements. There is also a possibility of non-genuine transactions being recorded when the counter party is a related party. Standard on Auditing 550 – Related Parties deals with auditor’s responsibilities related to fraud risk, understanding the impact of related party transactions on the financial statements and obtaining audit evidence for such transactions.

As part of the audit process, apart from the business rationale as mentioned above, the auditor should also evaluate the consideration received or paid for such transactions to assess whether those transactions were carried out at arm’s length or not. If the transactions are not at arm’s length, then the reasons for determining such pricing, its impact on accounting of such transactions, etc. are additional factors that the auditor should consider.

As seen in some  corporate scandals, the challenge for the auditor in the audit process was to unearth the related party transactions due to the fact that such transactions were camouflaged to depict as transactions with non-related parties. Parties that have control, significant influence or power to take decisions of the transactions may use opportunity which is not in the interest of the company. As a result, to evaluate KMPs of the company and therefore other related parties is one of the high-risk area from the audit perspective.

As a part of the audit, the auditor shall audit the identification of related parties as well as adequacy and correctness of the disclosures made in the financial statements for related party transactions.

STANDALONE ENTITY

Consider the transactions which prima facie do not seem to be a commercial transaction. For example, loans given by the entity for which there are no agreed terms of repayments and repayment schedule, changing the supplier without inviting quotations from other players in the market, non-monetary transactions involving property of the entity, transactions outside the normal course of business, etc. It is likely that such transactions are entered with related parties which may lack commercial substance. In such situations, the auditor needs to remain more alert and obtain persuasive audit evidence to determine the nature and objective of such transactions.

GROUP STRUCTURES

As one would expect, identification of related parties is more complex in group structures with various subsidiaries, associates, etc., because each component of the group may have its own related parties. Therefore, group audits pose a higher challenge for the group auditor in audit of related party transactions. Usually, the group auditor, as part of his audit instructions, shall inform the component auditor of various related parties of the group entities. The component auditor is expected to exercise higher skepticism while auditing the transactions entered into with the parties that may not be related party of the component that has entered into the transaction but is a related party to the overall group or to some other component in the group.

CONCLUSION

Related party identification and transactions with related parties has always been a key concern for regulators across the world. Therefore, regulations around such transactions are being tightened over the period. Though on one side it undoubtedly protects the interests of the members and other stakeholders, on the other side, unless the principle is followed in substance as per its intent, no regulation can prevent misuse of relationships in the business transactions. Therefore, governance mechanism of the entity and its code of ethics are the real safeguards for protecting the interests of the entity. Management and those charged with governance, board of directors, audit committee, etc. are collectively guardians of the interest of the company. If they play their role responsibly, it is only then that the expected transparency of related party transactions will be achieved.

How Well Rounded are Rules about Rounding off Numbers in Financials Statements?

Financial Statements (FS) indicate a company’s financial performance and position. In case of Public Interest Entities (PIE), FS serves numerous people/bodies like shareholders, analysts, regulators, etc.

The idea behind any reporting, is to enable the reader to gather information in a way she can comprehend with ease. Comprehension by reader is the ultimate test that a preparer should measure up his reporting, so that it is of value. IASB has also stated that understandability is an important feature that preparers of financial statements must strive for.

This short article walks you through the rule regarding ‘rounding off’ of figures in the financial statements under the Companies Act, 2013 as required by Schedule III – the absurdities, excesses and anomalies.

PRESENT LAW

Schedule III lays out the manner of presentation of financial statements and other information to ensure they give a true and fair view. In relation to rounding off of numbers, Schedule III mandates:

(i) Depending upon the Total Income of the company, the figures appearing in the Financial Statements shall be rounded off as given below:-

Total Income

Rounding Off

(a) less than one hundred crore rupees

To the nearest hundreds, thousands, lakhs
or millions, or decimals thereof.

(b) one hundred crore rupees or more

To the nearest lakhs, millions or crores,
or decimals thereof.

(ii) Once a unit of measurement is used, it should be used uniformly in the Financial Statements.

Emphasis supplied for the word shall, as it replaced the word may on 24th March, 2021.

The aforesaid provisions and changes of 24th March, 2021 imply:

a.    Rounding off is a part of ‘disclosure’ requirements of the Act and compliance with accounting standards (as section and Schedule speak of them as the leading criteria).

b.    Rounding off is mandatory (so it appears from the language of the clause and the amendment).

c.    If you do not round off, you are in violation of the Companies Act, 2013.

d.    Fine of Rs. 25,000 to Rs. 5,00,000 and even imprisonment of up to 1 year is prescribed under Section 129(7) of the Companies Act, 2013.

It is important to find out about ‘global best practices’ which ministers and MPs speak of with confidence, for convenience and selective expediency. FASB and IASB do not mandate rounding off. The idea is to refrain from RULES and rather set PRINCIPLES, and hence Ind AS / IAS 1.51.e and 1.53 talk of disclosure of level of rounding off (thousands, lakhs, millions or crores) when an entity rounds off to make it ‘understandable’.

However, MCA has made it mandatory. Additionally, it came out with this change, without ‘disclosure’ of any reason behind the change! How about a discussion? How about giving some background? Are there any issues that this mandate will address? In a lighter vein such ‘notifications’ including parts of CARO or Schedule III without discussion appear to be ‘naughtyfications’ because there is more mischief than meaning.   

PURPOSE AND COMPREHENDING NUMBERS

Let’s keep the above legal requirement on the side for a moment and look at other facets of rounding off. Rounding off is a trade-off of precision for comprehension. The numbers are also used to compare them with similar numbers of other entities. So numbers allow us not only to read FS of a company but also help us compare with numbers of other companies.

Rounding off also helps unwieldy numbers to be readable and fit for grasping easily. However, in most cases, rounding off should be used for publishing financial information and may not be necessary in actual FS. FS adoption ideally should be with full numbers, but what is circulated / published can be different from it. The rounding off prescribed in Schedule III many a times defeats the very purpose of rounding off. Here is how:

The way people understand numbers is quite peculiar. This becomes difficult when the numbers are rounded off a certain way. Look at the following table:

Sr.
No.

Number

What is it

How we
comprehend it

1

10,00,00,000

This is the actual Number

It is understood just the way it is. Just as we understand a WORD –
Coconut – we understand this number to be
10 Crores.

2

1000,000

When rounded in hundred

Each of the numbers given against Sr. No. 2 to 5 are meant to be
understood as 10 Cr but only because the legend says so that they are rounded
to 100s or 1000s etc.

3

100,000

When rounded in lacs

4

10

When rounded in crores

5

100

When rounded in millions

What rounding off says is that items listed in Sr. No. 1 to 5 mean the same thing. When you read the number ALONG with the rounding off LEGEND in your brain you have to UNROUND it to understand. Why? Because the number gives scale, and the scale is known by quantum. So, one has to un-round it to understand how large or small the values are. Because when the brain reads 100 as given in Sr. 5 it cannot recognize it as 10,00,00,000 given in Sr 1. It will have to use a TRANSLATION of rounding off legend to arrive at the real value.

PROBLEM 1: ABSURD RESULTS

Let’s see if the FS of a company are in thousands – 4 digits. Now, some numbers in the FS are in hundreds. This will put all numbers in single or double digits or even decimals. Obviously, this doesn’t make it easier to ‘comprehend’. Say an Intangible is already fully depreciated and having WDV that is 5% of its value can disappear from PPE Schedule entirely due to rounding off.

PROBLEM 2: INCONSISTENT LAWS

While rounding off is mandatory for presentation of FS, under the same Companies Act, 2013, and when it comes to submission of FS annually to the MCA under Form AOC 4, you have to provide un-rounded figures. There is no choice to give numbers in ‘00 or ‘000. Only full numbers are permitted. The question is: for Form AOC4 – should one add 0s that were removed to round off to comply with the Schedule III or will AOC4 need exact figures full numbers which are not audited or are in an Excel?

How will the compliance professional certify the AOC4 – when actual signed FS are rounded or can he adopt un-rounding basis stated above?

Which are the final numbers – the one with rounded amounts or one with actual numbers that are not ‘signed’ or approved for all other legal purposes whether under the Act or other laws?

Consider the departments/boards under the same Ministry of Finance – will they accept rounded figures? Say, Income Tax returns need full figures. GST returns need full figures.

PROBLEM 3: TWO FS   

Some clients want two FS. One for meeting rounding off requirement, and the other for tax and other purposes. Their CS is asking; which numbers should he take to fill the form?

PROBLEM 4: ROUNDING OFF AND CASTING

For smaller enterprises, rounding off makes, preparing FS even more difficult. There is already a problem with matching totals in Notes to main pages of FS and ensuring casting is correct.

PROBLEM 5: MAKING NUMBERS LOOK SMALLER

More than the technical and accounting considerations, an unintended consequence of this mandate for small companies is YOU ARE MAKING ME SUDDENLY LOOK SMALLER. Full numbers when I carry in my balance sheet is a feel-good factor and a contributing factor to confidence and external respect. As a slightly extra rounded person, I would like to
look less rounded (pun intended), but would definitely not want my financials to look ‘leaner’. Soft factors do matter.

WHAT MCA SHOULD CONSIDER?

1.    Prescribe comma placement – this is the single most important factor for improving the readability of numbers. Not placing a comma is a catastrophe for number reading and shows careless disregard for the reader.

2.    Prescribe a minimum font size – it’s impossible to read small fonts, especially in printed material. But even for e-copies, there should be a minimum font size.

3.    Allow only lacs and crores, not millions and crores – Million is another way to put comma. India needs to decide where it stands, lacs/ crores or thousands/ millions. But this is not the most important point although the Companies Act, 2013 sections generally specify numbers in crores and lacs.

4.    Rounding off threshold can be raised –
When a number becomes unwieldy – say HPCL Income of Rs. 250,000 Crores – 25,00,00,00,00,000 (eleven zeros) then rounding off makes sense.

5.    Rounding off for publication and not adoption – For most companies allow actual numbers and for publication purposes, rounding off can be done by management. FS need not be rounded off in most cases. FS are used for FULL numbers by most stakeholders and full numbers have more meaning for purposes that are of regulatory consequence.

6.    Materiality should be the basis of rounding off – A Rs. 1,000 Crores assets company, with a turnover of Rs. 5,000 Crores, could have a materiality of say 5 per cent of assets or 1 per cent of sales – about Rs. 50 Crores. This company can round off in crores. Less than 3 digit crores, perhaps require no rounding.

7.    For private limited companies which are not public interest entities, they should be out of the tangles of rounding off. The preparers and readers are SAME and obviously, the government has NOTHING to read into those financials. Even if they wanted to, they can read from exact numbers.

8.    Form AOC-4 should permit expressly rounded amounts or allow 000xxs to be added instead of actual numbers.

Finally, ease of doing business should guide such decisions. ‘Shall’ we say, rounding off ‘may’ be unwound a bit to make it well rounded.


COMMON PITFALLS IDENTIFIED BY REGULATORS

In the last couple of years, the Government of India (GOI) along with the Ministry of Corporate Affairs and other regulatory bodies have introduced significant regulatory reforms with respect to financial reporting in India. These reforms were introduced with an objective to establish more robust regulatory environment, transparent and reliable financial reporting framework that can be benchmarked globally, and increase investor confidence.

As a result of the above reforms, both the industry and audit profession have witnessed significant amendments in various provisions of the Companies Act 2013 (the Act), adoption of new accounting standards and auditing practices that are at par with global parameters, and formation of new regulatory bodies to closely monitor regulatory compliances.

The above initiatives have resulted into a multi-fold increase in the responsibilities of the members of ICAI, who are acting as an auditor of various companies, and vested with the responsibility to express an opinion on true and fair view of the financial statements, in light of the new provision and amendments introduced in the Act.

Although with all the above initiatives, we have witnessed a fast-paced improvement in both financial reporting and audit quality in a very short span of time, there is a lot of work that still needs to be done to ensure that this improvement process continue to give positive results and make high audit quality sustainable, and for which review boards and authorities have been constituted, as described below, to monitor and review the continuous progress:

National Financial Reporting Authority (NFRA):
The NFRA is newly constituted by GOI in 2018, with an objective to continuously improve the quality of all corporate financial reporting in India by monitoring and enforcing compliance of accounting and auditing standards and by overseeing the quality of services of the professions associated with ensuring compliance with such standards, and suggest measures for improvement in the quality of services. The NFRA issues Financial Reporting Quality Review Report (FRQRR) post its review of quality of financial reporting of the company under review, and Audit Quality Review Report (AQRR) post its review of quality of audit services provided by the audit firm under review. Both these reports are available on NFRA website.

Quality Review Board (QRB): The GOI along with ICAI had constituted QRB in 2007, consisting of a chairperson and ten other members. The objectives of QRB are similar to NFRA, with a difference that the scope of QRB is limited to reviews of quality of audit services provided to private limited companies, unlisted public companies below the thresholds specified under Rule 3(1) of NFRA Rules, 2018 and other entities not specified under Rule 3(1) of NFRA Rules, 2018, and also entities that are referred to QRB by NFRA.

QRB issues a consolidated Quality Review Report every year summarizing its observations on quality of services, provided by various members of ICAI. The reports issued are available on QRB website.

Peer Review Board (PRB): PRB was constituted by ICAI in 2002, with an objective to ensure that in carrying out the assurance service assignments, the members of ICAI have complied with technical, professional and ethical standards as applicable including other regulatory requirements thereto and have in place proper systems including documentation thereof, to demonstrate the quality of assurance services. Thus, the focus of PRB is more towards enhancing the quality of professional work by adopting robust procedures and techniques that results into more reliable and useful audit and reports. Audit firms that successfully clears peer review are awarded peer review certificates.

Financial Reporting Review Board (FRRB): FRRB was constituted by ICAI in 2002, with an objective to bring improvement in the quality of financial reporting and auditor’s report thereon. The focus of FRRB is towards compliance of applicable accounting standards, compliance of the format and disclosure requirements of Schedule III and other provision of Companies Act 2013, and auditor’s report.

Apart from the above, Securities and Exchange Board of India (SEBI) and Registrar of Companies (ROC), also review financial results / statements filed with them, and issue notices to corporates, in case there are non-compliances of applicable rules and regulations.

The objective of this article is to highlight some of the common observations made by above regulators, towards compliance of Standards on Auditing, Accounting Standards and Schedule III of the Companies Act, during their reviews, so that the readers of this article who are also acting in the capacity of auditors, can take extra care while dealing with similar situation, and achieve high quality audit.

The major observations made by the regulators are summarised in three broad categories i.e. Observations related to Standards on Auditing, Accounting Standards, and Schedule III. Further, below are the review reports that are primarily referred to highlight the observations:

–    Report on Audit Quality Review for the financial year 2020-21, issued by QRB.
–    Report on Audit Quality Review for the financial year 2019-20, issued by QRB.
–    FRQRR on the financial statement of Prabhu Steel Industries Limited, for the financial year 2019-20, issued by NFRA.
–    FRQRR on the financial statement of KIOCL Limited, for the financial year 2019-20, issued by NFRA.
–    Study on Compliance of Financial Reporting Requirements (under Ind AS framework) issued by FRRB.

COMMON OBSERVATIONS WITH RESPECT TO STANDARDS ON AUDITING
We need to understand and acknowledge that audit planning and execution is a lengthy process and require significant efforts and professional judgement, to express an opinion on the financial statements that is appropriate in the circumstances. This responsibility of the auditor increases to a significant extent, as and when a new provision or amendment has been introduced by the regulatory authorities, as these amendments usually have implications on various aspects of audit.

ICAI has issued Standards on Auditing and also issues other auditing pronouncements from time to time, that provide appropriate guidance to the auditors in various aspects of audit and assist them in ensuring that sufficient appropriate audit procedures have been performed and adequate evidences have been obtained that are relevant and reliable in the circumstances, and assist auditors to discharge their responsibilities.

The regulators while reviewing the audit work of the auditors refer these guidance and pronouncements to ensure that they have been adequately complied by the auditors while performing the audit. The common observations that the regulators have highlighted during such reviews are as under:

1. Standard on Quality Control (SQC-1)

Some of the most common findings with respect to engagement quality control and compliance of Standard on Quality Control (SQC-1) primarily includes:

–    Lack of adequate quality control manuals or implementation and monitoring of policies and procedures to ensure that the firm and its personnel perform the work that complies with professional standards, regulatory and legal requirements and issue reports that are appropriate in the circumstances.

–    Lack of communicating and documenting communication of quality control policies and procedures of the firm to the firm’s personnel, and the instances where the confirmations were obtained. More lack of established policies and procedures setting out criteria for identification of audits and reviews of financial information that should be evaluated to determine whether an engagement quality control review should be performed.
–    No written confirmation of compliance with policies and procedures on independence from all the firm personnel required to be independent and the instances where the confirmations have been obtained, the template used, did not address all the requirements of independence as envisaged under Code of Ethics and the provisions of the Act.
–    Absence of established policies and procedures for evaluating the independence before accepting non-audit engagements.
–    Absence of established policies and procedures for the acceptance and continuance of client relationships and specific audit. Further, not considering whether the firm has the capabilities, competence, time and resources to undertake a new engagement from a new or an existing client, not considering whether the firm personnel have experience with relevant regulatory or reporting requirements, or the ability to gain the necessary skills and knowledge effectively.
–    Absence of adequate reconciliations for UDINs generated as against bills raised for audit and attestation services provided.

The reviewers have reported highest number of adverse observations with respect to the SQC-1 and the primary parameters considered by them for ensuring the compliance, includes the following:

–    Whether the firm’s code of conduct includes the ethical requirements relating to audits and reviews of historical financial information, and other assurance and related services engagements.

–    Whether the person responsible for monitoring the system of quality control has appropriate experience for the role and assigned with sufficient and appropriate authority.
–    Whether a confirmation for maintenance of independence has been obtained from all the personnel required to maintain the independence, at reasonable intervals.
–    Whether there are adequate guidelines for the acceptance and continuation of audit clients and engagements including engagement for non-audit services.
–    Whether the quality control reviewer has been assigned to the audit engagements based on their risk profiles, and whether an appropriate mechanism has been established to ensure the involvement of quality control reviewer in all the significant areas of audit i.e., audit planning, audit observations require significant professional judgement, and issuance of audit opinion.
–    Whether the rotation of partners and senior personnel of audit engagements has been ensured at reasonable intervals.
–    Whether appropriate training programs have been conducted at reasonable intervals to ensure the competence and capabilities of the audit staff.
–    Whether there are adequate policies and procedures to ensure timely completion of audit documentation and its retention.

2. Audit engagement letter

The regulators in their review have commonly highlighted non-compliance of SA 210, Agreeing the terms of audit engagement, some of the commonly highlighted instances include:

–    Audit engagement letter executed post commencement of the audit.

–    Audit engagement letter not addressed to Board of Directors and not copied to Chairman of the Audit Committee, wherever applicable.
–    Absence of reference to the involvement of joint auditors
–    Audit and reporting on internal control with reference to financial statements, not included in the scope of audit.
–    Absence of reference to the expected form and content of the audit report to be issued by the auditor and a statement that there may be circumstances in which a report may differ from its expected form and content.
–    Audit engagement letter not signed by authorised person.

3. Audit documentation

Audit documentation is the primary evidence for the auditor to demonstrate that all the required audit procedures have been adequately performed to ensure compliance with professional standards, and various regulatory and legal requirements and considering this significance, the regulators and reviewers expect that the audit documentation should be prepared in such way so as to sufficiently describe the status of compliance with the standards on auditing, the timing and scope of implementation of audit procedures, the grounds for judgments, and the conclusions reached.

Further the audit documentation should also demonstrate that all the audit documentation has been adequately reviewed in a timely manner by the more experienced audit team member, audit engagement partner, and engagement quality control reviewer to confirm that sufficient appropriate audit evidence has been obtained to support the audit conclusions reached.

Some of the commonly highlighted observations in the audit documentation includes, inadequate documentation with respect to following significant audit areas:

–    Impairment assessment of property, plant and equipment, and intangible assets.

–    Compliance of financial covenants imposed by the lenders.
–    Going concern assessment, specifically evaluation of events and conditions triggering going concern and material uncertainty.
–    Evaluation of significant estimates.
–    Accounting evaluation of significant transactions.
–    Physical verification of inventory.
–    Impairment assessment of various financial assets i.e., trade receivables, Inter-corporate loans, investments, etc.
–    External confirmations from banks, financial institutions, vendors, customers, etc., for balances outstanding.
–    Identification of related party relationship.
–    Subsequent event assessment.
–    Documentation with respect to internal control with reference to financial statements i.e., process notes, risk control metrics and selection and testing of controls.
–    Analysis and conclusion of contingent liabilities.

Further with reference to the assembly and retention of audit file some of the below observations were highlighted:

–    Audit evidences collected / obtained were kept on record without linking it to any audit program or account balance;

–    Documents provided by the client and the documents generated / prepared by the audit team, were not adequately segregated and filed;

–    Inadequate documentation for discussions of significant matters with management or those charged with governance;

–    Delayed assembly of final audit file after the date of auditor’s report.

–    Addition and modification in audit documentation after the date of auditor’s report, without documenting the reasons for addition / modification.

4. Written representation

As per SA 580, written representations are necessary information that the auditor requires in connection with the audit of the entity’s financial statements. The regulators have highlighted that there are common instances where the auditors have missed to obtain the written representations from management on the matters like the management’s responsibilities for the design, implementation and maintenance of internal control to prevent and detect fraud, completeness of transactions and information provided, related party relationships and transactions with them, appropriateness of assumptions used in significant estimates etc.

It is worthwhile to highlight that it is mandatory for the auditors to obtain written representation from the management duly acknowledging their responsibilities with respect to various aspects of financial statements, also the written representation should be of a date that is close to the date of audit report, the best practice is to take the representation of the same date as of the audit report, and it should be taken on record by the Audit Committee and the Board of Directors, as the case may be, and signed by the personnel authorised by them.

5. Audit conclusion and reporting

The basic presumption of the regulators and reviewers before they start the review is that the audit opinion has been issued obtaining reasonable assurance whether financial statements as a whole are free from material misstatement, whether due to fraud or error; and the opinion complies with the applicable format of audit report and includes all the relevant paragraphs as required by standard on auditing. However, below are the few common observations that the regulators observed during their review:

–    Audit report strictly not in compliance with the format prescribed in SA 700 Forming an opinion and reporting on financial statements. The observations are more particularly towards reporting with respect to auditors’ and management responsibility paragraphs;

–    Absence of statement that there are no key audit matters identified, when there was no reporting on key audit matters, as required by SA 701 Communicating key audit matters;
–    No reporting in respect of the branches not visited and the matters specified under Section 143 (3) of the Companies Act, 2013 under “Report on Other legal and Regulatory requirements” in the Auditor’s Report;
–    Absence of basis of modification paragraph in the auditor’s report, and inadequate documentation to conclude the modified opinion;
–    Inadequate documentation in compliance of the requirements of SA 720 that auditor has read the other information to identify material inconsistencies, if any, with the audited financial statements.

Auditor’s opinion is the final outcome of the audit, and hence it is imperative that the audit documentation must be prepared in such a manner, so that it can clearly support the audit opinion issued by the auditors.

The best practice in terms of ensuring the adequate documentation to support the audit opinion is to fill the various checklists with respect to Standard on Auditing, Accounting Standards, Schedule III, Companies Act compliances, and other regulatory compliances as applicable to the audit. The engagement partner should also encourage audit teams to map all the financial statement captions, that are subject to audit with their respective workpapers, and do tick and tie of numbers to ensure that there are no miss outs. Further, the audit engagement team should also maintain the repository of Guidance notes issued by ICAI and amendments introduced in the Companies Act, so that their compliance can be ensured before the audit opinion is issued.

Source: Report on Audit Quality Review 2020-21


COMPLIANCE OF ACCOUNTING STANDARD

Books of account are the primary records based on which financial statements are prepared by the management and then the audit is performed by the auditors. So, in order to conclude that the financial statements are free from material misstatement, the auditor are required to ensure that all the applicable accounting standards for recording and disclosure of transactions in the financial statements, have been adequately complied by the management.

Preface to the Statement of Accounting Standards states that the mandatory status of an Accounting Standard implies that while discharging their attest functions, it will be the duty of the auditors to examine whether the Accounting Standard is complied with in the presentation of financial statements covered by their audit. In the event of any deviation from the Accounting Standard, it will be their duty to make adequate disclosures in their audit reports so that the users of financial statements may be aware of such deviation.

Regulators considering that the Section 143(3) of the Companies Act, 2013 (‘the Act’) requires the auditors to report on the compliance of Accounting Standards as prescribed under Section 133 of the Act, also reviews the financial statements and audit file, to ensure whether the said reporting has been accurately done by the auditors based on the audit procedures performed.

Highlighted below are some more frequently observed non-compliances, with respect to accounting standards that have most number of observations, and also a graph depicting the observations across all the accounting standards:

Source: Report on Audit Quality Review 2020-21

Ind AS 107 – Financial Instruments: Disclosures

–    Nature of financial assets and liabilities based on their method of measurement are not adequately disclosed i.e., financial assets and liabilities that are measured at amortised cost, measured at fair value through other comprehensive income and measured at fair value through Statement of profit and loss.

–    Not providing information about the significant credit risk concentration in the credit risk disclosures.
–    Not disclosing the sensitivity analysis for managing market risk, interest rate risk or effect on equity for managing foreign currency risk


Ind AS 7 – Statement of Cash Flows

–    Profit after tax is considered for the preparation of cash flow statement under indirect method.

–    Separate disclosure of cash inflow/outflow of funds from fixed deposits (other than cash and cash equivalents) has not been made.
–    Proceeds from sale of investments are disclosed as payment for purchase of investments under cash flows from investing activities.
–    Unrealised gains and losses arising from changes in foreign currency exchange rates on cash and cash equivalents held in foreign currency, has not been disclosed separately.
–    Non-cash adjustments under financing activities were disclosed as repayment of long-term borrowings and infusion of short-term borrowings.
–    Components of cash and cash equivalents have not been disclosed.
–    Cash flow from loans and advances disclosed as cash flow from investing activities.


Ind AS 19 – Employee Benefits

–    Provision for gratuity not measured and recognised as per the valuation method prescribed under Ind AS 19.

–    Actuarial gains / losses on the defined benefits plans are not recognised in other comprehensive income.
–    Expected contributions to the defined benefit plans for the next annual reporting period to provide an indication of the possible effects on the entity’s future cash flows, has not been made.
–    Inadequate disclosures with respect to sensitivity analysis of assumptions and description of any asset-liability matching strategies used by the plan.


Ind AS 24 – Related Party Disclosures

–    Relationship between parent and its subsidiary, associates, joint ventures and other related entities have not been fully disclosed.

–    Transactions and balance outstanding with all the related parties have not been fully disclosed.
–    Terms and conditions of loans received from related parties, have not been disclosed.
–    Disclosure of corporate guarantee and commitments given to related parties have not been disclosed.


Ind AS 37 – Provisions, Contingent Liabilities and Contingent Assets

–    Not disclosing the indication of uncertainties relating to the amount or timing of any outflow and the possibility of any reimbursement w.r.t contingent liabilities in the financial statements. Further, if the above disclosure was not possible, the fact is not disclosed that it is not practicable to disclose the information as above.
–    Accounting policy for contingent assets not in line with the requirements of Ind AS 37.

It is always advisable that the audit team must fill and document the accounting standard checklist as part of their documentation to ensure that the guidance of the applicable accounting standards with respect to recognition, measurement and disclosures have been duly complied with. Workpaper references of the detailed accounting evaluation of complex transactions should also be documented in the relevant sections of the checklist for ready references. Any such checklist must also be thoroughly reviewed both by the senior audit team members and the engagement partners before audit opinion is drawn.

The disclosure checklist as published by ICAI ‘Indian Accounting Standards (Ind AS): Disclosure Checklist (Revised February 2020)’, and ‘Accounting Standards (AS): Disclosure Checklist (Revised February 2020)’, can also be referred and used to achieve the above objective.

COMPLIANCE OF SCHEDULE III
The Companies Act, 2013 has prescribed the format for Balance Sheet and Statement of profit and loss under Schedule III, which is mandatory to be complied by all corporates in India. Auditors as part of their audit are required to ensure that general purpose financial statements as presented by the management must comply with the disclosure requirements of Schedule III, and material deviation if any, are reported in the auditor’s report.

Highlighted below are few non-compliances, with respect to the presentation of financial statements, as compared to the requirement of Schedule III, in their review report issued by the regulators:

Balance Sheet – Assets

–    Incorrect classification of advances given to vendors.

–    Investment in partnership firm was incorrectly shown as investment in equity instrument. Further, names of partners, total capital of firm and shares of each partner for investments in capital of partnership firms, not disclosed in the financial statements.
–    Disclosure regarding ‘bank balances other than cash and cash equivalents’ included deposits with ‘remaining maturity’ of more than three months but less than 12 months instead of ‘original maturity’ of more than three months but less than 12 months.
–    Current tax assets were not shown as a separate line item on the face of the balance sheet.
–    Nature of items shown as “others” was not specified for current financial assets and other current assets in the notes to the financial statements.
–    Investments not further classified based on their relationship with the investee i.e., subsidiary, associate and joint venture.


Balance Sheet – Liabilities

–    Working capital loan obtained from banks was not classified as loans repayable on demand from Banks under “Current Borrowings” in the balance sheet.

–    Terms of repayment and rate of interest not adequately disclosed for each of the borrowings.
–    Overdraft bank balance was not disclosed under Borrowings, instead it was deducted from balance with banks.
–    Provision for taxation disclosed as long-term provisions.
–    Capital creditors incorrectly disclosed as trade payables.
–    Total outstanding dues to micro enterprises and small enterprises, not disclosed on the face of the balance sheet.
–    Rights of the shareholders in the event of liquidation not disclosed.


Statement of profit and loss

–    Interest income from related parties was not disclosed separately, instead it is clubbed under miscellaneous income.

–    Profit on sale of scrap was wrongly shown as gain on sale of fixed assets in the Statement of profit and loss.
–    Disclosure for changes in inventories of finished goods, work-in-progress, and stock in trade was not disclosed in the manner as required in Schedule III.
–    Expenditure on corporate social responsibility, disclosed as ‘appropriation’ in the Reserves and Surplus, instead of being charged to the Statement of profit and loss as a separate line item with additional information by way of notes to financial statements.
–    Disclosure for payment made to auditors was not made in the manner as specified under Schedule III, and payment made to cost auditor included in the disclosure for payment to auditors.
–    Earnings per share not disclosed in the Statement of profit and loss.

It was also highlighted that rounding off requirements for the figures appearing in the financial statements to the nearest, lakhs, millions or crores, or decimals thereof, has not been complied with as per the requirements of Schedule III.

Further, Registrar of Companies (ROC), are also performing reviews of financial statements to ensure the compliance of the Act, and issuing notices to the auditors and companies for the non-compliances they are observing related to accounting standard, Schedule III and other requirements of the Act.

Financial statements as prepared by the management and audit opinion formed by the auditors are the two primary documents that are considered as the final outcome of the audit, and on which reliance will be placed by the various users of the financial statements. Hence, it is of utmost importance that due care must be taken to ensure that these documents are free from errors.

It is advisable that apart from filling of required checklists audit firms should also establish and follow the practice of independent reading of financial statements and audit reports, before they are attested and released, by the experienced audit partners or members of the firm, as part of their quality control practice, so as to avoid any apparent non-compliance or errors, that might have been missed by the audit team.

TO SUMMARISE
Auditors are playing a crucial role in achieving the objective of a robust financial reporting environment, and hence it is imperative that their quality of services should not be compromised and their independence should not be questioned by regulators and investors. To achieve this, the audit firms must follow a robust mechanism to ensure that they are continuously and consistently performing their duties, by complying with all the applicable rules and regulations, under all circumstances, and their independence is not getting impaired at any point of time.

The GOI has also acknowledged the efforts and contributions of auditors from to time, and have supported them in tightening the loose ends by appointing regulators that can review and highlight the weak points.

It has been rightly said that excellence can only be achieved by focusing on shortcomings and putting continuous efforts for improvement by producing better results, the saying equally applies to the auditing profession, with the advantage that independent regulators have been appointed to identify and highlight the shortcomings in audit, so that auditors can strive harder to improve their audit quality and issue audit opinions that are fully compliant with applicable laws and regulations.

VULNERABILITY ASSESSMENT : A TOOL FOR INTERNAL AUDIT

Internal auditing in the IT environment has been evolving rapidly, and modern auditors are updating their skills and tools to add value to their auditing function. It is no surprise that with more and more technological leaps in data processing, auditors have to keep abreast with technological advances. It is heartening to note that they are also not lagging in harnessing technology. Kudos to the internet revolution, pandemic situation and more complex frauds in the Fintech world.

New-age internal auditing is shifting its focus from transactional auditing to addressing risks of business processes. The audit scope has expanded and includes governance and executive management as well. More and more dimensions to their skills and challenges are waiting to be adopted. The auditor need not be a techie to unravel the mystery of technical frauds; he might as well depend upon the technical expertise within the organization or engage professionals with the required technical competency. What could be more satisfying than acquiring a little more technical knowledge and applying the same in auditing?

Auditing Standard SA 315 and International Auditing Standard ISA 315 (revised 2019) require the auditor to identify and assess the risk of material misstatement through an understanding of the entity and its environment.

Appendix 5 of ISA 315 contains illustrations about Understanding the Entity’s Use of Information Technology in the Components of the Entity’s System of Internal Control, which include understanding the complexity of IT applications and system security in general.

Appendix 6 of ISA 315 contains the areas to be covered under IT General Controls to identify and assess the risk of material misstatement to the auditee entity.

Hence, it has become necessary to identify and assess the risks arising out of the IT environment, including web applications, despite the complex nature of the applications and e-commerce transactions.

IT infrastructure consisting of hardware, physical servers, network components like routers, switches, firewalls, communication links, wireless access, cables and software such as operating systems, applications, virtual machines and databases are critical IT assets to any enterprise. This infrastructure’s resilience is entirely dependent upon how well it is managed and configured. Not only the management of the infrastructure, but the ability to monitor its security from external and internal threats has assumed paramount importance.

As the risk universe is becoming larger with advances in technology, not only the individual users but business enterprises, small or large, are becoming targets of cyber-attack.

The following case study would help to understand why such importance is to be given to vulnerability assessment:

Case Study: ABC Ltd. has a business model of providing a web application portal for online shopping for consumable products, garments and accessories for its customers. There is no retail outlet/showroom of the company, but it has multiple godowns/stores from where the goods are picked up and delivered to the customer’s doors as per online orders. The website provides payment gateway services through UPI, debit/ credit card payment facilities.

The internal auditor has conducted the audit for the internal control over financial reporting and also for its business processes for the last quarter and identified no significant deficiencies except for the reconciliation gaps in the suppliers’ accounts and internal control weakness in the goods receiving, returning and GST reporting.

On review of the internal audit reports by the audit committee, it was felt that despite an in- depth internal audit of the business processes and financial reporting, the following instances were not adequately addressed by the internal audit.

Customer complaints are increasing, which include slow response to the web application, duplicate deliveries, incorrect deliveries and Denial of Service due to frequent operational glitches of the system. Management has also received email alerts from Government Emergency Response Team that it has observed attempts to attack the company’s website portal from certain external IP addresses and has been advised to take appropriate measures.

The senior management discussed the matters with the internal audit team. The internal auditors, with the help of cyber security professionals, found the root cause was the lack of system monitoring and its operations and the absence of vulnerability assessment of the website and application. As a corrective action plan, the vulnerability assessment was carried out on the IT infrastructure and web portal, which unravelled the following weaknesses:

  • Operating system was not updated for the latest security patches.
  • Traffic to and from customer users was not secured due to outdated encryption protocol.
  • No preventive measures were taken on the website source code to conceal internal database confidential information.
  • Unprotected internal servers and weak firewall settings and their position have made the system vulnerable to external cyber-attack.

With the help of cyber security professionals and the internal audit team, all the high-risk vulnerabilities were fixed, and continuous monitoring of the web traffic was initiated. Consequently, the performance and website response improved, customer complaints reduced and reasonable information security was assured.

As an internal auditor, one always thinks of overseeing the implementation of the IT General Controls. There are a whole lot of areas, from access controls to business continuity plans which are reviewed and tested for operating effectiveness. However, that is not enough. The auditor may not discover operating system level weaknesses, or the lack of adequate controls embedded in the configuration of the servers and networking components. Similarly, the application installed to enable business processes may have weaknesses that would invite an external attack on the data supported by the application. The best way to identify serious and general weaknesses in the IT infrastructure and application is the Vulnerability Assessment.

Vulnerability Assessment is a method of identifying vulnerabilities or weaknesses in the installed IT infrastructure of an entity. The vulnerabilities are the gaps against a benchmark of parameters or globally accepted controls in the installation of devices. There are various methods by which vulnerability assessment is performed. A wide range of tools is available to identify vulnerabilities. At times, technically skilled professionals also conduct manual code reviews.

The following diagram will help to understand the process of vulnerability assessment and remediation.

 

 

For a better understanding, one can broadly divide the vulnerability assessment based on configuration related vulnerabilities or structural vulnerabilities and Software Application related vulnerabilities.

STRUCTURAL VULNERABILITIES

Vulnerabilities, where the weakness exists in the installation of hardware or network, are easy to identify, such as network is incorrectly designed, lack of security at entry level components like firewall, or configuration without considering the risk of data disclosure. Some of these are explained in the following paras for better understanding:

No Network Segregation
While designing a network, it is expected that all the machines used for specific functions should be segregated logically from other machines in the network. For example, machines (nodes) used for investment or treasury functions should be segregated from machines used for handling customer transactions. Similarly, super user functions like administration of database or user management should be segregated from end-user application machines. If this is not done, the risk of unauthorized intrusion into the network like ‘data entry level’ user being able to access the super user administrator machine and his privilege for malicious purpose cannot be ruled out.

Number of unnecessary Open Ports
In a network, a port refers to a logical door, necessary and forming part of a network device which has dedicated services attached to it. For instance, browsing service through the internet is made available by port 80 or 443; both have different protocols (method of using). For file transfer to a shared folder, port no. 20 is used. 23 is used for remote access protocol called Telnet and so on. A detailed list is available on any search engine.

If an entity computer is not used for remote access, a particular port that has enabled the remote access service through the open port needs to be disabled/closed.

Ports are an integral part of the internet communication model. All communication over the internet is exchanged via these logical ports. The internal auditor, therefore, needs to see that the network setup does not have unnecessary ports open. He needs to obtain a list of services required for the routine functioning of the network and should recommend the closure/disable of the unnecessary open ports. It is important to note that cyber criminals exploit unused ports for malicious use of the network.

Firewall misconfiguration
A firewall is a critical component which regulates the traffic between the internal network and the external world. It acts like a bastion for unauthorized entry into the internal network and, at times, prevents information from leaking to unauthorized destinations (URL). Firewalls are getting smarter and smarter these days with more flexibility in rules settings and can detect rogue users and perpetrators of DOS (denial of service) attacks.

A misconfigured firewall will be known through a vulnerability assessment, which helps greatly in fixing the intrusion detection issues.

Absence of DMZ or inappropriate network structure
In case web-based applications are accessed by customers, like in banking or online security trading, it is always advisable to create a subnet called a Demilitarized zone network to protect the internal network and critical servers and data from the external public internet. The risk of external attack is mitigated by providing an extra layer of security.

Remote access vulnerability
As in the work from home environment, access to the servers which store confidential data is made possible through an application or by entering an IP address from public internet from an unsecured endpoint. Due to frequent cyber-attacks on the communication lines, it is advisable to access the remote server by applying VPN (Virtual Private Network) for a secured link or applying high standard encryption to the communication messages. Remote access to a server by installing VPN helps not only to secure the endpoint, but provides traffic to be encrypted, which then cannot be sniffed by malicious intruders.

Uncontrolled direct access to the System
This occurs when a user is not verified through authentication like user ID and password. Further, when there is no layer of security of access levels, the user can simply enter the system by providing user ID and password, and can go beyond his role or privilege in accessing any unauthorized applications, data and root level file structures. A vulnerability assessment would indicate this weakness by reporting absence of Active Directory installation.

An Active Directory is a software tool installed in an enterprise network to control the users and their access area. It helps to organize users and provide a single sign-on access to the specified computing resources within the organization. Hence any user wanting to access any application or files first need to be present as an authorized user in the Active Directory.

SOFTWARE APPLICATION VULNERABILITIES
These vulnerabilities either arise out of disregarding security and confidentiality in input or processing of data activities. The weaknesses are inherent and cannot be revealed without a thorough application assessment. The vulnerability may arise out of web-based or independent, stand-alone applications. There are thousands of vulnerabilities that can be identified of which all are not critical. These can be graded based on impact on the security of a data or system. High damaging impact due to the existence of vulnerability is rated Critical, which needs to be addressed on priority. Other vulnerabilities can be high, medium or low-risk level vulnerabilities. Some vulnerabilities are ‘Information Type’ and may not harm the users of the application. Following are the most frequent high and critical risk level vulnerabilities often found in business applications and the network.

Weak Authentication Mechanism
In the case of application, the first level of access is user authentication by entering user identity, password and nowadays, additional authentication like OTP on mobile.

Vulnerability of weak authentication indicates that the user ID and password for access are easy to crack, or the password length and complexity are not strong enough to provide difficulty in cracking the password through Brute Force technique.

Network device with default password
Network devices like a router, firewalls or other components has been installed without taking care of changing the default password provided by the manufacturer/vendor.

As a result, hackers with knowledge of default passwords can access the network and cause data theft or data manipulation.

Remote access and code execution vulnerability
The remote code execution (RCE) vulnerability allows attackers to execute malicious code on a computer remotely. The impact of an RCE vulnerability can range from malware execution to an attacker gaining complete control over a compromised machine.

Application is vulnerable for directory traversal
Directory traversal (also known as file path traversal) is a web security vulnerability that allows an attacker to read arbitrary files on the server that is running an application. This might include application code and data, credentials for back-end systems, and sensitive operating system files. In some cases, an attacker might be able to write to arbitrary files on the server, allowing them to modify application data or behaviour and ultimately take complete control of the server.

Web Page can be defaced by unauthorized remote intruders
Website defacement happens when hackers access a website and leave pictures or messages across the site, thus defacing it. Simply put, hacktivists replace the content on your site with the content of their choice.

Some preventive measures are the Principle of Lease Privilege – allowing access to only limited on role-based access; reducing use of add-ons and plugins, which increase website vulnerabilities; and limiting error messages on the site, which often provide detailed information about file information which hackers can exploit.

Privilege right of access can be escalated through an ordinary user
In a network where, by applying certain techniques, one gains access to the user credentials, the attacker will use the user ID to gain administrative access rights and use it to enter another application or manipulate security settings to serve his malicious purpose. This can be identified with suspicious login attempts and unusual malware on sensitive systems. This would need an urgent incident notification to limit the damage to the application and data.

Certain Services e.g., MS SQL (MS structured query language) is running with default userid and password
Default user ID or passwords are given by the vendor at first time installation of an application/ device. It is expected that the default user ID and password be changed to prevent access to others. If not done, the default passwords are used by attackers to gain access since these are widely known. For instance, your Wi-Fi router normally has admin-admin user ID and password. This vulnerability arises out of ignorance or negligence in setting up the application. When a service like SQL is running with a default password, you are inviting an attack on the database.
 
Application stores sensitive information in clear text format
When read and write access for an application is not restricted during the development stage, an attacker can access sensitive information stored and use the same for further damage to the data and may modify the data, cause incorrect results and possible denial of service attack, local file/data inclusion vulnerability.

Vulnerability related to readability of data files with remote execution command
Several web application components are needed to run a web application. In a basic environment, there should be at least a web server software (such as Apache or IIS), web server operating system (such as Windows, Linux, MacOS), database server (such as MySQL, MSSQL or PostgreSQL) and a network-based service, such as FTP or SFTP. All the components need to be protected with restricted access or masking. In the absence of restricted complex access, for a secure web server, all of these components also need to be protected to ensure that sensitive data is secured during remote access.

Secured service like HTTPS or SSL not implemented
SSL or secured socket layer technology keeps internet connection secured and protects the data transferred between two systems. So too HTTPS, indicating that the protocol protects the integrity and confidentiality of data between the user’s computer and the website. Hence, it is now common to implement these secured protocols. The vulnerability to not having these installed poses a high risk during the transmission of data to and from the web application server.

Unrestricted File Upload Vulnerability
Where a web application does not verify the contents of the file being uploaded and does not reject invalid files, this provides an opportunity to attackers to upload malicious files, which could, in extreme cases, result in taking over the target system. Therefore, validation of what is being uploaded through the web application is absolutely important.

SQL and other Injection Vulnerability
In most business applications, SQL databases are used to store data and employ SQL commands to execute database updates. An SQL injection attack may result in serious data damage. Attackers begin with identifying vulnerable user inputs in a web application using a SQL database such as SQL Server, MySQL, and Oracle, among others, because applications with SQL injection vulnerability leverage such user input to execute malicious SQL statements. Next, the attackers create and send malicious content to the SQL server to execute malicious SQL commands and hamper the database. Businesses may witness detrimental impacts of a successful SQL injection as attackers use such attacks to gain control over sensitive database tables, and user identities, and manipulate financial data through this vulnerability.

Cross Site Scripting Vulnerability
When a user interacts with a vulnerable website, he is returned with malicious code, which then takes the victim to another malicious site. Thus, vital details of the victim user are then captured and monitored. Cross-site scripting vulnerabilities normally allow an attacker to masquerade as a victim user, carry out any actions that the user can perform, and access any of the user’s data. If the victim user has privileged access within the application, then the attacker might be able to gain full control over all the application’s functionality and data.

Web Cache Poisoning
A cache is temporary memory storage used for a website’s smooth operation. Cache poisoning is a type of cyber-attack in which attackers insert fake information into a domain name system (DNS) cache or web cache to harm users. In DNS cache poisoning or DNS spoofing, an attacker diverts traffic from a legitimate server to a malicious/dangerous server.

Vulnerability of URL being redirected (phishing attack)

When the user of a website is automatically redirected to another malicious website and is misguided to believe that the malicious website is a genuine website and is often asked to provide personal details like card number, bank account and UIDAI ID. Unfortunately, unless the user is aware of such masquerading, often the users are victims of financial loss and fraudulent transactions.

CONCLUSION

As more and more commercial transactions are conducted over the public internet, e-commerce and through apps, it has become all the easier for fraudsters to take the help of hacking tools and perpetrate frauds on innocent users/enterprises. Nowadays, the tools to hack IT servers, websites and web apps with guidelines and instructions are easily available on the dark net with minimal investment. The company’s employees and users who are unaware of the possible vulnerabilities may fall victim by clicking on unknown links or ignoring the system’s alert messages. It is therefore incumbent upon the internal audit team to perform a risk assessment of the IT environment by frequently conducting vulnerability assessments of the IT infrastructure and applications. It would certainly give the audit committee, and stakeholders improved assurance. The management would be made further aware of the red flags that compromise data integrity, processes, customer relations and company reputation.

INTERPLAY OF SCHEDULE III AND CARO – KEY IMPLEMENTATION CHALLENGES FOR PREPARERS OF FINANCIAL STATEMENTS AND AUDITORS

INTRODUCTION
Schedule III, which prescribes disclosures and formats of financial statements of every Company in India, was revised by notification dated 24th March, 2021 of the MCA. These amendments are effective from 1st April, 2021 i.e., for all financial statements for periods beginning on or after 1st April, 2021.
The companies following calendar year i.e., January to December
therefore will have to comply for periods commencing from 1st January,
2022. Since financial reporting is a critical communication mode between
the preparers and users of financial statements (FS), many of the
changes like disclosures about relationships with struck-off companies,
ratios, promoters’ shareholding, capital work-in-progress, intangible
assets under development, ageing analysis, undisclosed income, etc. have
far-reaching implications for prepares and statutory auditors.
Both will have to put extensive efforts in the preparation of the FS in
terms of understanding what is needed, gathering information, and
ensuring its accuracy and completeness as well as internal consistency.
Over the years, globally, the trend has been to make information that
the preparer has available to the user. Therefore, Schedule III, too
has, kept up with the pace in prescribing disclosures in granular
details that was earlier not available to investors. Not only that, but
the preparers are mandated to include similar additional information for comparative periods which adds to the challenge for companies and their auditors in this first year of implementation.

Well, that is not it. Companies (Auditor’s Report) 2020, i.e. CARO 2020 that was deferred twice, is also applicable for audits of FS commencing on or after 1st April, 2021
and; it is beyond compliance now due to various additional reporting
requirements. The good news is that CARO 2020 is aligned with the
several new clauses of Schedule III1. The intent is clear: the preparers
should make the disclosures in the FS before the auditor reports.

____________________________________________________
1 Reference may be to ICAI Announcement on Guidance Note on the Companies
(Auditor’s Report) Order, 2020 dated April 2, 2022.
Schedule
III also now mandate reporting on outbound or inbound loans, advances,
and investments that are intended to be routed via an intermediary
entity pursuant to reporting by auditors thereon under the main report
heading of ‘Report on other legal and regulatory requirements’. This
reporting will unmask the identity, amount and relationship with the ultimate beneficiary receiving those funds.
Considering the extensive changes in Schedule III and CARO 2020, the
year ending March 2022 is a big reporting change for both the prepares
as well as the auditors. Since an auditor is required to issue a true
and fair view on the FS, the additional disclosures as prescribed in
Schedule III will form part of FS and hence will be covered by the
auditor’s report and therefore will require further efforts. Schedule
III also requires the management to provide a declaration that relevant
provisions of the Foreign Exchange Management Act, 1999 and Companies
Act have been complied with for such transactions and the transactions
are not violative of the Prevention of Money-Laundering Act, 2002. The
auditor is made to inquire and report specifically on these aspects. ICAI
has issued a detailed implementation guide on Auditor’s Report under
Rule 11(d) of Companies (Audit and Auditors) Amendment Rules, 2017 and
Amendment to Schedule III to Companies Act, 2013.

The
objective of this article is to explain key changes introduced in
Schedule III and provide some plausible options to deal with the
challenges
in respect of new disclosure requirements of Schedule III along with reporting under CARO 2020.

ICAI has released a Guidance Note on Schedule III for both Division I and Division II (January 2022 edition) and a Guidance Note on CARO 2020,
which addresses some of the implementation questions. Additionally, the
exposure Draft on GN on CARO 2020 is already in the public domain and
is likely to be released shortly as the date of giving comments ends in
June 2022.

1. Relationship with Struck off Companies
This
disclosure requires the company to provide details of the balance
outstanding in respect of any transactions with companies struck off
under Section 248 of the Companies Act, 2013 or Section 560 of the
Companies Act, 1956. This disclosure is not limited to the purchase or
sale of goods or services but covers ‘any transactions’ including
disclosure regarding investment in securities of struck-off companies
and disclosure regarding shares of the company being held by struck-off
companies.

The data of companies struck-off is published by each Registrar of Companies (ROC) separately in PDF in Form No STK-7. Considering that there are about 25 ROCs
in major states in India, compiling this data can be a time-consuming
exercise. Also, Form STK-7 contains only the name of the company and the
Company Identification Number (CIN). Imagine the problem of identifying
companies from these lists when both vendor/customer lists run long and when duplicity of names is a known challenge.

On
top of this, the auditor has to report whether the company has
considered the latest list of struck off companies while identifying the
struck-off companies of all relevant locations. It might be possible
that the date on which the list of struck of companies has been compiled in Form STK – 7 do not coincide with the balance sheet date. Accordingly,
the identification of struck-off companies and its consequent
disclosure would be affected due to lack of updated information. In such
cases, the auditor should assess the processes established by the
Company to confirm that the disclosure is not materially misstated. One may argue as to whether such information justifies benefits vis-a-vis efforts by the company as well as the auditor. Such information may not affect true and fair view of the FS. The intent of this amendment is not clear and with such changes, FS may be used as a source of identifying non-compliances.

Companies
whose names were struck-off during the financial year, but an order had
been passed by any adjudicating authority (for e.g., NCLT) restoring
the company’s name before approval of the FS may not be considered as
struck-off companies.

It would be beneficial and useful for corporates if
MCA publishes a consolidated STK-7 report as of every month end, which
should be updated at specific intervals and provided in a MS Excel
format to enable companies to use this data as the base for their
disclosures.
Also, it would be beneficial if MCA can provide the PAN
no. in Form STK-7 along with CIN no. since many companies maintain
details of PAN no. of vendors and customers but not necessarily the CIN
no. This will definitely add to the stated policy of ease of doing
business.

There is no separate reporting under CARO 2020 on the above.

2. Computation of Ratios
Ratio
analysis plays an important role in assessing the financial health of a
company. The comparison of performance indicators in one company with
those of another can provide significant insight into the company’s
performance.

Schedule III disclosure now requires every company
(to which Division I, Division II and Division III of Schedule III
apply) to provide 11 analytical ratios with the details of what
constitutes the numerator and denominator. Further, the company shall
give a commentary explaining any change (whether positive or negative)
in the ratio by more than 25% as compared to the ratio of the preceding
year. While the Guidance Note provides no guidance on such
explanation, some examples (basis FS available in public domain) include
variation in current ratio is primarily due to temporary increase in
current borrowings and trade payables, variations in coverage, turnover
and other profitability ratios are primarily due to increase in turnover
and profitability etc.

SEBI Listing and Disclosure
Requirements (Amendment) Regulation, 2018 required disclosure of key
financial ratios in Management Discussion and Analysis (MD&A) in
Management Discussion & Analysis (MD&A). Also, an important
point to note is that SEBI also has prescribed in SEBI LODR (Amendment) Regulations, key financial ratios to be disclosed in the quarterly results of debt listed entities. However, the
list of ratios in Schedule III and SEBI requirement is not completely
aligned, though some of the ratios are common e.g., current ratio,
debt-equity ratio, debt service coverage ratio, inventory turnover and
debtors turnover.
One would have hoped that the two amendments would have been coherent and avoided DUPLICATION.

There
is a lack of clarity on various terms used in the Guidance Note on
Revised Schedule III e.g., Return on Capital Employed [Capital Employed =
Tangible Net Worth + Total Debt + Deferred Tax Liability]. The term ‘Tangible Net Worth’ has not been defined and different practices may be followed by companies. Further the guidance note prescribes a complex formula for computation of Return on Investment based on Time Weighted Rate of Return.
A simpler formula could have not only made sense to thousands of
preparers but also resulted in a more meaningful and uniform
calculation. However, since Schedule III requires an explanation of the
items included in the numerator and denominator for computing these
ratios, companies may adopt a simpler formula for computation and
explain this in the FS. However, this may lead to divergent practices
and the entire objective of providing consistent and comparable
information to investors will not be met.

The disclosures
required by NBFCs are completely different i.e., Capital to
risk-weighted assets ratio (CRAR), Tier I CRAR, Tier II CRAR and
liquidity coverage ratio.

CARO 2020 requires the auditor to
consider these prescribed ratios and assess whether any material
uncertainty exists in the repayment of liabilities.
This assessment is limited to material
uncertainty in repayment of liabilities and is different from the
assessment of material uncertainty on-going concern as envisaged under
SA 570.

To determine the items to be included in the
numerator and in the denominator for any ratio, reference may be drawn
from several sources for e.g., ratio’s usage in common parlance,
investor reports, industry reports, market research reports, approach of
credit rating agencies, etc. As per the ICAI Guidance note on Schedule
III, there may be a need to factor in company-specific and sector-specific nuances
that may require necessary modifications to the reference considered.
In other words, items included in numerator and denominator of any ratio
may not be standardized across companies as the calculation methodology
would be based on facts and circumstances of each company, nature of
transactions, nature of industry/sector in which the company operations
or the applicable regulatory requirements that a company needs to comply
with.

Lease liabilities–computation of ratios

There
was no specific guidance earlier on the classification of lease
liabilities. Reference was drawn by the companies from the disclosure
requirements of finance lease obligation in the guidance note on Ind AS
Schedule III. The current maturities of lease liabilities were disclosed
under other financial liabilities (similar to current maturities of
finance lease obligation) and for long-term maturities of lease
liabilities, it was allowed to classify the same either under long-term
borrowings or under other non-current financial liabilities. The amendment
made in Schedule III clarifies that long-term maturities and current
maturities of lease obligations needs to be classified under non-current
and current financial liabilities respectively.

With this specific clarification,
the earlier debate on whether lease liabilities were to be classified
under borrowings or under other financial liabilities is settled.
It
will lead to consistency in presentation requirement of all companies
and ensure smooth benchmarking in industry. ICAI Guidance Note provides
that debt-to-equity ratio compares a Company’s total debt to
shareholders equity and provides the following method of computation:

Debt-Equity Ratio = Total Debt/Shareholder’s Equity

Considering
the fact that now financial ratios are required to be disclosed in the
FS, a question may arise as to whether lease liability will be factored
in debt equity ratio or not.
Some of the FS issued in public domain
include lease liability in computation of debt equity ratio and formula
has been given for such computation. Further, in case of debt service
coverage ratio, the Guidance Note specifically includes interest and
lease payments in debt service.

3. Reclassification – Presentation of comparative period numbers
As per Note 7 to General Instructions for Preparation of Balance Sheet, when
a company applies an accounting policy retrospectively or makes a
restatement of items in the financial statements or when it reclassifies
items in its financial statements, the company shall attach to the
Balance Sheet, a Balance Sheet as at the beginning of the earliest
comparative period presented. Also, paragraph 41 of Ind AS 1
require an entity to reclassify comparative amounts, unless
impracticable, if an entity changes the presentation or classification
of items in its financial statements of the current reporting period.

The amendments may require the companies to either changing the presentation or classification of certain items in the FS. Such
changes result in providing additional information to the users of the
FS and are required to be made by Companies in order to comply with the
statutory requirements of Ind AS Schedule III.
ICAI Guidance note on
Schedule III clarifies that the Company may not present a third balance
sheet as at the beginning of the preceding period when preparing FS in
line with the amended requirements of Ind AS Schedule III. However,
comparative information may be required to be reclassified by all
companies since revised Schedule III will lead to change in presentation
or classification of items in the FS of the current reporting period. Detailed disclosures should be given in the FS for such reclassification.

4. Borrowings obtained on the basis of security of current assets and reporting on Working capital limits
Schedule III requires where the company has borrowings from banks or
financial institutions on the basis of security of current assets, it
shall disclose whether quarterly returns or statements of current assets
filed by the company with banks or financial institutions are in
agreement with the books of account; and in case of any differences, the
company is required to provide summary of reconciliation and disclose
reasons of such material discrepancies. CARO 2020 reporting would be required only in case where working capital limits are sanctioned in excess of INR 5 crores and obtained on the basis of current assets security. However, no
such limit criteria is mentioned in requirements of Schedule III
amendment. Schedule III requires to provide the disclosure in case of
all types of borrowing which are obtained basis current assets security.
However, CARO reporting is only required in case of sanctioned working capital.

Instances
of differences may be relating to difference in value of stock, amount
of debtors, ageing analysis of debtors, etc. between the books of
account and the returns/statements submitted to banks/financial
institutions.

The auditor is required to comment on discrepancies.
The issue may arise wherein in case the returns/statements after having
been furnished with the banks are revised and such revised
statements/returns have been submitted to the bank, then whether the
comparison should be made with respect to such revised
returns/statements. In all such cases, it may be factually reported that
the return has been subsequently revised, and it is important for the
auditor to obtain copy of the revised return duly acknowledged by bank.
However, since the reporting is based on the quarterly returns or
statements filed by the company, auditor is required to report on
discrepancies even if the differences/discrepancies are reconciled at
the year-end. The auditor needs to exercise his/her professional
judgment to determine the materiality and the relevance of the discrepancy to the users of FS while reporting under this clause.

In
order to verify that the copy of returns/statements provided by
management is the same as the one submitted to the bank, the auditor
should request for a copy duly acknowledged by the lender.

5. Trade Receivables and Trade Payables
Schedule
III now requires ageing of trade receivables and trade payables from
due date to be included in the FS in the prescribed format. Further,
trade receivables and trade payables need to be further bifurcated into disputed and undisputed balances. Where disputed/ undisputed dues have not been defined under Schedule III and it may be challenging to identify the disputed dues
when the company is having a running account with parties with long
list of reconciliation items. The Guidance Note provides a
principle-based definition i.e. a dispute is a matter of facts and
circumstances of the case; however, dispute means disagreement between
two parties demonstrated by some positive evidence which supports or
corroborates the fact of disagreement.

This disclosure is
required only in respect of Trade Receivables and Trade Payables. Items
which do not fall under Trade Receivables / Trade Payables are not
required to be disclosed. For expel certain companies like
construction/project companies, have contract assets (unbilled revenue).
This disclosure is not required in case of unbilled revenue.

Earlier companies were not mandated to give detailed ageing. Many
companies may not have adequate system of generating ageing data of
trade payable as required now in the amendment including tracking of
trade payables, which are disputed.
Considering detailed ageing data is required to be furnished in the FS, companies should ensure that their ERP
are geared up to furnish such information. Companies must institute
robust internal control and documentation for categorization between
disputed and undisputed dues.

The amendment clarifies that unbilled dues should be disclosed separately.

There is no separate reporting under CARO 2020 on the above.

6. Capital Work-in-progress (CWIP) and intangible assets under development
The
revised Schedule III requires disclosure of the total amount of
CWIP/intangible assets under development in the FS to be split between
two broad categories namely, ‘Projects in progress’ and ‘Projects temporarily suspended’ along with its ageing schedule. The disclosure is not required to be presented at an asset/project level,
however, the total amount presented in this disclosure should tally
with the total amount of CWIP/ intangible assets under development as
presented in the FS.

In respect of assets/projects forming part of CWIP/ intangible assets under development and which have become overdue
compared to their original plans or where cost is exceeded compared to
original plans, disclosure is required to be given for expected
completion timelines in defined ageing brackets
. It is important to
assess at what level the CWIP/intangible assets under development would
be capitalised i.e., whether CWIP/ intangible assets under development
would be capitalised as a whole or whether capitalised on a breakdown
basis. The unit of measure for recognition of property plant and
equipment/intangible asset can also serve as a useful guide.

Disclosures
mandated are very extensive. Companies will need to reconfigure or make
changes in their ERPs to collate the necessary information. The
amendment also needs to provide information separately for overdue
projects or projects which have exceeded costs compared to original
plan.

Companies are required to assess accounting implications on account of delay or suspension or cost overruns relating to capital projects.
Some of the key risks which they need to focus on are appropriateness
of borrowing cost capitalization, impairment of PP&E, capitalization
of abnormal costs.

There is no separate reporting under CARO 2020 on the above.

7. Undisclosed income
The
Company shall give details of any transaction not recorded in the books
of accounts that has been surrendered or disclosed as income during the
year in the tax assessments under the Income Tax Act, 1961 (such as,
search or survey or any other relevant provisions of the Income Tax Act,
1961), unless there is immunity for disclosure under any scheme and
also shall state whether the previously unrecorded income and related
assets have been properly recorded in the books of account during the
year.

CARO 2020 requires specific reporting by the auditor on undisclosed income. The meaning of “undisclosed income” shall be considered based on the Income Tax Act, 1961 or basis judicial decisions
provided on undisclosed income. What constitutes voluntary admission
poses several challenges, especially where the company has pending tax
assessments which have been decided up to a particular stage, and the
company chooses not to file an appeal. In such cases, the auditor needs
to review the submissions and statements filed in the course of
assessment to ascertain whether the additions to income were as a
consequence of certain transactions not recorded in the books.

Where undisclosed income and related assets of the earlier year have been recorded in the FS of the current year, the auditor should assess compliance of Ind AS 8/AS 5 with respect to correction of prior period error. Under Ind AS 8, prior period errors are corrected by restating the comparative information. Restatement of previously issued FS raises doubts on company’s internal controls. The
auditor should consider the Guidance Note on Audit of Internal
Financial Controls Over Financial Reporting while forming the opinion on
internal financial controls.

8. Compliance with approved Scheme(s) of Arrangements
The
disclosure prescribed under Schedule III would be required to be
provided in the FS of all companies involved in a scheme of arrangement
filed under Sections 230 to 237 of the Companies Act, 2013, including
the FS of the transferor company if required to be prepared after the
-approval of a scheme of arrangement.

A scheme of arrangement
sanctioned by the competent authority under prevalent laws will have the
effect of overriding requirements of the Accounting Standards where
differing requirements are present in sanctioned scheme vis-à-vis the
requirement of the relevant Accounting Standards. An issue might
arise for a composite scheme of arrangement e.g. A single scheme of
arrangement deals with the merger under section 230 as well as reduction
of capital under Section 66 of the Companies Act, 2013.
In this
regard the auditor should consider Section 129(5) of the Companies Act,
2013 which requires the company to disclose in its FS, the deviation
from the accounting standards, the reasons for such deviation and the
financial effects, if any, arising out of such deviation and ICAI’s
Announcement on ‘Disclosures in cases where a Court/Tribunal makes an
order sanctioning an accounting treatment which is different from that
prescribed by an Accounting Standard’ also provide disclosures as
introduced in Schedule III to the Companies Act, 2013.

The requirements
stated above require disclosure of any deviations from the accounting
requirements, including deviation arising from scheme of arrangements
approved under sections 230 to 237 of the Companies Act, 2013.

Accordingly, where a single scheme of arrangement deals with the merger
under section 230 as well as reduction of capital under section 66 of
the Companies Act, 2013, deviations if any from the accounting
requirements should be disclosed in the FS.

9. Applicability to Consolidated Financial Statements
The
Guidance note on Schedule III provides the following guidance on the
applicability of Schedule III requirements to consolidated financial
statements (CFS). Schedule III itself states that the provisions of the
Schedule are to be followed mutatis mutandis to a consolidated financial
statement. MCA has also clarified vide General Circular No. 39/2014
dated 14th October, 2014 that Schedule III to the Act with the
applicable Accounting Standards does not envisage that a company, while
preparing its CFS, merely repeats the disclosures made by it under
standalone accounts being consolidated. Accordingly, the company would need to give all disclosures relevant to CFS only. Guidance
note provided detailed guidance on many disclosure requirements to help
users understand what should be furnished in the FS. The Guidance note
also provides some exemptions from disclosures e.g., the company is not
required to disclose analytical ratios in the CFS. However, a debt –
listed company governed by SEBI LODR Regulations, 2015 (as amended) will
be required to make disclosures in the consolidated financial results.
Unlike CARO 2016, only new clause (xxi) in CARO 2020 will apply to the
CFS of the company. Qualification/Adverse remarks in CARO in the
audit report of companies which are consolidated in the CFS will be
required to be reported.

BOTTOM LINE
The amendments
to Schedule III and the introduction of CARO 2020 will add value to the
FS and auditor’s report for stakeholders, regulators, lenders, and
investors. The implementation is a real challenge, and timely
guidance/clarification may result in achieving the real objectives i.e.,
enhanced transparency and timely information. One would have hoped that
smaller entities/non-public interest entities would have been spared
from reporting on several of the above disclosures. A materiality/value
threshold would have also eased the burden on many preparers. A phased
manner of disclosure would also have reduced the burden on the preparers
and clarified issues in the course of time. If Companies resort to
boilerplate disclosures to ensure compliance, the real purpose of
introducing these changes may get lost.

WHAT IS SPECIAL ABOUT SPECIAL PURPOSE FRAMEWORK? WHEN TO APPLY SA 700 VS. SA 800?

The article discusses when auditor issues report under Standard on Auditing (SA) 700 – Forming an Opinion and Reporting on Financial Statements vs. SA 800 – Special Considerations – Audit of Financial Statements Prepared in Accordance with Special Purpose Frameworks.

SPECIAL PURPOSE FINANCIAL STATEMENTS
SA 800 defines special purpose financial statements as financial statements prepared in accordance with a special purpose framework. SA 210 – Agreeing the Terms of Audit Engagements states that a condition for acceptance of an assurance engagement is that the criteria referred to in the definition of an assurance engagement are suitable and available to intended users. Therefore, it is imperative that for auditing special purpose financial statements, intended users is one of the key considerations.

Having said that, the manner of opining on special purpose financial statements is similar to opining on general purpose financial statements. SA 800 requires the auditor to apply the requirements of SA 700 when forming an opinion and reporting on special purpose financial statements. Similarly, title of audit reports for both the types of financial statements remain the same i.e. “Independent Auditor’s Report”.

What are the examples when special purpose financial statements are prepared and when general purpose financial statements are prepared?

General purpose financial statements

Special purpose financial statements

• Financial statements prepared under Ind
AS / Indian GAAP to meet the provisions in sale / purchase agreements.

• Financial statements prepared in
accordance with financial reporting provisions of a contract.

• Financial statements are prepared under
Ind AS / Indian GAAP for the purpose of submission to a lender.

• Financial statements prepared on the
cash receipts and disbursements basis
of accounting for cash flow
information that may be requested by a key supplier.

 

• Financial information prepared for
consolidation purposes to be submitted by a component to its parent entity,
prepared in accordance with instructions issued by group management to the
component.

FAIR PRESENTATION FRAMEWORK VS. COMPLIANCE FRAMEWORK
The financial statements (both general purpose financial statements and special purpose financial statements) can be either under fair presentation framework or compliance framework.

In case of fair presentation framework, as the name goes, fair presentation of financial statements is to be achieved. Therefore, management may provide disclosures beyond those specifically required by the framework and it is acknowledged by the management. It also acknowledges that it may depart from the framework to achieve fair presentation. In such framework, the auditor opinion uses following language:

(a) “In our opinion, the accompanying financial statements present fairly, in all material respects, […] in accordance with [the applicable financial reporting framework]; or

(b) In our opinion, the accompanying financial statements give a true and fair view of […] in accordance with [the applicable financial reporting framework].”

In case of compliance framework, financial statements need to follow the requirements of the framework. Therefore, the management acknowledgements discussed above in fair presentation framework do not exist in compliance framework. In such framework, the auditor opinion uses following language:

“In our opinion, the accompanying financial statements are prepared, in all material respects, in accordance with [the applicable financial reporting framework].”

REPORTING ON FINANCIAL STATEMENTS PREPARED IN ACCORDANCE WITH A GENERAL PURPOSE FRAMEWORK FOR A SPECIAL PURPOSE
In such cases, financial statements prepared for a specific purpose are prepared in accordance with a general purpose framework, such as Ind AS or Indian GAAP, because the intended users have determined that such general purpose financial statements meet their financial information needs.

In contrast, financial information prepared for consolidation purposes to be submitted by a component to its parent entity prepared in accordance with instructions issued by group management to component is not in accordance with general purpose framework. The reason is Ind AS / IFRS / Indian GAAP / US GAAP or similar general purpose framework is not followed for such financial information.

In such scenario, the audit report should be prepared in accordance with SA 700. The auditor may include “Other Matter” paragraph in accordance with SA 706 Emphasis of Matter Paragraphs and Other Matter Paragraphs in the Independent Auditor’s Report. Paragraph A14 of SA 706 discusses restriction on distribution or use of the auditor’s report. It states that when audit report is intended for specific users, the auditor may include “Other Matter” paragraph, stating that the auditor’s report is intended solely for the intended users, and should not be distributed to or used by other parties. Such inclusion of “Other Matter” paragraph in the audit report is not mandatory. The auditor will use his judgment in the circumstances to determine whether distribution or use of his audit report needs restriction or not and accordingly will determine inclusion of such “Other Matter” paragraph in his audit report.

Fair presentation framework vs. Compliance framework
Usually, the audit reports issued in India use general purpose fair presentation framework. However, illustration 5 in SA 700 also provides an example of auditor’s report on financial statements of non-corporate entity prepared in accordance with a general purpose compliance framework.

REPORTING ON FINANCIAL STATEMENTS PREPARED IN ACCORDANCE WITH A SPECIAL PURPOSE FRAMEWORK
In such scenario, the audit report should be prepared in accordance with SA 800. SA 800 requires description of the applicable financial reporting framework. In case of financial statements prepared in accordance with the provisions of a contract in the example above, the auditor shall evaluate whether the financial statements adequately describe any significant interpretations of the contract on which the financial statements are based.

SA 800 also adds to the responsibility of management when it has a choice of financial reporting frameworks in the preparation of financial statements. The new responsibility is management has to determine that the applicable financial reporting framework is acceptable in the given circumstances. Therefore, the paragraph in auditor’s responsibility that describes management’s responsibility shall refer to such additional responsibility also as follows:

“Management is responsible for the preparation of these financial statements in accordance with [basis of accounting], for determining the acceptability of the basis of accounting, and for such internal control as management determines is necessary to enable the preparation of financial statements that are free from material misstatement, whether due to fraud or error.”

There is a risk that the special purpose financial statements may be used for purposes other than those for which they were intended. To mitigate such risk, the auditor is required to include an Emphasis of Matter (EOM) paragraph in the audit report stating that it may not be suitable for other purposes.

In addition to EOM paragraph mentioned above, the auditor may consider it appropriate to indicate that the auditor’s report is intended solely for the specific users. This is not a mandatory requirement although. Usually as part of the engagement acceptance consideration, before accepting the engagement to audit non-statutory financial statements, the auditor will consider the basis on which he may agree for the auditor’s report to be made available to third parties.

If EOM and restriction on use paragraph is to be used, it may be worded as follows:

“Basis of Accounting and Restriction on Distribution and Use

Without modifying our opinion, we draw attention to Note [X] to the financial statements, which describes the basis of accounting. The financial statements are prepared to assist the partners of [name of partnership] in preparing their individual income tax returns. As a result, the financial statements may not be suitable for another purpose. Our report is intended solely for [name of partnership] and its partners and should not be distributed to or used by parties other than [name of partnership] or its partners.”

Fair presentation framework vs. Compliance framework
SA 800 provides illustrations of auditor’s reports on special purpose compliance framework as well as special purpose fair presentation framework.

When financial statements are prepared based on the needs of a regulator, by itself it does not mean that those are special purpose financial statements. The test of whether such financial statements are special purpose financial statements or general purpose financial statements is the framework used to prepare those financial statements. For example, Section 129(1) of the Companies Act, 2013 requires financial statements to comply with accounting standards notified under section 133 and to be in the form prescribed in Schedule III. In such cases, the regulator has prescribed compliance with accounting standards, which is a general purpose framework. Therefore, these are general purpose financial statements. In addition to complying with accounting standards, the regulator requires the format to be in Schedule III, but that does not change the underlying framework itself.

It is not the intended users (public at large or specific identified users) that distinguish general purpose financial statements as against special purpose financial statements. It is the underlying framework used for preparation of financial statements, that decides whether the financial statements are general purpose or special purpose financial statements.

FINANCIAL STATEMENTS IDENTIFIED AS “SPECIAL PURPOSE FINANCIAL STATEMENTS” IN GUIDANCE NOTES
Some of the Guidance Notes issued by The Institute of Chartered Accountants of India identifies financial statements discussed in respective guidance notes as “special purpose financial statements”. As a result, such financial statements may be considered as “special purpose financial statements” even if those may not meet the definition of this term as given in SA 800 and discussed above. For example, the Guidance Note on Combined and Carve-out Financial Statements states that the said Guidance Note should not be construed to be applicable to the general purpose financial statements as the combined / carve out financial statements are prepared for specific purpose and, therefore, are “special purpose financial statements”. Similarly, the Guidance Note on Reports in Company Prospectuses refers to SA 800 and the Guidance Note on Combined and Carve-out Financial Statements as the format to be used for specific report.

CONCLUSION
The auditor must have clarity about the difference between general purpose financial statements and special purpose financial statements. The audit reports on these two types of financial statements are governed by two different auditing standards (SA 700 and SA 800). Depending on the type of financial statements, contents of the audit report differ such as description of framework under which financial statements are issued, describing basis of accounting in the audit report, etc.

CERTIFICATION ENGAGEMENTS

INTRODUCTION
Chartered accountants in practice are requested to certify and attest multiple documents. These can be a net-worth certificate, turnover certificate, an ITR (Income Tax Return) certificate, ODI (Overseas Direct Investment) certificate, certificate required by banks for loan/renewal/compliance purposes, and certifications for tender purposes as for local inputs or statutory compliance certificates.
Considering the importance of these certificates and the need to bring uniformity in reporting, the ICAI issued a Guidance Note on Reports or Certificates for Special Purposes (Revised 2016) (GN). The purpose of this GN is to guide on engagements requiring a practitioner to issue reports other than those issued in audits/reviews of historical financial information. Guidance Notes assist professional accountants in implementing the Engagement Standards and the Standards on Quality Control issued by the AASB under the authority of the Council of ICAI.
As per the GN, a report or certificate issued by a practitioner can provide either a reasonable or a limited level of assurance depending upon the nature, timing and extent of procedures to be performed based on the facts and circumstances of the case. Therefore, when a practitioner is required to give a certificate or a report for special purpose, a careful evaluation of the scope of the engagement needs to be undertaken, i.e., whether the practitioner would be able to provide an opinion (in a reasonable assurance engagement) or a conclusion (in a limited assurance engagement) on the subject matter.

Reasonable assurance
engagement

Limited assurance engagement

• An
assurance engagement in which the practitioner reduces engagement risk to an
acceptably low level in the circumstances of the engagement, as the basis for
the practitioner’s opinion.

 

• The
practitioner gives a report in the form of positive assurance (direct) and
nature timing and extent of procedures are more extensive.

• An
assurance engagement in which the practitioner reduces engagement risk to a
level that is acceptable in the circumstances of the engagement but where
that risk is greater than for a reasonable assurance engagement.

 

• The
practitioner gives a

 

(continued)

 

report
in the form of negative assurance (indirect) and nature timing and extent of
procedures are moderate.

Examples – Certificates Based on Reasonable Assurance

ü Certification of Turnover for past
years

ü Certification of Net worth of
entity

ü Certification of Derivative Exposures

ü Certification of compliance with Buyback
Regulations

ü Annual Performance Report (APR)
Certificate

ü Overseas Direct Investment (ODI)
Certificate

Examples – Certificates Based on Limited Assurance

ü Certification of Non-financial
information
required for Tender

ü Certificate on Accounting treatment
in conformity with Accounting standards

ü Certificate issued by a Professional Accountant
other than auditor

 

This article aims to highlight the key aspects relating to issuance/challenges of certificates that the auditor/professional accountant should consider.

ENGAGEMENT ACCEPTANCE PROCEDURES
The practitioner should consider relevant ethical and independence requirements while accepting or continuing an engagement. The practitioner should agree in writing the terms, i.e. objective, scope, responsibilities of practitioner and responsibilities of the engaging party, fees, type of assurance in detail and limitations on use based on the eventual use in the engagement letter. Any change in engagement scope should not be agreed to unless there is a reasonable justification. In case of limitation on scope imposed, the practitioner should not accept the assignment where he will end up disclaiming his opinion.
WHEN ASSURANCE REPORT/CERTIFICATE IS PRESCRIBED BY LAW OR REGULATION
Sometimes, the applicable law and regulation or a contractual arrangement that an entity might have entered into prescribes the layout or wording of reports or certificates. These wordings generally contain the words such as ‘Certify’ or ‘True and Correct’. These words, i.e., ‘True and Correct’ indicate absolute assurance. Absolute assurance indicates that the documents certified are 100% free from misstatements, and the auditor’s engagement risk has been reduced to zero. The practitioner should refrain from using words that indicate absolute assurance and clarify that only a reasonable or limited assurance is provided.

Points to consider when the format/layout is prescribed by law:

•    Certificate is to be prepared as per the format specified by the regulatory authority (e.g. APR certificate).
•    Enclose a statement containing essential elements of the assurance report to the certificate.
•    A separate line stating “to be read with the enclosed statement of even date” shall be inserted towards the end of the certificate and above the signature. Such statement shall be enclosed with the certificate.
•    Underlying management statement/annexure, duly attested, on which auditor will issue the certificate.
•    To evaluate whether intended users might misunderstand the assurance conclusion and whether additional explanation in the assurance report can mitigate possible misunderstanding.

Example1
RBI had alleged wrong certification of a Company by a CA Firm (Respondent) which did not meet dual principle business criteria (Income & Asset Criteria) as required in terms of the Non-Banking Financial (Non Deposit Accepting or Holding) Companies Prudential Norms (Reserve Bank) Directions, 2015. Further, respondent failed to issue exception report to RBI.
Findings
The respondents are held guilty of gross negligence and professional misconduct  falling within the meaning of Clause (7) of Part I of Second Schedule of Chartered Accountant Act,1949 for violation of “Non-Banking Financial Companies Auditor’s Report (Reserve Bank) Directions, 2013”.

 

1   Report/Orders issued by ICAI
disciplinary Committee on Non Compliances in issuing Certificate/Report.

WHEN ASSURANCE REPORT/CERTIFICATE IS TO BE GIVEN WHILE ISSUING/CERTIFYING PROVISIONAL/PROJECTED STATEMENTS
Usually, clients approach banks for new loans/renewal/enhancement of loans. Many bankers ask such clients to produce three years of audited financials/provisional/projected financials and get them signed. It is pertinent to note there is no circular by RBI requesting such underlying documents. The Chartered Accountants Act, 1949 (Clause 3 of Part I of the Second Schedule) deems a CA in practice guilty of professional misconduct if he permits his/firm’s name to be used in connection with an estimate of earnings contingent upon future transactions in a manner which may lead to the belief that he vouches for the accuracy of the forecast. This means that a practitioner cannot certify whether a business will achieve a future result or not as per the projected financial statements. However, the projections can be examined by a Chartered Accountant under SAE 3400-The Examination of Prospective Financial Statement (PFI). PFI could be in the form of a forecast, a projection or a combination of both, for example, a one year forecast plus a five-year projection. We must note PFI contains projections/forecasts involving uncertainty, and therefore adequate care must be taken on the type of assurance given. PFI is highly subjective, and it requires the exercise of considerable judgment. The practitioner needs to assess the source and reliability of the evidence supporting management’s assumptions/estimates and, where hypothetical assumptions are used, whether all significant implications of such assumptions are considered. The auditor should document important matters in providing evidence to support his report on the examination of prospective financial information and evidence that such examination was carried out in accordance with the SAE. The auditor can provide only a moderate level of assurance on the reasonableness of management’s assumptions used and reasonable assurance (opinion) on the PFI’s proper preparation based on the assumptions, and its presentation in accordance with the relevant financial reporting framework.

Similarly, for the certification of ITR, members are advised not to certify ITR as a true copy as per FAQs on UDIN-issued by ICAI. However, they can make an opinion/ certificate/ report about ITR based on its source, location and authenticity of data from which it is being prepared, and UDIN is required.

ICAI has also issued a Guidance Note on Reports in Company Prospectuses (Revised 2019). This Guidance Note guides compliance with the Companies Act, 2013 and the SEBI  (Issue of Capital and Disclosure Requirements) Regulations, 2018 relating to the reports required to be issued by CAs in prospectus issued by companies for Indian offerings. Underwriters and lead managers usually undertake a due diligence process on the information contained in the prospectus. As a part of that process, they also seek to obtain an added level of comfort from the auditors on various aspects of the prospectus (in the form of a comfort letter), in addition to the auditors’ report already contained in the prospectus. The auditor should agree with the lead manager on the scope and limitation of the issuance of a comfort letter.

MATTERS REQUIRING ATTENTION WHILE ISSUING CERTIFICATE/REPORT

Disclosures   
It is generally seen that practitioners cannot provide complete disclosures such as disclosure of responsibilities of the parties involved, the subject matter, and disclosure of the intended purpose of the certificate. Disclosures provide clarity and help avoid misunderstandings of the objective, scope, responsibilities, subject matter, and applicable criteria. Issuers should make it a practice to provide detailed disclosures in their certificates and reports that will leave little to the imagination of the user. In case where a format is prescribed, or a certificate is to be issued in a specific format, there is always a challenge to detail the disclosures/qualifications etc. Also, where there are specific formats/certification over portals-Fixed formats, there is no specific place for mentioning/inserting UDIN, and this adds as a limitation while issuing a certificate.
Certification of non-financial information

While a client applies for tenders, many documents are required to be certified by the CA. Sometimes non-financial documents are also requested to be certified by a CA. The auditor may use the work of an expert for non-financial information after considering its competency, capability and objectivity.
Key Performance Indicators-SEBI Disclosures
In its consultation paper, SEBI has planned tougher pricing norms for startup IPOs. SEBI believes the disclosures made under the ‘Basis of Issue Price’ section in an offer document need to be ‘supplemented with non-traditional parameters’ and other Key Performance Indicators (KPIs). For example a technology or app-based startup, the KPIs could be figures like the number of downloads or average time spent on a platform. Further, it is not always possible to correlate KPIs with the issue price. KPIs can be dynamic, evolve with time, and can be volatile due to technology changes depending on the management’s strategies and learnings from previous quarters. KPIs would be further required to be certified by a statutory auditor/independent CA. It would be challenging for an auditor, and it will have to be seen if giving such a certificate is feasible since the auditor will not have the required skills for non-financial KPI’s. SEBI should provide guidelines on how KPIs need to be disclosed. For example, the guidelines could specify that the following information should be accompanied with the disclosure of KPIs:
• a clear definition of the metric, and
• how it’s calculated.
For example, when disclosing ‘acquisition of new customers’, it should define whether the numbers indicate the basis on which a new customer is identified. For example, it is a new customer because it has downloaded the App for a subsequent time, or it is a new customer because it has placed the first order in a particular period, or it is a new customer because it has logged in from a new device.
When report is issued based on Agreed Upon Procedures Engagement
In an Engagement to Perform Agreed-upon Procedures regarding Financial Information-SRS (Standard on Related Services) 4400, the client requires the auditor to issue a report of factual findings based on specified procedures performed on the specified subject matter of specified elements, accounts or items of a financial statement.
Example – An ongoing arbitration engagement – where the dispute pertains to revenue realisation/valuation from a real estate project, the client has requested the auditor to perform agreed-upon procedures concerning individual items of financial data, say, revenue and accounts receivable, and has provided books of accounts, supporting documents from buyers and valuation reports by independent valuers.
The procedures performed will not constitute an audit or a review. Accordingly, no assurance will be expressed, whereas in the issuance of a report/certificate (reasonable/limited assurance), an opinion is given.
Sources and Methodology
A practitioner will be better off stating the sources of his information. It will be better to state where the data/audit evidence is obtained. This will safeguard the practitioner and clarify the sources to the reader. Where the underlying data is relied upon by the practitioner, he may state so in his report. Often copies are provided by the client via scan on emails. The practitioner may consider evaluating the genuineness or otherwise of such documents. A practitioner may mention the methodology adopted by him in undertaking the assurance activity.
Example2 – The CA (Respondent) issued a certificate to a Bank for account opening without verifying the underlying documents and ensuring its genuineness. The board findings stated that the certificate is a written confirmation of the facts stated therein. When a Chartered Accountant issues a certificate, it is believed to be ‘True and Correct’. The respondent ought to have exercised due professional scepticism to see that the correct facts as to the existence of the necessary documents.
Findings – The respondent is guilty of ‘Other Misconduct’ falling within the meaning of item (2) of Part IV of First Schedule to the Chartered Accountants Act 1949 read with section 22 of the said act.
Representations and Documentation
Adequate guidance is available on obtaining management representations. A practitioner may be cautious when relying on representation as primary evidence. Considering the limited nature of assurance or reasonable assurance engagements, a practitioner should obtain adequate management representations to correlate these with other evidence. When representations are not provided, or clients disagree to do so, the practitioner may treat this as a red flag. A practitioner should maintain adequate documentation that forms the basis of his report / certificate and reference it appropriately.

 

2   Report/Orders issued by ICAI
disciplinary Committee on Non Compliances in issuing Certificate/Report.

Title, Content and Structure
The GN provides for the content, flow and structure of the report. It is observed that many practitioners continue to provide certificates like before without following the format prescribed. This especially involved obtaining UDIN and affixing the UDIN to the signature panel. One may refer to the recent FAQ on UDIN (January 2022) for various aspects relating to UDIN covering numerous situations. Addressing the report to the proper party is very important. The format also prescribes an opinion para, which requires clear and complete articulation of what is being reported.
Restriction on use
It is important to state that a certificate is issued for a specific purpose and therefore should only be used for that purpose and not for any other purposes. Often a certificate is issued for FEMA or specific banks, and the practitioner may state the purpose and/or user.
Issuance of incorrect certificates for taking benefit of license/scheme/tax benefits/subsidy
A practitioner should ensure utmost care while issuing a certificate after verifying all underlying documents and diligently performing necessary audit procedures. It is seen that authorities have held professionals guilty if the certificate is incorrectly issued based on significant errors/frauds in books of accounts which the practitioner ignored. In a few cases where certificates are to be issued to tax authorities, it is seen that figures are manipulated to take undue advantage of license/scheme/tax benefit/subsidy.
Example3 – The respondent had issued bogus certificates of past exports based on which the concerned importers were able to obtain advance licenses and DEEC Book for duty-free imports. This resulted in evasion of duty to the government to the extent of Rs. 1crore.
Findings – The respondent is guilty of ‘Other Misconduct’ falling within the meaning of Section 22 read with section 21 of the Chartered Accountant Act, 1949. The respondent is separately prosecuted under the Customs Act, and a penalty is imposed on him.

 

3   Report/Orders issued by ICAI
disciplinary Committee on Non Compliances in issuing Certificate/Report.

Other Points
Materiality – Materiality must be considered in the context of qualitative factors, and when applicable, quantitative factors. When considering materiality in particular engagements, the importance of both the factors is a matter of professional judgment.
Internal Audit Report and Internal Control – Where the practitioner plans to use the internal audit functions’ work, he should evaluate its competence, objectivity and quality control and whether its work is relevant for the engagement. The practitioner should obtain an understanding of internal controls and needs to evaluate its inherent limitations.
BOTTOM LINE
Considering the various challenges, there is a lot of risk and exposure for the auditor while issuing such certificates. The auditor may be called upon by various regulators if there is an issue related to the certificate/report. The auditor must ensure that he has obtained and preserved sufficient and appropriate audit evidence and apply professional scepticism and professional judgment while arriving at the opinion. Certificates serve numerous purposes, and as CAs, it is our responsibility to issue them with due care and diligence. There is an increasing requirement for the auditor to issue certificates in the statutory format. Considering the same, ICAI may consider looking at its Guidance Note to avoid rejection of such certificates.  

MATERIALITY WITH REFERENCE TO THE FINANCIAL STATEMENTS

INTRODUCTION
Materiality is a widely used concept for the preparation and presentation of financial statements and reporting thereon. Management assesses the materiality with respect to the preparation and disclosures made in the financial statements, aiming at the information needs of the primary users of the financial statements (i.e., existing and potential investors, lenders and other creditors) that can influence their decisions regarding investments, and providing their services or resources to the entity.

Auditors, on the other hand, assess the materiality while making judgements about the nature, timing and extent of the audit procedures to be performed and the implications of the misstatements observed during the audit to express an opinion as to whether the financial statements are prepared, in all material respects, in accordance with the applicable financial reporting framework.

Further, from the auditor’s perspective, there could be other considerations like the type of audit opinion based on the pervasiveness of misstatements, reporting under CARO 2020, internal financial controls with reference to the financial statements, and the restatement of financial statements etc., wherein materiality plays a crucial role.

In this article, an attempt has been made to discuss the importance of materiality for the preparers and the auditors along with the key aspects of the guidance available for its assessment.

MATERIALITY FROM MANAGEMENT’S PERSPECTIVE
The Institute of Chartered Accountants of India (‘ICAI’) had issued SA 320 – Materiality in Planning and Performing an Audit, and Implementation Guide to Materiality in Planning and  Performing An Audit (‘Implementation Guide’) to define the auditor’s responsibility to apply the concept of materiality in planning and performing an audit of financial statements, and SA 450 – Evaluation of misstatements, to explain how materiality is applied in evaluating the effect of identified misstatements on the audit and of uncorrected misstatements, if any, on the financial statements. However, there is limited guidance for determining the materiality for the preparation and presentation of the financial statements from the management’s perspective.

Materiality, amongst others, is a fundamental qualitative characteristic to identify the types of information that are likely to be most useful for the primary users of the financial statements, as described in the Conceptual Framework for Financial Reporting under Ind AS, as issued by ICAI. As per Ind AS 1 – Presentation of Financial Statements and Ind AS 8 – Accounting Policies, Changes in Accounting Estimates and Errors, ‘Information is material if omitting, misstating or obscuring it could reasonably be expected to influence decisions that the primary users of general-purpose financial statements make on the basis of those financial statements, which provide financial information about a specific reporting entity. Materiality depends on the nature or magnitude of information, or both. An entity assesses whether information, either individually or in combination with other information, is material in the context of its financial statements taken as a whole’. The Guidance note on Ind AS Schedule III, also suggests the same guidance with exceptions for items of income or expenditure which exceeds 1% of revenue from operations or Rs. 10,00,000 whichever is higher, and continuing defaults in repayment of borrowings for consolidated financial statements.

In the above definition, the emphasis is placed on the below two statements, to define materiality:

Assessing whether an omission, misstatement or obscuring could influence economic decisions of users

The materiality assessment can be done by considering the characteristics of the potential users of the financial statements. Here it is worth noting that the users of the financial statements include present and potential investors, employees, lenders, suppliers and other trade creditors, customers, governments and their agencies and the public. Each of these users uses financial statements to satisfy some of their different needs for information. For example:

•    investors might be interested in the various disclosures related to revenue, profitability, dividend, credit risk, capital management, etc.;

•    customers might be interested in the disclosures related to going concern of the entity due to long term supply contract and service dependency;

•    lenders and suppliers might be interested in disclosers related to cash flows and assessment of the ratios to know the economic health of the entity; and

•    the public might be interested in knowing if the entity  has a significant contribution in its sector, or to the overall economy of the country.

Further, it is important to understand that information is said to be obscured if it is communicated in a way that would have a similar effect for primary users of financial statements to omitting or misstating that information. Some of such examples may include disclosure of material information by using vague or unclear language, disclosure of material information in scattered way, aggregating dissimilar information etc.

Nature and magnitude of information

At times the size and nature of the information itself determine its relevance. For example:

•    the reporting of a new segment may affect the assessment of the risks and opportunities facing the entity irrespective of the materiality of the results achieved by the new segment in the reporting period;

•    Mergers and acquisitions by the entity;

•    Change in the government policies for the sector in which the entity operates;

•    Exceptional or additional line items, headings and subtotals in the statement of profit and loss, when such presentation is relevant to an understanding of the entity’s financial performance;

•    Related party transactions; etc.

The Framework for the Preparation and Presentation of Financial Statements in accordance with Indian Accounting Standards issued by ICAI also states that the materiality assessment needs to take into account how users could reasonably be expected to be influenced in making economic decisions. Further, the information about complex matters like fair valuation assumptions and methodologies for the valuation of financial instruments, disclosures related to expected credit loss of financial assets, sensitivity analysis, ratio analysis, income tax reconciliation, etc. that should be included in the financial statements because of its relevance to the economic decision-making needs of users should not be excluded merely on the grounds that it may be too difficult for certain users to understand.

Based on the above guidance, the standard emphasizes the qualitative evaluation of information to be presented in the financial statements, including any misstatements, rather than restricting it to any quantitative threshold.

The above methodology will require management to do a detailed deliberation on all the disclosures required to be presented in the financial statements, including any omissions and misstatements, both individually and collectively with others, at the financial statements level to conclude if a required disclosure or misstatements is material, considering the primary users of the financial statements.

For example, as per Ind AS 8, an entity shall correct material prior period errors retrospectively in the first set of financial statements approved for issue after their discovery by:

(a) restating the comparative amounts for the prior period(s) presented in which the error occurred; or

(b) if the error occurred before the earliest prior period presented, restating the opening balances of assets, liabilities and equity for the earliest prior period presented.

In the above guidance, though the standard talks about correcting the material prior period errors, it does not give additional guidance on what is considered material in quantitative terms or any methodology to quantify it.

Here again, the emphasis is placed on the qualitative aspects of the misstatements. If management believes that the prior period errors are so material that it can adversely affect the true and fair presentation of the financial statements or influence the economic decision of the primary users of the financial statements, then such prior period errors are required to be corrected in accordance with the guidance given under Ind AS 8.

On the other hand, the audit team is required to evaluate any such prior period errors based on the materiality assessed for the audit of the financial statements.

A reference can also be drawn to ‘Practice Statement 2, Making Materiality Judgements’, which is a non-mandatory guidance published by the International Accounting Standards Board (‘IASB’).

The IASB, in the said practice statement, has introduced a four-step model illustrating the role of materiality in the preparation of financial statements and clarifies how a materiality judgement needs to be made. A brief overview of the model is as under:

Step
1 Identify

 

Identify
information that primary users might need to make decisions about providing
resources to the entity.

 

Step
2 Assess

 

Assess
whether information is material based on both quantitative and qualitative
considerations.

 

Step
3 Organise

 

Based
on the output of materiality judgement and different roles of the primary
financial statements and the notes, decide whether to present an item of
information separately in the primary financial statements, to aggregate it
with other information and/or to disclose the information in the notes.

 

Step
4 Review

 

Review
the information from an

aggregated
perspective, once the draft financial statements are prepared to see if
entity needs to revisit the assessment made in Step 2, to provide/reorganise/
remove information.

 

The materiality for the financial statements must also be discussed with management and Those Charged with Governance (TCWG) by the auditors as per the requirement of SA 260 (Revised) – Communication with Those Charged with Governance while planning the audit of the financial statements.

As during the said discussion, materiality for the financial statements is discussed in detail by both the parties, taking into account all the relevant quantitative and qualitative factors. Management may decide to follow the same quantitate threshold as materiality for the preparation of financial statements unless it chooses to follow a lower threshold by considering a different methodology that is more suitable for the entity.

MATERIALITY FOR THE AUDIT OF THE FINANCIAL STATEMENTS
SA 320 and the Implementation Guide provides detailed guidance for the identification of materiality for the audit of the financial statements. However, considering that the identification of materiality requires significant professional judgement, below are two case studies that can be helpful in exercising the professional judgement:

Case study 1

A Ltd is a public listed entity operating in the telecom sector. A is a well-established telecom service provider from the last decade and presently in the process of incurring significant capital expenditure, to upgrade its infrastructure with latest 5G technology. A is able to maintain a consistent revenue from operations. However, its profit before tax (‘PBT’) is at a lower end, with a declining trend, due to its product pricing to tackle competition.

The Engagement Partner of the audit firm XYZ & Associates LLP, the statutory auditor of the Company, has decided to consider PBT as a benchmark for materiality, considering the following reasons:

• The Company’s PBT margin is presently at par with the other market participants in the industry,

• Being an established listed entity, the retail investors are more focused on profitability and dividends,

• Lenders of the Company have imposed financial covenants for maintaining profitability in the lending arrangement, and

• A Ltd. is already an established player in the industry. Hence, capital expenditure for technological upgradation is to secure the future market presence and hence not the present primary focus of the users of the financial statements.

Here it is important to note that:

• if the Company’s profitability had been volatile, then revenue from operations or gross profits would be a more suitable benchmark, and

• if the Company had been a new entrant in the industry and in the process of creating the required infrastructure, then net assets or total assets would have been a suitable benchmark.

Case study 2

Continuing with the above example, post deciding on the benchmark, the audit team is now identifying a suitable percentage to be applied on the PBT to quantify the materiality for the financial statements as a whole and the performance materiality. Below are a few more facts that the audit team has considered in quantifying the materiality:

• PBT includes an exceptional expenditure of Rs 20 crores,

• There were no audit qualifications given in the previous year’s audit reports,

• The Company operates in a highly regulated environment,

• There are significant related party transactions, and

• The Company carries significant debt.

The Engagement Partner of the audit firm, has decided the materiality for the financial statements as a whole and the performance materiality, based on the following:

• PBT will be normalised by excluding the exceptional expenditure of Rs 20 crores. The said normalisation is done as the transactions that are exceptional, unusual or non-recurring in nature tend to distort the actual state of affairs of the business, if not excluded.

• 5% of the normalised PBT will be used to quantify the materiality for the financial statements as a whole. SA 320 and the Implementation Guide do not prescribe any specific percentage for any of the benchmarks of materiality, however one can use a range for gross and net benchmarks, for example, 5% to 10% for net benchmarks like profit before tax and 0.5% to 2% for gross benchmarks like revenue from operations or total assets.

• The engagement partner, in the above example, has followed the range of 5% to 10% for PBT and has decided to adopt a lower materiality of 5%, considering that A Ltd is a new audit client and operates in a highly regulated environment with significant related party transactions, and as such indicates higher audit risk.

• The engagement partner has decided performance materiality to be 70% of the materiality for the financial statements as a whole. Like materiality, SA 320 and the Implementation Guide do not prescribe any specific percentage for performance materiality. As per SA 320, performance materiality is set to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements in the financial statements exceeds materiality for the financial statements as a whole, and as such professional judgement is required to be exercised to determine how much reduction is required to the materiality at the financial statements as a whole. This can again be done by following a range which may be between 50% to 80% based on the risk assessment procedures and misstatements identified in earlier year’s audit.

• The engagement partner in the above case study has considered a moderate performance materiality of 70%, considering it a new audit engagement and moderate risk of material misstatement.

However, here it is important to note that the concept of materiality should not be applied while ensuring the compliances with laws and regulation, for example compliance of various sections of Companies Act like sections 185, 186, 188 etc., or where the law specifically require reporting without following the materiality like reporting under specific clauses of CARO 2020.

MATERIALITY FOR THE AUDIT OF INTERNAL FINANCIAL CONTROL WITH REFERENCE TO THE FINANCIAL STATEMENTS

Though we discussed above that ICAI has issued SA 310 and SA 405 to provide guidance on the audit of the financial statements, there may be a question if the said guidance can also be applied to determine the materiality for the audit of internal financial control with reference to the financial statements. The said question was answered in the ‘Guidance Note on Audit of Internal Financial Controls Over Financial Reporting (‘Guidance Note’)’ issued by ICAI, which states that the auditor should apply the concept of materiality and professional judgment as provided in the Standards on Auditing and this Guidance Note while reporting under section 143(3)(i) on the matters relating to internal financial controls with reference to the financial statements for both standalone and consolidated financial statements. The Guidance note has further clarified that the audit team should use the same materiality consideration as they would use in the audit of the entity’s financial statements as provided in SA 320.

Similar guidance is also given in the Technical Guide on Audit of Internal Financial Controls in Case of Public Sector Banks issued by ICAI.

However, it is important to note that the for the purpose of internal financial control, the audit team should consider the misstatements at an aggregate level rather than netting them off.  For example, control deficiencies that lead to an overstatement of expenses and overstatements of income may have a net impact that is less than the materiality, but at an aggregate level, they may have a material financial implication on the financial statements that may lead to material weakness and modification in the audit report on internal financial control.

MATERIALITY CONSIDERATION FOR REPORTING UNDER COMPANIES (AUDITOR‘S REPORT) ORDER, 2020 (‘CARO’)
The Guidance Note on CARO 2020 issued by ICAI also requires auditors to use materiality while evaluating the reporting considerations and ensure adequate documentation wherein any unfavourable comments have not been reported in view of the materiality of the item. The Guidance Note further states that for the purpose of CARO reporting, the auditor should consider the materiality in accordance with the principles enunciated in SA 320.

For example, in the case of clause 3(iii) of the CARO, while reporting on the repayment schedule of various loans granted by the company, the auditor examines the loan documentation of all large loans and conducts a test check examination of the rest, having regard to the materiality.

However, for certain clauses reporting should be made, irrespective of the materiality, for instance:

• Any discrepancies of 10% or more in the aggregate for each class of inventory and, whether they have been properly dealt with in the books of account, is required to be reported irrespective of the materiality, considering the specific reporting requirement of clause 3(ii)(a) of CARO.

• In case of reporting for consolidated financial statements, if a qualification/adverse remark is given by any individual component, then there is a presumption that the item is material to the component and hence not required to be re-evaluated from the materiality at the consolidated financial statement level. Hence every qualification/adverse remark made by every individual component including the parent should be included while reporting under clause 3(xxi).

IN SUMMARY
Materiality with reference to the financial statements is subject to significant judgement both by the management and the audit team. While from the management’s perspective its determination depends on the qualitative aspects, except where specific quantitative threshold has been prescribed like in Schedule III, whereas from the auditor’s perspective its determination is driven from both qualitative and quantitative factors. However, for both parties, materiality plays a pivotal role in ensuring the preparation of financial statements that are free from material errors and contains all the required disclosures relevant to the primary users of the financial statements, including issuance of audit report thereon.

AUDITOR’S REPORTING – GROUP AUDIT AND USING THE WORK OF OTHER AUDITORS

The term ‘group’ as defined in Accounting Standard 21 and Indian Accounting Standard 110 includes parent and all its subsidiaries. Consolidated financial statements are the financial statements of a group presented as those of a single enterprise which includes consolidation of financial statements of parent, subsidiaries, associates and joint ventures in accordance with applicable accounting standards. Standard on Auditing (SA) 600, ‘Using the Work of Another Auditor’ establishes standards when an auditor, reporting on the financial statements of an entity (the group—in the case of consolidated financial statements), uses the work of another auditor on the financial information/statements of one or more components included in the financial statements of the entity. ICAI has also issued a Guidance note on Consolidated Financial Statements to provide guidance on the specific issues and audit procedures to be applied to audit consolidated financial statements.

Under the International Standard on Auditing 600 issued by International Auditing and Assurance Standards Board, the group auditor is responsible for the direction, supervision, and performance of the group audit and the appropriateness of the group audit report. Where SA 600 applies and when the group auditor has to base his/her opinion on the financial information of the entity as a whole relying upon the statements and reports of the other auditors, the group auditor shall clearly state in his/her report the division of responsibility for the financial information included in a group financial statement of components audited by other auditors and that they have been included as such after performing appropriate procedures. However, it is important to note that it is not blind reliance on the work done by other auditors.

When the group auditor or principal auditor concludes that the financial information of a component is immaterial, the procedures outlined in SA 600 do not apply. Principal auditor should consider materiality portion of financial information which the principal auditor audits, degree of knowledge regarding business of the components, risk of material misstatement in financial information of the components audited by other auditor, whether principal auditor can perform additional procedures before accepting his/her position as principal auditor.

The objective of this article is to highlight some important aspects relating to group audits in India and role and responsibilities of the principal auditor or the group auditor when using the work of other auditors.

ISSUE 1 – ACCESS TO WORKING PAPERS OF COMPONENT AUDITORS
ICAI issued a clarification in May 2000 which provides that an auditor is not required to provide the client or the other auditors of the same enterprise or its related enterprise such as a parent or a subsidiary, access to his audit working papers. The main auditors of an enterprise do not have the right of access to the audit working papers of branch auditors. In the case of a company, the statutory auditor must consider the report of the branch auditor and has a right to seek clarifications and/or to visit the branch if he deems it necessary to do so for the performance of the duties as auditor. An auditor can rely on the work of another auditor without having any right of access to the audit working papers of the other auditor. For this purpose, the term ‘auditor’ includes ‘internal auditor’. The only exception is that the auditor may, at his discretion, in cases considered appropriate by him, make portions of or extracts from his working papers available to the client.

The above clarification is based on the principles of SA 230, Audit Documentation, in accordance with which audit documentation is the property of auditor and SA 200, Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with Standards on Auditing, which provides that the auditor should respect the confidentiality of information acquired in the course of his work and should not disclose any such information to a third party without specific authority or unless there is a legal or professional duty to disclose. In addition to this, Part I of the Second Schedule to the Chartered Accountants Act, 1949 provides that “A Chartered Accountant in practice shall be deemed to be guilty of professional misconduct, if he discloses information acquired in the course of his professional engagement to any person other than his client, without the consent of his client or otherwise than as required by any law for the time being in force.”

In line with the above, under SA 600, where another auditor has been appointed for the component, the principal auditor would normally be entitled to rely upon the work of such auditor unless there are special circumstances to make it essential for him to visit the component and/or to examine the books of account and other records of the said component. However, this poses a practical limitation on the principal auditor while conducting a group audit.

ISSUE 2 – RESPONSIBILITY OF PRINCIPAL AUDITOR/GROUP AUDITOR WHILE USING WORK OF ANOTHER AUDITOR
(i) SA 600 requires that the Principal Auditor should perform the following procedures while planning to use the work of another auditor:

• Consider the professional competence of Other Auditor, if other auditor is not a member of ICAI;

•    Obtain sufficient appropriate audit evidence, that the work of other auditor is adequate for principal auditor’s purpose. For this purpose, the principal auditor should advise the other auditor of the use that is to be made of the other auditor’s work and report and make sufficient arrangements for co-ordination of their efforts at the planning stage of the audit. The principal auditor would inform the other auditor of matters such as areas requiring special consideration, procedures for the identification of inter-component transactions that may require disclosure and the timetable for completion of audit; and advise the other auditor of the significant accounting, auditing, and reporting requirements and obtain representation as to compliance with them;

• There should be sufficient liaison between the principal auditor and the other auditor. For this purpose, the principal auditor may find it necessary to issue written communication(s), i.e., group instructions to the other auditor;

• The principal auditor should share detailed group audit instructions to other auditor, which may include the following:

• Significant Risk-Group Financial Statement Level (e.g., management override of control, revenue recognition, impairment).

• Group Structure-Details of subsidiary/joint venture and % stake for current year and previous year.

• Significant accounting and auditing issues.

• Timetable of communication, contacts, communication protocols.

In addition to being asked to complete group audit questionnaires and/or provide memoranda of work performed, component auditors may be asked to report directly to group auditors in the form of an audit or review opinion on financial information i.e., the group reporting/consolidation package prepared by component management.

• Principal auditor may require another auditor to submit a detailed questionnaire with reference to the work performed by him, checklist etc.

Consider significant findings of other auditor and perform supplement tests if necessary.

(ii) Regulation 33(8) of SEBI (Listing Obligations and Disclosure Requirements) (Regulations) 2015

SEBI Circular dated 29th March, 2019 states that the principal auditor is required to send Group Audit / Review Instructions to component auditors for audit/review of the consolidated financial statements / results. Since the audit/review report requires specific assertion on performance of procedures in accordance with the SEBI Circular, it is mandatory that component auditor should respond to the instructions and provide the requisite information.

It is important to note that the parent company management is responsible for ensuring co-ordination between the principal and other auditor to comply with the requirements of SA 600.The requirements specified in the SEBI circular seems to be mandatory for the entities whose accounts are to be consolidated with the listed entity and to the statutory auditors of entities whose accounts are to be consolidated with the listed entity.

The circular requires the principal auditor to communicate its requirements to the component auditors on a timely basis. This communication shall set out the work to be performed, the use to be made of that work, and the form and content of the component auditor communication with the principal auditor. Therefore, the principal auditor is required to send the group audit/review instructions to the component auditor, and if the component auditor does not respond to such instructions on a timely basis, then it may be considered as a non-compliance with the requirements of the circular since the audit/review report (format issued by SEBI) requires specific assertion that “we also performed procedures in accordance with the Circular issued by SEBI under Regulation 33(8) of the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015, as amended, to the extent applicable”.

Accordingly, if the component auditor does not respond to the questionnaire, checklist or information request sent by the principal auditor, it may be considered as a scope limitation, and the principal auditor may issue a qualified opinion/conclusion in such a situation in accordance with SA 705, Modifications to the Opinion in the Independent Auditor’s Report.

ISSUE 3 – CONSIDERATION OF MATERIALITY BY PRINCIPAL AUDITOR
The principal auditor is required to compute the materiality for the group as a whole (which is different from materiality to issue an opinion on the standalone financial statements), which should be used to assess the appropriateness of the consolidation adjustments (i.e., permanent consolidation adjustments and current period consolidation adjustments) that are made by the management in the preparation of CFS. The parent auditor can also use the materiality computed on the group level to determine whether the component’s financial statements are material to the group to determine whether they should scope in additional components and consider using the work of other auditors as applicable.

ISSUE 4 – REPORTING BY PRINCIPAL AUDITOR
SA 600 requires that the report on consolidated
financial statements and standalone financial statements (in a situation where the branch auditors are other than principal auditor), should state clearly the division of responsibility between principal auditor and other auditor. The principal auditor should express a qualified/disclaimer of opinion if:

• Principal auditor cannot use the work of other auditor and is unable to perform sufficient additional procedures as required by SA 600.

• If there is modification in another auditor’s report, then the principal auditor should consider whether the subject of the modification is of such nature and significance, in relation to the entity’s financial information and whether it requires a modification of the principal auditor’s report.
    
It is important to note the requirements in Guidance Note on Audit of Consolidated Financial Statements, which requires that while considering the observations (for instance, modification and /or emphasis of matter/other matter in accordance with SA 705/706) of the component auditor in his report on the standalone financial statements, the parent auditor should comply with the requirements of SA 600. Reference should be made to paragraph 23 of SA 600 which states, “In all circumstances, if the other auditor issues, or intends to issue, modified auditor’s report, the principal auditor should consider whether the subject of the modification is of such nature and significance, in relation to the financial information of the entity on which the principal auditor is reporting, that it requires a modification of the principal auditor’s report.”

Hence, the principal auditor needs to evaluate the observations (modification and /or emphasis of matter) in the component auditor’s report, in his auditor’s report on the CFS. For example, the considerations may include materiality and scope of the component; the assessment of risk of material misstatement for the group; the impact of the modification in light of the materiality thresholds for the group audit, etc.

The principal auditor should document how they have dealt with the qualifications or adverse remarks contained in the other auditor’s report in framing their report on the CFS of the group, considering materiality and risk assessment of the component.

The principal auditor of Consolidated Financial Statements in accordance with an ICAI announcement is required to state if certain components have been audited by other auditor and if such component/s is/ are material to the consolidated financial statements of the Group.

Where the financial statements of one or more components are unaudited, the principal auditor should consider unaudited components in evaluating a possible modification to his/her report on the consolidated financial statements. The evaluation is necessary because the auditor (or other auditors, as the case may be) has not been able to obtain sufficient appropriate audit evidence in relation to such consolidated amounts/balances. In such cases, the auditor should evaluate both qualitative and quantitative factors on the possible effect of such amounts remaining unaudited when reporting on the consolidated financial statements using the guidance provided in SA 705, Modifications to the Opinion in the Independent Auditor’s Report. If such unaudited component/s is/are not material to the consolidated financial statements of the group, the principal auditor is required to state this fact in an ‘Other Matter’ paragraph.

REPORTING ON KAM
Reporting on KAM applies to audit reports issued on consolidated financial statements of listed entities, in addition, to the report issued on standalone financial statements. The Implementation guide to SA 701 refers to SA 600 in case where the parent’s auditor is not the auditor of all the components to be included in the consolidated financial statements. It further states that the group auditor would be required to assess matters that in his professional judgement, are key audit matters from the perspective of consolidated financial statements. This needs to be done at the planning stage and updated during the performance of the audit.

Though there is no mandatory requirement in SA 701 read with SA 600 to mandatorily send group reporting instructions to the auditors (if they are different from group auditors) of unlisted subsidiaries to specifically seek a response to KAM pertaining to these subsidiaries, however, since the group auditor would be required to assess matters that in his professional judgement, are key audit matters from the perspective of
consolidated financial statements, the group auditor may seek a response from component auditor if any KAM is required to be included for that component. This can be done as part of the group audit instructions.

ISSUE 5 – RESPONSIBILITY OF THE COMPONENT AUDITOR/OTHER AUDITOR
During planning, performance or completion of the audit, component auditor/other auditors are expected to communicate with the principal auditor immediately if:

• Timing of the work creates an irresolvable problem,

• Instructions are not fully understood,

• It is necessary to vary procedures from those specified,

• Circumstances arise that may result in a qualified opinion,

• Services have been performed without the appropriate pre-approvals or consideration of the independence matters discussed in the group audit instructions,

• Local conditions are such that work cannot be done within the estimated time or fee,

• Issues are identified that may affect work performed outside their territory, or

• Other auditor become aware of events, transactions, or recent or proposed legislative changes that may have a significant impact on the component or other members of the affiliated group (e.g., instances of fraud, significant changes to the level of control reliance, illegal acts, etc.).

The principal auditor will request acknowledgement of receipt of Group Audit Instructions and confirmation of cooperation from other auditor. Other auditor will be required to comply with the Guidance Note on Independence of Auditors (Revised), Code of Ethics issued by Institute of Chartered Accountants of India and the Companies Act, 2013 in relation to the work carried out on the component.

ISSUE 6 – AUDITORS’ REPORTING ON INTERNAL FINANCIAL CONTROLS OVER FINANCIAL REPORTING IN CASE OF CONSOLIDATED FINANCIAL STATEMENTS

Section 129(4) of the 2013 Act states that the provisions of the 2013 Act applicable to the preparation, adoption and audit of the financial statements of a holding company shall, mutatis mutandis, apply to the consolidated financial statements. The parent auditor is required to report in the case of consolidated financial statements under Section 143(3)(i) of the 2013 Act on the adequacy and operating effectiveness of the Internal Financial Controls over Financial Reporting, for the components only if it is a company under the 2013 Act.

The auditors of the parent company should apply the concept of materiality and professional judgment while reporting under section 143(3)(i) on the matters relating to Internal Financial Controls over Financial Reporting that are reported by the component auditors. The auditor should also assess the impact, if any, of the subject matter of any qualification, adverse opinion or disclaimer stated by any of the component auditors in their respective components, and any remedial measures effected by the parent company to mitigate the effect of such observations in the component audit reports on the financial reporting process for the consolidated financial statements.

ISSUE 7 – AUDITOR’S REPORTING UNDER CARO 2020
There are certain new/revised clauses in CARO 2020, which are related to consideration of reports of other auditors, e.g.:

• Consideration of reports of the internal auditors
(Clause 3(xiv)),

• Consideration of the issues, objections or concerns raised by the outgoing auditors in case of resignation of auditors during the year (Clause 3 (xviii)),

• Reporting on funds taken by the company from any entity or person on account of, or to meet the obligations of its subsidiaries, associates or joint ventures
(Clause 3(ix)(e)), and

• Reporting on loans where the company has raised loans during the year on the pledge of securities held in its subsidiaries, joint ventures or associate companies and report if the company has defaulted in repayment of such loans raised (Clause 3(ix)(f)).

Additionally CARO 2020 is also applicable to audit report for consolidated financial statements for only one clause i.e. clause (xxi) of CARO requires an auditor to comment on whether there have been any qualifications or adverse remarks by the respective auditors in the Companies (Auditor’s Report) Order (CARO) reports of the companies included in the consolidated financial statements, if yes, details of the companies and the paragraph numbers of the CARO report containing the qualifications or adverse remarks need to be indicated. The following points should be noted in this regard:

• Reporting under this clause is only required for those entities included in the consolidated financial statement to whom CARO 2020 is applicable.

• CARO report is to be included as separate annexure in the audit report to the consolidated financial statements.

• Assessments of responses by component auditors as qualification/adverse remark requires application of professional judgment.

• The concept of materiality is relevant when reporting under CARO. However, if a qualification/adverse remark is given by any individual component, there is a presumption that the item is material to the component. Hence when reporting under clause 3(xxi), the auditor is not required to re-evaluate the materiality from a consolidation perspective. Hence every qualification/adverse remark made by every individual component including the parent should be included while reporting under this clause.

• Qualification/adverse remarks given in parent company’s standalone CARO report are also required to be included.

• In case the audit report of the components has not yet been issued by its auditor, then the principal auditor would include the fact in his/her report.

BOTTOM LINE
Effective two-way communication between the principal auditor and the component auditor is of essence for the group audits, the starting point for which is the clear and timely communication of the requirements by way of group audit instructions. Also, it is equally important for the group management to play an active role for high-quality group audits. Similarly, when the auditor decides to use the work of another auditor e.g., branch auditor in an audit of standalone financial statements, internal auditor or auditor’s expert, the principal auditor should adhere to the procedures prescribed in SA 600 and ensure timely planning and communication along with documentation to demonstrate performance of such procedures. Besides this, the principal auditor is required to communicate important and group-related matters to those charged with governance and group management in a timely manner.  

INTERNAL CONTROL CONSIDERATIONS FOR UPCOMING AUDITS

Internal controls are unique to every company and are designed according to the company’s size and structure. A robust framework of internal control protects company’s interests, promotes accountability, and enables the preparation of reliable and accurate financial information. Under the Companies Act, 2013 (‘2013 Act’), the Board of Directors of a company are required to establish internal controls that are adequate and operate effectively. An auditor reporting obligation has been prescribed under section 143(3)(i) of the 2013 Act for reporting on the adequacy and operating effectiveness of internal financial controls with reference to financial statements (‘IFCFS’). The Guidance1 Note on Audit of Internal Financial Controls Over Financial Reporting (‘Guidance Note’) guides some of the implementation challenges.

In the current environment, internal control considerations continue to remain one of the key focus areas of stakeholders. A robust internal control framework is the only tool that can cater to the increased stakeholders’ expectations. This article aims to highlight the key aspects relating to design and operating effectiveness of internal controls that the auditor should consider during the upcoming audits of financial statements prepared under the 2013 Act for F.Y. 2021 – 2022 and onwards.

PLETHORA OF NEW FINANCIAL STATEMENT DISCLOSURES AND AUDITORS REPORTING OBLIGATIONS

Schedule III to the 2013 Act and auditors reporting obligations under Companies (Auditor’s Report) Order, 2020 (‘CARO 2020’) and other2 auditors reporting obligations under the 2013 Act have been overhauled with an aim to strengthen objective decision making by the stakeholders. Though it would be expected that auditors reporting is restricted to matters disclosed in the financial statements, some of the new reporting requirements deviates from this fundamental principle. The following is a snapshot that summarizes the key financial statement disclosures and key auditors’ requirements, including the matters which are common:

New
matters which warrant disclosures in financial statements and require
reporting by auditors (Key)

 

New financial statement
disclosures (Key)

(No
specific auditors reporting obligations prescribed)

 

New auditors reporting
obligations (Key)

(No
specific disclosures in financial statements)

Schedule III and CARO 2020


Agreement of quarterly returns/ statements with books of accounts for
borrowings taken against security of current assets.


Grant of loan/ advances in the nature of loan which are repayable on
demand or granted without specifying any terms or repayment period.


Material uncertainty in repayment of liabilities basis assessment of
financial ratios, etc.


Undisclosed income.


Wilful defaulter.

    Corporate
social responsibility.

Schedule III and other2
reporting matters


Lending and borrowings masking the ‘Ultimate Beneficiary’.


Granular ageing analysis of certain captions e.g., trade receivables
including ageing of disputed and undisputed receivables.


Accounting of scheme of arrangement and explanation for deviation, if
any, with applicable accounting standards.


Transactions with struck off companies.

CARO 2020:


Enhanced reporting of loans, investment, etc
e.g., evergreening3 of loans.


Internal audit.


Whistle blower complaints.


Short term funds used for long term purpose.

     Cash
losses.

Other2
reporting matters:


Compliance with dividend norms.

_____________________________________________________________

1   Issued in September 2015.

2   As prescribed under Rule 11 of the Companies
(Audit and Auditors) Rules, 2014.

3   In general parlance it implies an attempt to mask
loan default by giving new loans to help delinquent borrowers to repay/adjust
principal or pay interest on old loans.

A cursory reading of some of the new auditors’ requirements (e.g. lending and borrowings masking the ‘Ultimate Beneficiary’) might give the impression that these requirements expand the boundaries of an audit engagement requiring the auditor to perform procedures that are generally performed in an investigation. However, it might be noted that these reporting obligations have been prescribed in relation to the audit of financial statements. Accordingly, the auditor should consider Standards on Auditing and other guidance in planning and performing the audit procedures to address the risk of material misstatement as stated above. Some of the considerations are as follows:

• Substance vs. legal form– Schedule III to the 2013 Act and CARO 2020 have significantly enhanced the reporting obligations relating to loans, guarantees, etc. The auditor should verify that the controls have been established to critically assess the substance of the transaction irrespective of the legal form. To illustrate – basis relevant facts and circumstances, it might be appropriate to conclude that extension of a loan (such as one day prior to the expiration of tenure) is in substance evergreening of loans even though the loan is not technically ‘overdue’ – which is the trigger for reporting under CARO 2020.

• Critical assessment of funding needs of the borrower and its utilisation of funds- Schedule III provides disclosures relating to conduit lending/ borrowing transactions, etc, masking the ‘Ultimate Beneficiary’ and related matters. Further, management must also provide representations to the auditor that there are no such transactions except for that disclosed in the financial statements. Under the Companies (Audit and Auditors) Rules, 2014, the auditor must comment whether such management representation has been obtained and whether the representation is materially misstated. The auditor should assess whether the controls have been established to evaluate the funding needs of the borrower (prior to granting of loans) and periodically obtain end-use report of the funds from the borrower.

• Efficacy of periodic book close process- The auditor should review existing book close process and assess whether reliable information is generated which enables accurate filing of quarterly returns/ statements with the lenders. Where differences exist – assess whether proper explanations for differences have been documented and approved as per the authority matrix of the company.

• Competence of objectivity of management experts- Controls regarding assessing the competence and objectivity of management experts involved if any e.g., in case of revaluation of property, plant and equipment/ intangible assets, assess compliance with Companies (Registered Valuers and Valuation) Rules, 2017 to the extent applicable.

•    Avoid hindsight- Presentation of comparative information for new disclosures pursuant to the requirements of Schedule III might involve making necessary estimates and require the exercise of judgement. The auditor would need to be ensure that the estimates/ judgement involved are based on the information available as at the end of the previous year and without using hindsight information e.g., trade receivable under litigation till end of previous year has been disclosed as disputed trade receivable in the previous year even though such litigation has been disposed of by the end of the current year.

MATERIAL4 UNCERTAINTY RELATING TO GOING CONCERN
Circumstances affecting management’s assessment of going concern might change rapidly in the current environment, e.g., adverse key financial ratios or challenges in the realisation of financial assets and payment of financial liabilities may cast significant doubt on the company’s ability to continue as a going concern. As required under Standard on Auditing, 570, Going Concern, the auditor is required to report in a separate paragraph in the audit report if a material uncertainty relating to going concern exists.

•    Schedule III to the 2013 Act now requires companies to disclose:

•    Certain financial ratios in the financial statements (e.g., debt service coverage ratio) and explain any change in the ratio by more than 25% as compared to the preceding year.

•    Ageing of trade receivables and trade payables.

•    CARO 2020 requires the auditor to comment whether material uncertainty exists on the company’s ability of meeting its liabilities within a period of one year from the balance sheet date.

____________________________________________________________________

4   A
material uncertainty exists when the magnitude of its potential impact and
likelihood of occurrence is such that, in the auditor’s judgment, appropriate
disclosure of the nature and implications of the uncertainty is necessary for
the fair presentation of the financial statements (in the case of a fair
presentation financial reporting framework).

It might be noted that the going concern assessment under Standards on Auditing and reporting under CARO 2020 is not is the same – though there might be interlinkages. Under CARO 2020, the auditor’s responsibility is limited to assessing a company’s solvency i.e. material uncertainty, if any on the company’s ability to meet its liabilities; whereas going concern assessment is a much wider assessment of the entity. The auditor would need to assess whether a material uncertainty exists related to events or conditions that, individually or collectively, may cast significant doubt on the company’s ability to continue as a going concern e.g. a Company that is in the business of selling garments under a brand licensing agreement, might face a material uncertainty relating to going concern, if the license is not expected to be renewed. Another situation might be, where a company has hived off substantially all of its business and, absence of any concrete business plan, might indicate that material uncertainty relating to going concern exist.

The Guidance Note requires the auditor to make appropriate disclosures to state the inherent limitations on IFCFS and the limitations in consideration of such controls operating as at the balance sheet date for the future operations of the company. The assessment of material uncertainty relating to going concern involves judgement about inherently uncertain future or outcomes of events/ conditions. These judgements can be made only on the basis of what is known at the balance sheet date. The outcome of future operations of the company cannot be reliably predicted for all events/ conditions. In the current business and economic environment, what may be a reasonable assumption today may no longer be so, a short time later. Hence there are limitations in the operation of IFCFS for the company’s future operations. Following are examples of uncertainties that might create limitations on IFCFS operating as at the balance sheet date:

• Uncertainties around management’s ability to execute its turnaround strategy such as addressing reduced demand and to renew or replace funding especially where market value of unencumbered assets has deteriorated.

• Effect of business disruptions e.g., disruption of supply chain.

•  Effect of actions of the company on its long-term solvency e.g., deferral of payment of trade payables may affect long term solvency of the company.

• Where support letter has been provided by the Parent company – the uncertainties around the ability of the Parent company to discharge the obligations of the subsidiary as and when they fall due.

Accordingly, where a material uncertainty relating to going concern has been identified, the auditor should assess the inherent limitations on the operation of the IFCFS regarding the future operations of the company and should appropriately disclose such limitations in the audit report pursuant to requirements of the Guidance Note.

MATERIAL PRIOR PERIOD ERRORS
While auditing the financial statements for the current year, material errors in the financial statements of the previous years might be identified. Prior period errors occurs if undisclosed income of previous years is identified in the current year or due to mathematical mistakes, mistakes in applying accounting policies in respect of recognition, measurement, presentation, or disclosure, etc. Examples of prior period errors could be where due to the effects of inadequate controls on cut-offs, excess revenue was recognised in previous years. Another example could be where unaccounted cash was generated from scrap sale of previous years.

•    Schedule III to the 2013 Act requires companies to provide:

•    Details of any transaction not recorded in the books of accounts that has been surrendered/ disclosed as income during the year in the tax assessments, unless there is immunity for disclosure under any scheme. The company is also required to state whether the previously unrecorded income and related assets have been properly recorded in the books of account during the year.

•    Specific disclosures for Ind AS compliant company e.g., changes in other equity due to prior period errors.

•    CARO 2020 has also prescribed reporting obligations for auditors in case of undisclosed income.

Under the Guidance Note, errors observed in previously issued financial statements in the current financial year or restatement of previously issued financial statements to reflect the correction of a material misstatement has been included as an indicator of material weakness5. Where a material weakness in IFCFS exists, the Guidance Note requires the auditor to modify the IFCFS opinion. In determining the type of modification, i.e., qualification, disclaimer, or adverse the auditor should assess its pervasiveness of the material weakness, which might include the following:

• Manner of treatment of the prior period error in the current year’s financial statements . As per the Guidance Note, pervasive effect on the IFCFS include those matters that impacts the audit opinion on the company’s financial statements. It might be noted that under Ind AS 8, the material prior period errors are corrected by restating the comparative amounts unless such restatement is impracticable. Under AS 4, comparatives are not restated but are normally included in the determining net profit or loss for the current period.

•  The root cause which resulted in a material prior period error.

• The combination of the identified material weakness with other aspects of the financial statements, e.g., linkage with data used in management estimates or effect of the prior period error on the disclosures.

• The interaction of the control which failed to detect material misstatement with other controls, (e.g., the interaction of General IT controls, linkage to a transaction-level control or financial reporting process such as controls over the prevention and detection of fraud, significant transactions with related parties, controls over the financial statement close process).

PRIOR PERIOD ERRORS IDENTIFIED BY THE MANAGEMENT
There might be a situation where material prior period errors were identified by the management through its internal controls. Even in such case, the above mentioned considerations would be relevant to assess the consequential implications. As per the Guidance Note, the auditor should report if the company has adequate internal control systems in place and whether they were operating effectively as at the balance sheet date. It should be noted that when forming the opinion on internal financial controls, the auditor is required to test the same during the financial year under audit (and not just as at the balance sheet date) though the extent of testing at or near the balance sheet date may be higher, e.g. if the company’s revenue recognition was erroneous throughout the year but was corrected, including for matters relating to internal control that caused the error, as at the balance sheet date, the auditor is not required to report on the errors in revenue recognition during the year.

Accordingly, the auditor should assess the design and operating effectiveness of the new/ revised controls implemented by the management which aims to augment the book close process and avoid erroneous financial reporting. Where the new/ revised controls operate effectively by the balance sheet date and the auditor concludes that no material weakness exists as at the balance sheet date, the audit opinion on IFCFS would be unmodified.

EXEMPTION TO AUDITORS OF CERTAIN PRIVATE COMPANIES FROM REPORTING ON IFCFS
MCA has exempted auditors from reporting on IFCFS of a private company if such private company’s turnover is less than INR 50 crores as per latest audited financial statements and the aggregate borrowings from banks or financial institutions or anybody corporate at any point of time during the financial year is less than INR 25 crores. However, this exemption can be availed only if the private company has not committed a default in filing its financial statements under section 137 or annual return under section 92 of the 2013 Act. The assessment of the qualifying criteria poses certain challenges – some of them are discussed below:

ASSESSMENT OF TURNOVER CRITERIA
Financial statements under Schedule III do not disclose ‘Turnover’ but instead disclose ‘Revenue from operations.’ The items comprising turnover and revenue from operations are similar to a very large extent, but differences exist – as stated below:

Turnover as
defined under section 2(91) of the 2013 Act means aggregate value of the
realisation of amount made from:

 

  Sale,
supply or distribution of goods or


Services rendered, or both,

 

by the company during a financial year.

Under Schedule III Revenue From
operations
comprise:

 


Sale of products,


Sale of services


Grants or donations received (in case of section 8 companies only) and


Other operating revenues.

It might be noted that there is no specific reference of ‘Other operating revenues’ in the definition of turnover. ‘Other operating revenues’ include revenue arising from a company’s operating activities, i.e., either its principal or ancillary revenue-generating activities, but which is not revenue arising from the sale of products or rendering of services.

In order to derive the amount of turnover, the auditor should:

•  First, consider the amount of sale of products and sale of services as appearing in the latest audited financial statements.

•  Next, the auditor should obtain a breakup of other operating revenues to identify items, if any, that might qualify as turnover e.g., sale of manufacturing scrap would qualify as turnover as it arises during the process of manufacturing of finished goods. Similarly, government grants recognised under other operating revenues should be excluded as it is neither earned from the sale of goods nor the rendition of services.

ASSESSMENT OF BORROWING CRITERIA
One of the conditions for availing the exemption is that if ‘at any point of time’ during the financial year, prescribed borrowings are less than INR 25 crores. This seems to imply that the exemption is available even if borrowings from banks or financial institutions, or any body corporate is less than INR 25 crores in any day of the year under audit. The proposition is explained through the following illustrations:

Borrowings
from banks/financial institutions/body corporate

Exemption
available?

As at 1
April 20X1

2 April
20X1 to 31 March 20X2

Balance
as at 31 March 20X2

Nil

Borrowing
of INR 100 crores raised

INR 100
crores

Yes

INR 500
crores

? Borrowing of INR 100 crores raised on 5
April 2021

? Entire borrowing of INR 600 crores repaid
on 30 March 20X2 (i.e., one day before year end)

Nil

Yes

INR 90
crores

INR 5
crores repaid

INR 85
crores

No

Accordingly, the auditor should obtain the movement of borrowings, if any, from prescribed parties and assess whether the thresholds for availing exemption are met.

IFCFS REPORT ON CONSOLIDATED FINANCIAL STATEMENTS
The consolidated financial statements of a private company might include certain subsidiaries/ associates/ joint ventures which are exempted from obtaining auditor’s report on IFCFS at standalone level pursuant to the MCA exemption, as discussed above. This creates quite interesting situations and poses unique challenges to the auditors of the holding company while opining on IFCFS of the consolidated financial statements:

Section 129(4) of the 2013 Act states that the provisions of the 2013 Act is applicable to the preparation, adoption and audit of the financial statements of a holding company shall, mutatis mutandis, apply to the consolidated financial statements. Accordingly, all consolidated financial statements prepared under the 2013 Act should be accompanied with the auditor’s report (including annexures thereon) unless specifically exempted under the 2013 Act. Thus, in the above illustrative scenarios as well, the auditor of the Parent company would need to report on IFCFS of consolidated financial statements.

The Guidance Note provides that reporting on the adequacy of IFCFS on consolidated financial statements would be on the basis of the audit reports as submitted by the statutory auditors at the standalone level. Hence, where IFCFS report has not been provided due to the exemption, auditors of such companies are not required to separately provide an audit report on IFCFS to the auditor of the Parent Company as this would nullify the MCA exemption. Thus, basis the Guidance note, in the above scenarios, the audit report of IFCFS on consolidated financial statements should state that the IFCFS report covers only those companies on which the IFCFS report has been provided at the standalone level. The auditor may consider including a statement in the introductory paragraph of the IFCFS report in this regard as this would clearly set out the coverage and scope of the IFCFS report on consolidated financial statements. The auditor should consider consequential changes to the IFCFS report regarding references of the exempted private company.

In a nutshell

•    Considering the multitude of changes, an early dialogue with the stakeholders, including the auditors, would help mitigate implementation challenges to a large extent. For continuing requirements, auditors should reassess if any change in the audit strategy basis his experience would be necessary.
•    The auditor should consider the consequential effect of observations in IFCFS on other aspects of audit report ,e.g., Reporting on adverse effect on the functioning of the company [Section 143(3)(f)].

CARO 2020 SERIES: NEW CLAUSES AND MODIFICATIONS RESIGNATION OF STATUTORY AUDITORS AND CSR

(This is the eighth and last article in the CARO 2020 series that started in June, 2021)

PART A – RESIGNATION OF STATUTORY AUDITORS

 

BACKGROUND

There have been several instances of resignations by statutory auditors mid-way through their tenures in the recent past. Whilst that may be legally permissible, what is more important is whether there is anything which is more than what meets the eye in the resignation that the incoming auditor needs to know. Also, resignation of an auditor of a listed entity/its material subsidiary before completion of the review/audit of the financial results/statements for the year due to frivolous reasons such as pre-occupation may seriously hamper investor confidence and deny them access to reliable information for taking timely investment decisions.

SCOPE OF REPORTING

The scope of reporting pertaining to the aforesaid clause is as under:Whether there has been any resignation of the statutory auditors during the year, if so, whether the auditor has taken into consideration the issues, objections or concerns raised by the outgoing auditors. [Clause 3(xviii)]

PRACTICAL CONSIDERATIONS IN REPORTING

Before proceeding further it would be pertinent to note certain statutory requirements and professional pronouncements.SEBI Circular [CIR/CFD/CMD1/114/2019 dated 18th October, 2019]

The key requirements in respect thereof are summarised hereunder:

a) All listed entities/material subsidiaries shall ensure compliance with the following conditions while appointing/re-appointing an auditor:

• If the auditor resigns within 45 days from the end of a quarter of a financial year, then the auditor shall, before such resignation, issue the limited review/ audit report for such quarter.

• If the auditor resigns after 45 days from the end of a quarter of a financial year, then the auditor shall, before such resignation, issue the limited review/ audit report for such quarter as well as the next quarter.

• Notwithstanding the above, if the auditor has signed the limited review/ audit report for the first three quarters of a financial year, then the auditor shall, before such resignation, issue the limited review/ audit report for the last quarter of such financial year as well as the audit report for such financial year.

b) The auditor proposing to resign shall bring to the notice of the Audit Committee the reasons for his resignation including but not limited to areas where he has not been provided the necessary information / documents and explanations to matters raised during and in connections with the audit.

c) The above information has to be provided to the company in the format specified in Annexure A of the Circular, as under:

Sr.
No.

Particulars

1

Name of the listed
entity/ material subsidiary:

2

Details of the
statutory auditor:

a. Name:

b. Address:

c. Phone number:

d. Email:

3

Details
of association with the listed entity/ material subsidiary:

a.
Date on which the statutory auditor was appointed:

b.
Date on which the term of the statutory auditor was scheduled to expire:

c.
Prior to resignation, the latest audit report/limited
review report submitted by the auditor and date of its submission.

4

Detailed
reasons for resignation:

5

In
case of any concerns, efforts made by the auditor prior to resignation
(including approaching the Audit Committee/Board of Directors along with the
date of communication made to the Audit Committee/Board of Directors)

6

In
case the information requested by the auditor was not provided, then
following shall be disclosed:

a.
Whether the inability to obtain sufficient appropriate audit evidence was due
to a management-imposed limitation or circumstances beyond the control of the
management.

 

b.
Whether the lack of information would have significant impact on the
financial statements/results.

 

c.
Whether the auditor has performed alternative procedures to obtain
appropriate evidence for the purposes of audit/limited review as laid down in
SA 705 (Revised).

 

d.
Whether the lack of information was prevalent in the previous reported
financial statements/results. If yes, on what basis the previous
audit/limited review reports were issued.

7

Any other facts
relevant to the resignation:

Declaration
I/ We hereby confirm that the information given in this letter and its attachments is correct and complete.

I/ We hereby confirm that there is no other material reason other than those provided above for my resignation/ resignation of my firm.

Signature of the authorized signatory

Date:
Place:
Enclosures:

d) The listed entity / material subsidiary should cooperate in providing all the information and documents as requested by the auditor.

e) Disclosure should be made by the company as soon as possible but not later than twenty four hours of the Audit Committees’ views.

Duty of Outgoing Auditor [Section 140(2) of Companies Act, 2013]

The auditor who has resigned from a company shall file within a period of 30 days from the date of resignation a statement in Form ADT-3 with the company and the Registrar of Companies. In the case of a government company or any other company-owned or controlled by any of the governments, the auditor shall also file such a statement with the Comptroller and Auditor-General of India.

Clause 8 of Part I of First Schedule of the Chartered Accountants Act, 1949

A Chartered Accountant in practice shall be deemed to be guilty of professional misconduct, if he accepts a position as auditor previously held by another chartered accountant without first communicating with him in writing;

The underlying objective is that the member may have an opportunity to know the reasons for the change in order to be able to safeguard his own interest, the legitimate interest of the public and the independence of the existing accountant. It is not intended, in any way, to prevent or obstruct the change. When making the enquiry from the outgoing auditor, the one proposed to be appointed or already appointed should primarily find out whether there are any professional or other reasons why he should not accept the appointment.

The existence of a dispute as regards the fees would not constitute valid professional reasons on account of which an audit should not be accepted by the member to whom it is offered. However, in the case of an undisputed audit fees for carrying out the statutory audit under the Companies Act, 2013 or various other statutes having not been paid, the incoming auditor should not accept the appointment unless such fees are paid.

Implementation Guide on Resignation/ Withdrawal from an Engagement to Perform Audit of Financial Statements Issued by ICAI (the “Implementation Guide”)

In view of the increasing instances of withdrawal from audit engagements mid-way through the tenure, the ICAI has issued the above Implementation Guide that the outgoing and incoming auditors need to be aware. The Implementation Guide identifies various reasons for the resignation of auditors as under:

• SA 210 “Agreeing to the Terms of Audit Engagements” – If the auditor is unable to agree to a change in the terms of the audit engagement and is not permitted by the management to continue the original audit engagement, the auditor shall withdraw from the audit engagement.

• SA 220 “Quality Control for an Audit of Financial Statements” – If the engagement partner is unable to resolve the threat to independence with reference to the policies and procedures that apply to the audit engagement, if considered appropriate, the auditor can withdraw from the audit engagement.

• SA 240, “The Auditor’s Responsibilities relating to Fraud in an Audit of Financial Statements” – If, as a result of a misstatement resulting from fraud or suspected fraud, the auditor encounters exceptional circumstances that bring into question the auditor’s ability to perform the audit, the Standard suggests the withdrawal from the engagement as one of the options, subject to following certain procedures and measures.

• SA 315, “Identifying and Assessing the Risks of Material Misstatements Through Understanding the Entity and its Environment” – Concerns about the competence, integrity, ethical values or diligence of management, or about its commitment to or enforcement of these, may cause the auditor to conclude that the risk of management misrepresentation in the financial statements is such that an audit cannot be conducted. In such a case, the auditor may consider, where possible, withdrawing from the engagement, unless those charged with governance put in place appropriate corrective measures.

• SA 580, “Written Representations”– If the auditor is unable to obtain sufficient appropriate audit evidence, then the auditor is expected to determine the implications thereof to decide whether to qualify the opinion or to resign.

• Non-payment of auditor’s remuneration.

• Issuance of a Qualified report.

The Implementation Guide emphasises that the auditor is expected to describe the above specific circumstances, amongst others, while giving the reasons for resignation, instead of mentioning ambiguous reasons such as other preoccupation or personal reasons or administrative reasons or health reasons or mutual consent or unavoidable reasons.

Keeping in mind the above reporting requirements, the following are some of the practical considerations that could arise whilst reporting under this clause:

a) Modified Report issued by the outgoing auditor:-The nature and extent of the modification should be critically evaluated by the incoming auditor both from a qualitative and quantitative perspective. In doing so he may have to generally rely on oral discussions with the outgoing auditor since he may not be willing to part with the internal documentation and working papers, especially if it is an unlisted / non-public interest entity to which the SEBI circular mentioned earlier would not apply. In such circumstances he should advise the outgoing auditor to communicate in writing the specific reasons for withdrawal as per the Implementation Guide mentioned above to the appropriate level of management and those charged with governance and insist on a copy thereof, especially if the minutes do not reveal much. In such cases, there is no rule, written or unwritten, which would prevent an auditor from accepting the appointment in these circumstances once he has conducted proper due diligence before accepting the audit. He may also consider the attitude of the outgoing auditor and whether it was proper and justified.

b) Performing appropriate due diligence before stepping into the Outgoing Auditors shoes:- It is imperative that the incoming auditor undertakes appropriate inquiries and performs due diligence procedures as under before stepping into the shoes of the outgoing auditor who has withdrawn from the engagement:

(i) Evaluate diligently about the entity, the scope of the mandate, the resources (time, manpower and competence) available to execute the audit and then take a conscious call to accept or not to accept the engagement.

(ii) Have auditors frequently resigned from the entity in the past.

(iii) Evaluate the reasons for issuance of qualified, disclaimer opinion by the outgoing auditor.

(iv) Whether entity is regular in payment of statutory dues.

(v) Review the financial statements to ascertain any indication that the going concern basis may not be appropriate.

(vi) Check and understand accounting policies or treatment of specific transactions that cast doubt on the integrity of the financial information.

(vii) Are there issues arising from communication with the outgoing auditors, professional or otherwise, which suggest that the incoming auditor should decline the appointment.

(viii) Check whether the entity is involved in any long drawn litigation with the regulatory authorities.

(ix) Consider any other information available in the public domain.

CONCLUSION
The regulators have tightened the rules for withdrawal by statutory auditors from the engagement midway through their tenure to ensure that companies do not go scot-free and brush under the carpet any irregularities and misappropriations. The reporting responsibilities under this clause would ensure that there is a proper channel of communication between the incoming and outgoing auditors regarding any adverse matters concerning the entity.

PART B – CORPORATE SOCIAL RESPONSIBILITY (CSR)

BACKGROUND

The provisions dealing with CSR have been in force for a few years and many companies have now ingrained it as part of their DNA. Earlier, the approach of the regulators was more in the nature of ‘comply or report’. However, the emphasis is now on ensuring that companies take their CSR obligations more seriously. Earlier, there was no responsibility on auditors to comment on CSR compliance separately, and only the Board of Directors were required to report on the same. However, reporting under CARO 2020 would ensure greater accountability on companies who were not taking CSR seriously.SCOPE OF REPORTING
The scope of reporting pertaining to the aforesaid clause is as under:

a) Whether, in respect of other than ongoing projects, the company has transferred unspent amount to a Fund specified in Schedule VII to the Companies Act within a period of six months of the expiry of the financial year in compliance with second proviso to sub-section (5) of section 135 of the said Act. [Clause 3(xx)(a)]
b) Whether any amount remaining unspent under sub-section (5) of section 135 of the Companies
Act, pursuant to any ongoing project, has been transferred to special account in compliance with the provision of sub-section (6) of section 135 of the said Act. [Clause 3(xx)(b)]

PRACTICAL CONSIDERATIONS AND CHALLENGES IN REPORTING

Before proceeding further it would be pertinent to note certain 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:

Where the company covered under section 135 of the companies act, the following shall be disclosed with regard to CSR activities in the financial statements;

1

amount
required to be spent by the company during the year,

2

amount
of expenditure incurred,

3

shortfall
at the end of the year,

4

total
of previous years shortfall,

5

reason
for shortfall,

6

nature
of CSR activities,

7

details
of related party transactions, e.g., contribution to a trust controlled by
the company in relation to CSR expenditure as per relevant Accounting
Standard/ Indian Accounting Standard,

8

where
a provision is made with respect to a liability incurred by entering into a
contractual obligation, the movements in the provision during the year should
be shown separately.

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.

Other Relevant Statutory Provisions

Section 135(5) and (6) of the Companies Act, 2013

Section 135(5):
The Board of Directors of every eligible company shall ensure that the Company spends in every financial year, at least 2% of the average net profits of the company during the 3 immediately preceding financial years, in pursuance of the CSR policy. The net profit shall be as computed in terms of section 198.

The expression “three immediately preceding financial years” in sub-section (5) shall be read as number of years completed by a newly incorporated company.

“Unspent amount” as referred to in sub-section (5) unless relates to an “ongoing project” shall be transferred to a fund specified in Schedule VII within 6 months of the end of the financial year.

Section 135(6):
Any amount remaining unspent under sub-section (5), pursuant to any ongoing project, fulfilling such conditions as may be prescribed, undertaken by a company in pursuance of its Corporate Social Responsibility Policy, shall be transferred by the company within a period of thirty days from the end of the financial year to a special account to be opened by the company in that behalf for that financial year in any scheduled bank to be called the Unspent Corporate Social Responsibility Account, and such amount shall be spent by the company in pursuance of its obligation towards the Corporate Social Responsibility Policy within a period of three financial years from the date of such transfer, failing which, the company shall transfer the same to a Fund specified in Schedule VII, within a period of thirty days from the date of completion of the third financial year.

Permissible CSR Activities [Schedule VII read with the Rules]:

Schedule VII prescribes the following broad heads of activities on which the prescribed classes of Companies need to spend to fulfil their CSR obligations:

Sub

Clause

Broad
Area

Projects
or Programmes related to Activities in the following areas

i)@

Hunger,

Healthcare,

Sanitation etc.

• Eradicating extreme hunger, poverty and
malnutrition 

• Promoting health care including
preventive health care and sanitation

• Contribution to the Swatch Bharat Kosh.

• Provision for aids and appliances to
differently abled persons *

i)@

(continued)

• Disaster relief in
the form of medical aid, supply of clean drinking water and food supply*

• Trauma care around
highways in case of accidents*

• Supplementing of
Government Schemes like mid-day meal by corporates through additional
nutrition*

• Enabling access to
or improving delivery of public health systems (also covered under Clause iv
below)*

• Social Business
Projects involving giving medical and legal aid to road accident victims*
(also under Clause ii below)

ii)@

Education and vocational skills

• Promotion of education including special
education and employment enhancing vocational skills amongst:

(i) children,

(ii) women,

(iii) elderly, and

(iv) differently abled.

• Road safety awareness programmes
including drivers training, training
to enforcement personnel, traffic safety*

• Awareness of the above aspects through
print, audio and visual media*

• Setting up of Research Training and
Innovation Centres  for the benefit of
predominantly the rural community covering the following aspects:

(i) Capacity building for farmers covering best
sustainable farm management practices*

(ii) Training agricultural labour on skill development*

• Providing Consumer Protection Services
covering the following aspects:

(i) Providing effective consumer grievance redressal
mechanism*

(ii) Protecting consumer’s health and safety,
sustainable consumption, consumer service, support and complaint resolution*

(iii) Consumer rights to be mandated*

(iv) All other consumer protection programmes and
activities*

• Donations to IIMs for conservation of
buildings and renovation of classrooms (also covered under clause v below)*

• Donations to Non Academic Technopark not
located within an academic institution
but supported by the Department of Science and Technology*

• Research and case studies in the areas
specified in Schedule VII (normally under the respective areas and, if not,
under this clause)*

iii)

Gender
equality

and

empowerment
of

disadvantaged

sections

• Promoting gender equality,

• Empowering women,

• Setting up of hostels, old age homes and
hostels for women and orphans, day care centres and such other

facilities for senior citizens, and

• Measures for reducing inequalities faced
by socially and economically backward groups.

• Slum Rehabilitation Projects and EWS
Housing*

iv)

Environmental

and
ecological

sustainability
and

conservation
of

natural
resources

• Maintaining ecological balance,

• Protection of flora and fauna,

• Maintaining quality of air and water

• Contribution to the Clean Ganga Fund

• Setting up of Research Training and
Innovation Centres for the benefit of predominantly the rural community
covering the following aspects:

(i) Doing own research on the field for individual
crops to find out the most cost optimal and agri-ecological sustainable farm
practices with a focus on water management*.

(ii) To do Product Life Cycle Analysis from the solid
conservation point of view*

• Renewable energy projects*

v)

Heritage,
Art and

Culture

• Protection of natural heritage,

• Protection of art and culture,

• Restoration and maintenance of related
buildings and sites of historical importance and works of art,

• Setting up public libraries,

• Promotion and development of traditional
arts and handicrafts

vi)

Armed
Forces

Measures for the benefit of:

(i) armed forces,

(ii) veterans, and

(iii) war widows.

vii)

Sports

• Training to promote:

(i) rural sports,

(ii) nationally recognised sports,

(iii) paralympic sports, and

(iv) Olympic sports

Any training provided outside India to
sports personnel representing any State or Union Territory at National or
International level.

viii)

Political

Contributions

• Contributions to Prime Ministers National
Relief fund
or

• Contributions to other funds set up by
the Central

Government for socio economic development
and relief and for the welfare of:

(i) Scheduled Castes,

viii)

(continued)

(ii) Scheduled Tribes

(iii) other backward classes and

(iv) women

ix)

Technology

Incubators

Contributions or funds provided to
technology incubators located within academic institutions approved by the
Central Government.

x)

Rural Development Projects

Any project meant for development of rural
India will be covered*

xi)

Slum Development Projects

Any project for development of slums would
be covered

xii)

COVID -19 Related Areas

Funds may be spent for COVID-19 purposes
under the following activities/Funds:

  Eradicating hunger, poverty and
malnutrition $

   Disaster
Management, including relief, rehabilitation and reconstruction activities $

   Contribution
to PM Cares Fund $

   Contribution
to State Disaster Management Authority $

    Ex-gratia
payment to temporary/casual/daily wage workers for the purpose of fighting
COVID-19 $

   Spending for setting up makeshift
hospitals and temporary COVID care facilities will be eligible under items
(i) and (xii) of Schedule VII. #

     Companies
engaged in R & D activities for new vaccines, drugs and medical devices
in the normal course of business may undertake similar new activities for
COVID-19 related matters for FYs 2020-21, 2021-22 and 2022-23 subject to the
following conditions:

a) Such
activities are carried out in collaboration with institutes or organisations
mentioned in item ix of Schedule VII

b)
Details thereof are disclosed in the Annual Report on CSR Activities

[Inserted
in the CSR Amendment Rules vide notification dated
24th August, 2020]

*As per the MCA Circular dated 18th June, 2014 providing clarifications on various aspects related to CSR activities.

@ The above referred circular provides that the items included under sub clauses (i) and (ii) above, should be interpreted liberally so as to capture their essence.
The above circular has also clarified on certain related aspects as under:

• One off events like marathons, awards, charitable concerts, sponsorship programmes etc. would not qualify as CSR expenditure.
Only activities undertaken in project / programme mode are permissible.
• Expenses incurred in pursuance of legal obligations under Land, Labour or other laws would not quality as CSR expenditure.

$ As per MCA Circular dated 23rd March, 2020.
# As per MCA Circular dated 22nd April, 2021.

Monitoring Unspent Funds:
The provisions dealing with tracking and treatment of unspent funds, excess amounts spent and capital assets created or acquired as per the recent amendments which are crucial to reporting under this clause are tabulated and summarised hereunder:

Note:

The Funds specified under Schedule VII are as under:
• PM National Relief Fund
• Swach Bharat Kosh
• Clean Ganga Fund
• PM CARES Fund
• State Disaster Management Authority
• Skill Development Fund

Excess Amounts Spent:
As per the amended Rules, notified on 22nd January, 2021, any excess amount beyond the prescribed limit can be set off against the spending requirements in the immediately succeeding three financial years subject to the following conditions:

a) The excess amount available for set-off shall not include any surplus arising out of the CSR activities.

b) The Board of Directors shall pass a resolution specifically permitting the same.

The aforesaid carry forward shall not be allowed for excess amounts spent during any financial year ended before 22nd January, 2021.

Creation and Acquisition of Capital Assets:
As per the amended Rules, any CSR amounts may be utilised by a Company towards creation or acquisition of capital assets, only if the assets are held by any of the following:

a) A company registered under Section 8 of the Act, or a Registered Public Trust or Society having charitable objects and a CSR Registration Number; or

b) Beneficiaries of the said CSR project in the form of Self-Help Groups or Collective Entities; or

c) A public authority.

In case of any such assets existing prior to the amendment i.e. 22nd January, 2021, the same shall be transferred within 180 days from the commencement date.

Keeping in mind the above reporting as well as requirements, the following are some of the practical challenges that could arise in reporting under these clauses:

a) Reporting Issues and Challenges in the Initial Period of Applicability:- The amendments are prospective from 22nd January, 2021. Accordingly only the unspent amount for F.Y. 2020-21 in respect of other than ongoing projects needs to be transferred to the fund specified in Schedule VII within six months from the end of the financial year. This is the case even if the Company has unspent amounts in earlier years. However, if the Company has made provisions for unspent amounts of the earlier years, which remains outstanding as on 31st March, 2021 the same should be transferred to the separate bank account or Schedule VII fund as the case may be within the prescribed periods as indicated earlier. The auditors should ensure that appropriate factual disclosures are made where deemed necessary. Further, there could be several other practical issues which could be encountered in the first year of reporting, few of which are discussed hereunder together with their possible resolution by the auditors, coupled with appropriate reporting of all relevant facts as deemed necessary based on their best judgement:

Issues

Possible
Resolution

A Company has a running project that was
commenced few years back and is expected to continue for next 2 years. Can
this be considered as an Ongoing project?

Subject to the definition of ongoing
project in terms of the timeline, the Board of Directors can henceforth
consider and approve this current running project as an Ongoing Project with
reasonable justification.

A CSR project was undertaken and
subsequently abandoned by Implementing Agency due to lack of additional
funds. Can this be considered as an Ongoing project? 

Subject to the definition of ongoing
project in terms of the time line, the Board of Directors can henceforth  consider and approve the aforesaid project
as an Ongoing Project with reasonable justification.

A Company contributed a certain amount to
the Implementing Agency for the construction of a hospital. It paid the full
amount in F.Y. 2020-21, whereas the hospital is expected to be completed in
F.Y. 2022-23. Can this be considered as an Ongoing project? 

If the Company has already paid the whole
amount of its CSR obligations during F.Y. 2020-21, then it is not required to
consider it as Ongoing Project. However, it is the duty of the Board as per
Rule 4 (5) to satisfy itself that the funds so disbursed have been utilized
for the purpose and in the manner as approved by it and the CFO or the person
responsible for financial management need to certify to that effect. Hence
the Company needs to have a report from the Implementation Agency for the
spends and utilization of funds and report it in the Board Report for F.Y.
2020-21 with facts and details. Further, a mandatory impact assessment
needs to be done by a Monitoring Agency in case of companies with mandatory
spending of Rs. 10 crores or more in the three immediately preceding
financial years and for individual project outlays in excess of Rs.1 crores as
per the amended Rules.

b) Monitoring in case of Multiple Projects:– In case of companies having huge CSR budgets and financing multiple projects, both ongoing and others, a robust internal control mechanism would have to be implemented to monitor project-wise utilisation to ensure that unspent amounts are transferred on a timely basis and their subsequent utilisation in case of ongoing projects, which needs to be verified by the auditors to enable them to report compliance under Clause 3(xx)(b). Whilst there is no requirement to maintain separate special bank accounts for each project it is desirable to ensure proper monitoring and greater transparency. The Board may consider laying an appropriate policy in this regard.

c) Funds Utilised towards acquisition of Capital Assets in earlier periods:- For companies that have utilised funds in earlier periods and shown them as capital assets, it is mandatory to transfer the same within 180 days from 22nd January, 2021 to the prescribed authorities /entities as indicated earlier. Though no specific reporting is required under these clauses, it would be incumbent on the auditors to verify the same as part of their audit and in case the report is dated after the expiry of the said period, he may consider drawing attention to the same since it is a statutory requirement. Similar factual disclosure could be considered in the case where the period of 180 days has not elapsed on the date of signing, and the same are not transferred.

d) Transactions with Related Parties:- In many companies, CSR obligations are fulfilled by transferring the funds to group entities registered as NPOs under Section 8/25 of the Companies Act, 2013 / 1956. In such cases, care should be taken to ensure that the same are towards approved projects. The monitoring of the same is done in accordance with the revised guidelines on monitoring and impact assessment, including the need for involving an external agency, if required, as discussed earlier. In case of any lapses or deficiencies noticed the same should be factually reported under Clause 3(xx)(b) based on materiality and use of judgement.

CONCLUSION
The additional reporting requirements have placed very specific responsibilities on the auditors to supplement the revised regulatory landscape of CSR of “comply or pay up”, which views CSR spending more as a tax then a social obligation. As is always the case, it is the auditors who have to bell the cat!

AUDIT QUALITY MATURITY MODEL – WHAT IS YOUR SCORE?

The Institute of Chartered Accountants of India (ICAI) has issued the Audit Quality Maturity Model – Version 1.0 (“AQMM” or the “Model“) in June, 2021. In the ICAI Council meeting held on 9th January, 2021, it was decided that both the Peer Review Board and the Centre for Audit Quality (CAQ) would need to develop an ecosystem that is acceptable to both. Such a collaborative approach would have the advantage of the CAQ developing the quality standards and the Peer Review Board testing the said standards.

Quality has always been the focus of ICAI. Recently, the Hon’ble Supreme Court told Bar Council of India’s lawyer, while asking to refrain from lowering the standards of entrance exams for law schools, “Look at how ICAI does it for Chartered Accountants. They control intake and also the quality.” The audit profession always had an enhanced focus on quality. The Model spells out the expectations from the audit firms in terms of audit quality, and Peer Review Board can test the implementation of these standards.

AQMM is initially recommendatory. In the Explanatory Memorandum on Applicability of AQMM, it is stated that the ICAI Council will review, after one year, the date from which it would become mandatory. Its applicability to firms is determined based on the firm’s audit clients. If a firm has the below types of audit clients, AQMM applies to them:
– A listed entity; or
– Banks other than co-operative banks (except multi-state co-operative banks); or
– Insurance companies.
Firms auditing only branches are not covered in the applicability.

MODEL TO MEASURE AUDIT QUALITY OF DIFFERENT FIRMS
When the user or consumer selects any service or product, he looks for the highest quality. Then why should audit as a service not have the highest quality that audit firm can deliver? It should have. However, how to measure the quality of audit that different firms provide? The final output, i.e. the audit report, is written based on Standards on Auditing. Nevertheless, the underlying audit on which it is based is a quality that stakeholder expects. Has the firm evaluated its audit quality? To answer these questions, ICAI has issued AQMM – the Model that has a scoring system based on the firm’s competencies. With this, the firm will be able to evaluate, in an objective manner, the quality of its audit and will also get guidance on its quality improvement areas. Every competency against which the firm scores low points indicates room for improvement.

Even though it is recommendatory, the drive has to come from within. By very nature itself, the audit profession has far-reaching consequences if quality is not followed. It is not similar to any other generic service available in the market. Through his audit report, the auditor assures various stakeholders of the financial statements of entities that carry out businesses affecting the entire economy. Every audit firm should regularly evaluate whether its service is of the highest quality. Just like good product brands enjoy a good reputation in the market due to their highest standards on quality, audit as a service also need to go through rigorous quality checks before it is delivered to the stakeholders. One may argue that when auditing standards are followed, it is good enough to ensure that audit quality is maintained. However, such an argument is not correct. The auditing standards help the auditor obtain reasonable assurance on the financial statements that he seeks to provide his opinion. However, complying with auditing standards, which is bare minimum expectation from auditor, by itself does not speak of audit quality. If one understands the difference between a product and another similar product that has gone through quality tests, AQMM exactly does that to the audit as a service. It adds quality tests to an audit being delivered by the auditor.

For an audit firm’s quality system, a quality audit is a critical part of the system. The audit landscape has changed over the years and is changing rapidly. Technology supports the audit in a big way – be it data analytics, various audit software being used by the audit firms or artificial intelligence in various audit tools.

VARIOUS QUALITY CONTROL MEASURES
There are several initiatives taken by the regulators to improve and review the audit quality. For example, ICAI has already issued Standard on Quality Control (SQC) 1, which requires the firms to establish system of quality controls. ICAI has also established the Financial Reporting Review Board (FRRB) that reviews general purpose financial statements and auditor’s reports to determine compliance with disclosure and presentation requirements. ICAI has also established Peer Review Board to conduct peer reviews. Since 2007, the Central Government has constituted Quality Review Board. AQMM is another such initiative that aims to improve audit quality.

AUDIT COMPETENCIES INCLUDED IN AQMM
AQMM is meant to identify which audit competencies are good, which are lacking and develop a roadmap for upgrading where the competencies are lacking. It is a self-evaluation guide for the audit firms to know their level of audit maturity. The guide looks at the overall firm as a whole and not only audit process. It considers the firm’s HR department, administration, IT support, legal department, etc. From an operations perspective, it considers the engagement team, leadership team, audit tools, networking team, MIS, etc.

The Model considers a firm’s competencies in the following three main areas:

1. Practice Management – Operation.
2. Human Resource Management.
3. Practice Management – Strategic / Functional.

Each of these areas is further sub-divided into specific elements in that area. The Model provides a scoring mechanism, i.e. the firm shall based on self-evaluation, calculate its score based on the score criteria and basis given in the Model. Therefore, this Model is like a marking mechanism for the audit firms to understand their Audit Quality Maturity. The Model provides various competencies that the firm should have. A score is given based on the presence or absence of such competency. For example, if the firm has the stated competency, it will get the score indicated in the Model. If the firm does not have such competency, it gets a zero score for such (non)competency. The Model also provides negative points for certain negative observations, which are described later in the article. The total maximum score that the Model provides is 600 points divided as a maximum of 280 points for Practice Management – Operation, a maximum of 240 points for Human Resource Management and a maximum of 80 points for Practice Management – Strategic / Functional. However, the Model does not give the basis for allotting a specific score to a particular competency. Therefore, there could be differing views where one may argue that a specific competency should have been given more weightage than to the other.

Let us understand the competencies included in each of the above areas.

1. Practice Management – Operation
The total of 280 points in this area is sub-divided into the following competencies:

Competencies

Maximum score

Practice areas of the firm

12

Work flow – practice manuals

16

Quality review manuals or audit tool

24

Service delivery – effort monitoring

36

Quality control for engagements

80

Benchmarking of service delivery

16

Client sensitisation

16

Technology adoption

64

Revenue, budgeting and pricing

16

Total

280

As expected, this area has maximum scoring because a large part of audit quality is reflected in the operational practice management of the firm. Within this, quality control for engagements carries the highest score. Quality control includes: competencies related to partner / quality review; percentage of engagements with ‘satisfactory’ rating based on a quality review; proportion of engagements without findings requiring significant improvements by ICAI or other regulatory bodies; audit documentation in compliance with Standard on Quality Control (SQC) 1; availability of accounting and auditing knowledge resources in soft copy archive form for Q&As, thought leaderships, dedicated technical desk, etc.; time spent on understanding the business of the client, identification of risks and planning audit engagement, etc.
How can firms improve their score in this area?

Though the scoring matrix gives a detailed break-up for various competencies, there are specific competencies that, in my view, the firms should focus on initially. These are very important from an audit quality perspective and will help them significantly improve the score.
These are:

1. Develop standard templates for the firm for engagement letters, management representation letters, audit documentation, audit reports, etc. The firms can also consider using templates issued by ICAI.

2. Develop standard checklists to ensure compliance with accounting and auditing standards.

3. Develop a practice manual of the firm that contains audit methodology ensuring compliance with auditing standards and their implementation.

4. Focus on the audit planning stage, including maintenance of documentation for hours budgeted, etc. Discuss and document client’s business understanding, risk assessment of material misstatement in accordance with Standard on Auditing 315, Identifying and Assessing the Risk of Material Misstatement through Understanding the Entity and its Environment.

5. Monitor audit progress, backlogs, unfinished engagements and client interactions so that audit can be completed within agreed timelines.

6. Use of audit tools, analytics, artificial intelligence-based audit procedures, etc.

7. Implement quality review process in the firm.

2. Human Resource Management
The total of 240 points in this area is sub-divided into the following competencies:

Competencies

Maximum score

Resource planning and monitoring as per
firm’s policy

28

Employee training and development

44

Resources turnover and compensation
management

104

Qualification skill set of employees and use
of experts

32

Performance evaluation measures carried out by the firm

32

Total

240

As this area relates to Human Resources (HR), its focus is on resources turnover and compensation. This competency has a maximum score compared to any other competency in the three main areas. Audit quality largely depends on the staff working on the engagement. Therefore, HR forms a critical area to ensure that quality staff is available for audits and resources turnover is well managed to ensure timelines are met. It is given that resources turnover cannot be eliminated, and therefore, the Model recognises this fact by stating the question as “Does the firm identify measures to keep the employee turnover minimal?” Compensation structuring goes hand in hand with resources turnover. This also includes building appropriate team structure, maintaining minimal employee turnover ratio, retention policy, identification of employee relationship with the firm, statutory contributions and other benefits made available by the firm, revolving door for audit staff, engagement level reviews and performance evaluation, access to technology and favourable remote working policies, gender diversity, holiday policies, staff well-being policies, employee surveys, recruitment policies and compensation mapped to knowledge and experience, etc. Many firms run specific programs to increase gender diversity. With additional family responsibilities compared to men, women may find path to leadership difficult which demands more of their time. There could have been more specific parameters to assess the quality of the resources and score based on such parameters, for example, the average number of years of audit experience per person the firm has, industry specialisation of the firm, etc.

How can firms improve their score in this area?

To start with, firms may consider implementing the following steps:
1. Develop a pyramid structure required to carry audits.
2. Determine training hours in a year per employee.
3. Maintain minimal employee turnover ratio, develop revolving door policy, holiday policy, compensation
policy.
4. Develop written key performance indicators for employees and partners.

3. Practice Management – Strategic / Functional
The total of 80 points in this area is sub-divided into the following competencies:

Competencies

Maximum score

Practice management

20

Infrastructure – Physical and others

48

Practice credentials

12

Total

80

Though this area shows a lesser score than the other two areas, this also has negative scoring. For negative scoring (non)competencies, the score considered is zero when such criteria are absent. If such criteria are present, it will give a negative score to the firm in this Model. For example, if the practice has an advisory as well as a decision, to not allot work due to unsatisfactory performance by the CAG office, it gets a negative five score. But if the firm does not have such non-competency, then the score is zero. Similar is the case if the firm has a negative assessment in the report of the Quality Review Board or if there has been a case of professional misconduct on the part of a member of the firm where he has been proved guilty.

Therefore, though the total shows a lesser maximum score in this area, there are many attributes that need to be considered here. Infrastructure competency in this area has a lot of significance. It includes branch network, centralised/decentralised branch activities, information security, data analytics tools, adequate infrastructure such as internet, etc., for remote working. As the name of the competency goes, it covers both types of infrastructures – physical and others. In the current times, physical infrastructure is losing relevance. As we have seen during the Covid pandemic, remote working has become a new normal. Technology has overcome the need for having a physical infrastructure, office space, meeting rooms, etc. For similar reasons, it is possible for the firms to work for clients in different geographies globally without having a branch presence in such geography. During Covid times, many global companies have outsourced their work to low-cost countries. It is possible for such country entrepreneurs to deliver the output only because of technology, without having any place of business in the client’s country/region. Therefore, the competency of physical infrastructure has become irrelevant now. Another concern over this competency is its relevance to audit quality. Having more branches and, therefore, getting higher score in the Model has no relation to the firms’ audit quality. A small firm with no branch may also have a very good quality in its audits. Therefore, keeping other factors the same, if such a firm scores less than other firms with more branches, does such score really speak of audit quality? Of course, not. The other competency of Practice Management includes balanced mix of experienced and new assurance partners, the firm’s independence as per ICAI Code of Ethics, Companies Act, 2013 and other regulatory requirements, whistle-blower policy, etc.

If based on the evaluation of performance by a government body or regulatory authority has resulted in debarment or blacklisting of the firm, it will have negative scoring.

How can firms improve their score in this area?

Some of the initial steps firms can consider in this area are:
1. Develop network through branches, affiliates, etc.
2. Get good connectivity through an intranet, internet, VPN and other means.

DETERMINING A FIRM’S LEVEL
Based on the total score, the Model defines four levels of firms. Level 1 is very nascent, and level 4 is a firm that has adopted standards and procedures significantly. These four levels are based on percentage in each section as less than 25%, 25% to 50%, 50% to 75% and above 75%. AQMM also clarifies that the status should not be publicised or mentioned by audit firms on any public domain such as professional documents, visiting cards, letterheads or signboards, etc., as it may amount to solicitation in view of the provisions of the Chartered Accountants Act, 1949.

CONCLUSION
Though AQMM is recommendatory, it is an excellent tool for self-evaluation by audit firms. Having said that, one may argue that a lesser score does not necessarily mean that audit quality is not ensured by the firm. But there needs to be an objective assessment of the quality, and AQMM would go a long way in such assessment. If audit firms follow the Model and improve their competencies, it will bring high quality across the audit profession. Therefore, it is a welcome step of providing such a standard Model to audit firms. In the coming years, if the firms voluntarily adopt this Model and improve their competencies, they will gain higher credibility in the eyes of the client given that their product, i.e. audit, has assured quality.

[The views expressed in this article by the author are personal.]

CARO 2020 SERIES: NEW CLAUSES AND MODIFICATIONS REPORTING ON FINANCIAL POSITION

(This is the seventh article in the CARO 2020 series that started in June, 2021)

BACKGROUND

One of the most important assumptions underlying the preparation of the financial statements is ‘going concern’. The trigger for the same rests on two underlying pillars- namely, cash losses and the ability to meet the existing financial liabilities within the foreseeable future, generally within one year from the balance sheet date.

The reporting requirements discussed hereunder on the above two pillars are very relevant in the scenarios whereby the companies are facing financial stress, or net worth has been eroded or in case of companies where there are significant doubts on their continuing as a going concern. These situations are particularly relevant in current times of stress on the business due to the COVID pandemic.

SCOPE OF REPORTING
The scope of reporting can be analysed under the following clauses:

Clause No.

Particulars

Nature of change, if any

Clause 3(xvii)

Cash Losses:

New Clause

Whether the company has
incurred cash losses in the financial year and in the immediately preceding
financial year, if so, state the amount of cash losses.

Clause 3(xix)

Financial Position
Including Financial Ratios:

New Clause

On the basis of the
financial ratios, ageing and expected dates of realisation of financial
assets and payment of financial liabilities, other information accompanying

(continued)

 

the financial statements,
the auditor’s knowledge of the Board of Directors and management plans,
whether the auditor is of the opinion that no material uncertainty exists as
on the date of the audit report that company is capable of meeting its
liabilities existing at the date of balance sheet as and when they fall due
within a period of one year from the balance sheet date.

 

PRACTICAL CHALLENGES IN REPORTING

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!.

REVISITING AUDITING STANDARDS

EXECUTIVE SUMMARY

Section 149(3) of the Companies Act, 2013 makes a short statement to the effect that, ‘Every auditor shall comply with the Auditing Standards’. This proviso legalised the necessity for auditors to follow Auditing Standards. The recent reports of the National Financial Reporting Authority (NFRA) on the work of the auditors raise a lot of questions about how (and also whether they should) Regulators look at Auditing Standards and whether the expectations of the Regulators from the auditing fraternity are changing.

Background to Auditing Standards

As mentioned earlier, section 143(9) of the Companies Act states that ‘Every auditor shall comply with the Auditing Standards’. This is followed by section 143(10) which clarifies that the Institute of Chartered Accountants of India, in consultation with the National Financial Reporting Authority (NFRA) would recommend Auditing Standards for adoption by the Central Government. Till that time, the Auditing Standards issued by the ICAI would have to be followed.

The ICAI has issued 40 Auditing Standards segregated into seven different areas:

Sl. No.

Area

No. of standards

1

General
principles and responsibilities

9

2

Risk
assessment and response to assessed risks

6

3

Audit
evidence

11

4

Using
the work of others

3

5

Audit
conclusions and reporting

6

6

Specialised
areas

3

7

Standards
on review engagements

2

 

Total

40

These standards cover an eclectic variety of areas and are comprehensive in their coverage to enable auditors of any type of entity to discharge their duty with confidence. The standards within the above broad areas are detailed below:

General principles and responsibilities

The nine Auditing Standards on general principles and responsibilities lay down the foundation for the Auditing Standards on other topics. These Standards cover an eclectic array of areas such as the terms of the audit engagement, quality control, documentation and the auditor’s responsibilities relating to fraud. In addition, they also provide guidance on consideration of other laws and regulations, communicating with Those Charged With Governance (TCWG) and communicating deficiencies in internal control. These are considered to be the general responsibilities of the auditor. While the terms of the audit engagement are best left to the auditor and the client, there should not be a situation where there is no engagement entered into at all just because of familiarity. In a similar vein, both the quality and quantity of the audit documentation maintained are equally important for the audit.

Risk assessment and response to assessed risks

One of the greatest risks in the preparation and presentation of financial statements is that of material misstatement. The six Auditing Standards on risk assessment and response to the risks that have been assessed by the auditor mandate planning the audit of financial statements and understanding the entity and its environment to assess risks of material misstatement. Since no audit can cover a comprehensive review of all transactions, one of the Auditing Standards covers the concept of materiality. It is also important that the auditor conduct some procedures as a response to the risks that he has assessed. The auditor would also have to evaluate the action to be taken on misstatements that have been identified during the audit.

Audit evidence

The importance of reviewing and retaining evidence that has been gathered during an audit can never be over-emphasised. The series of Auditing Standards on audit evidence describes what is audit evidence and provides specific considerations for specific items. External confirmations (such as bank balances and balances of trade receivables) would have to be obtained. As there would be a lot of audit evidence available regarding the entity being audited, the auditor has to use analytical procedures and sampling techniques to ascertain the quantum of evidence that he would need. The set of Auditing Standards on audit evidence provides guidance on transactions with related parties, subsequent events, assessing the going concern concept and obtaining written permissions.

Using the work of others

Many a time during an audit, the auditor has to use the work of other auditors such as Internal Auditors, Concurrent Auditors and Stock Auditors. It is also possible that the auditor may have to use the work of experts such as fair valuers for land and building and financial assets. These areas have been covered in the three Auditing Standards on using the work of others.

Audit conclusions and reporting

The finished product or the end result of an audit assignment is the issuance of the Audit Report. The Audit Report contains different paragraphs such as forming an opinion and reporting on the financial statements, communicating Key Audit Matters in the independent auditors’ report, communicating matters that in the opinion of the auditors need emphasis (Emphasis of Matter) and modification to the opinion in the Independent Auditors’ Report. All of the above areas have been covered in separate Auditing Standards.

Specialised areas

Often, auditors are engaged to attest financial statements prepared in accordance with special purpose frameworks. For example, the Securities and Exchange Board of India (SEBI) mandates auditors to attest the financial statements presented in the draft red herring prospectus that precedes an IPO. The 800 series of Auditing Standards provides guidance on how these should be conducted and reported.

Standards on review engagements

On some occasions, auditors are asked to review historical financial statements and review interim financial information. SEBI requires auditors to perform a limited review of the quarterly results of listed companies. The standards on review engagements have been issued with the intention of enabling auditors to carry out these engagements. Since the review engagements are not audits, it is necessary that the Audit Report states these facts – these and other matters have been covered in the standards on review engagements.

The opinion of the auditors in their Audit Report is based on their conducting the audit on the basis of Auditing Standards prescribed by section 143(10) of the Companies Act, 2013.

In the present environment where business transactions are becoming complex and technology drives almost everything, the task of auditing becomes riskier. Recently, Regulatory investigations and interventions have also focused on compliance with Auditing
Standards.

IS THERE A CHANGE IN THE EXPECTATIONS OF AUDITORS FROM USERS OF FINANCIAL STATEMENTS?

One of the contexts in which the importance of Auditing Standards needs to be viewed is whether there is a change in the expectations of auditors from users of financial statements. In 1896, Justice Lopez ruled in the case of Kingston Cotton Mills that the auditor is a watchdog and not a bloodhound. Those days are long gone. To take an analogy from cricket, auditors these days are more like an umpire who needs to report on anything that needs to be reported by the laws or regulations without fear or favour. Auditing Standards are the tools that the auditor will use to report. Although there is a vast array of Auditing Standards, the users of financial statements cannot expect the auditor to detect well-conceived fraudulent transactions. However, the auditor would be able to sensitise the users of financial statements on areas that are of concern to him. It is up to the management to take note of these and ensure that corrective action is taken. Using Key Audit Matters, Emphasis of Matter and other paragraphs permitted by Auditing Standards, the auditor should be able to red-flag issues that could snowball into a crisis later.

AUDIT RISKS

In the present environment, audit risks have increased manifold. Over the last decade or so, most Regulators all over the world have had to issue negative comments on auditors who failed to report on entities that were deteriorating rapidly and ultimately had to either apply for bankruptcy or be sold at a bargain. A leading real estate company in the UK and a company in the infrastructure development and financing space in India are cases in point. In both these cases, auditors were auditing these companies for a very long time and hence were aware of the pain points. Yet, they failed to report on these. An extract from the report of the NFRA on the auditors of one of the companies reads:

‘This AQR has the objective of verifying compliance with the Requirements of Standards on Auditing (SAs) by the audit firm relevant to the performance of the engagement. The AQR also has the objective of assessing the Quality Control System of the audit firm and the extent to which the same has been complied with in the performance of the engagement.’

As a part of the conclusion, the report states:

‘The instances discussed below of failure to comply with the requirements of the SAs are of such significance that it appears to the NFRA that the audit firm did not have adequate justification for issuing the Audit Report asserting that the audit was conducted in accordance with the SAs. In this connection, the NFRA wishes to draw attention to Response 12 in the ICAI’s Implementation Guide on Reporting Standards (November, 2010 edition) that says that “A key assertion that is made in this paragraph is that the audit was conducted in accordance with the SAs”; and that “If during a subsequent review of the audit process, it is found that some of the audit procedures detailed in the SAs were not in fact complied with, it may tantamount to the auditor making a deliberately false declaration in his report and the consequences for the auditor could be very serious indeed”. It bears emphasis that the very serious consequences referred to would ensue irrespective of whether such non-compliance was or was not associated with a proved financial reporting misstatement. Failure to comply with any of the requirements of applicable SAs indicates that the audit firm has failed to achieve the central purpose of the audit and that there was not an adequate basis to issue the report that it did.’

Even if we assume that such cases should be treated as an exception, the conclusions reached by the NFRA should be a matter of concern to the auditing fraternity.

An issue that needs to be discussed is whether Regulators and Government agencies should be given the power to prescribe Auditing Standards and also review whether auditors have followed these standards. Auditing Standards are a part of the Companies Act, 2013 and auditors who do not comply with these Standards are violating the Act. The Act itself has a number of penal provisions for non-compliance. Hence, getting other Regulators also to penalise auditors would not only result in multiplication of roles but also cause confusion as to who takes the action first. Auditing Standards are best left to the Institute of Chartered Accountants and taking action for non-compliance is best left to the Companies Act.

COVERAGE OF AUDITING STANDARDS

As can be seen from the list tabulated above, Auditing Standards cover an eclectic variety of topics from audit risks to documentation to sampling. If applied in toto, the present set of Auditing Standards should be able to cover all risks that an auditor may face during the audit – the standards would also enable auditors to minimise their risks. However, since Regulators seem to be raising their expectations from the auditors, auditors would need to take extra care to ensure that the audit team has followed all Auditing Standards.

CONCLUSION

From the above discussion it can be concluded that auditors need to focus their attention on the applicability of Auditing Standards to the entity under audit and how they have documented the manner in which the requirements of the particular Auditing Standard have been carried out. The Public Company Accounting Oversight Board (PCAOB) in the United States carries out regular inspections in accordance with the provisions of the Sarbanes Oxley Act. A cursory analysis of their reports reveals that auditors have two options to prove that they have followed all Auditing Standards in an audit:

  •  Maintain and produce documentary evidence that they have followed all auditing standards; and

 

  •  Produce persuasive other evidence, other than oral assertions and explanations.

 

AUDITOR’S REPORTING – UNVEILING THE ULTIMATE BENEFICIARY OF FUNDING TRANSACTIONS

Corporate frauds have emerged as the biggest risk that companies are exposed to and are increasingly becoming a major threat not only to the corporates but equally to the economy at large. Such unwanted incidents have a domino effect on the economy since they cause severe financial stress, loss of investor confidence, erosion of investor wealth and serious reputational damage. It has been observed that most of these incidents involve round-tripping of funds undertaken through a complex chain of pass-through entities for the benefit of the ultimate beneficiary.
The Ministry of Corporate Affairs (MCA) has been cognizant of this ever-increasing threat and has regularly been tightening the framework under the Companies Act, 2013 (‘2013 Act’) through appropriate monitoring, vigilance and disclosure mechanisms. One such mechanism included imposing restrictions on the number of layers that can be created by companies where they create shell companies for diversion of funds or money laundering. Section 2(87) of the 2013 Act read with the Companies (Restriction on Number of Layers) Rules, 2017 imposes a limit of two layers of subsidiaries except for certain exemptions. Similarly, section 186(1) provides that a company can make investments through not more than two layers of investment companies unless prescribed otherwise. The approval mechanism has been prescribed u/s 185 for granting (directly / indirectly) of loans, guarantees, etc., to prescribed persons including any person in whom any of the directors of the company is interested.
In furtherance of this objective and to reduce opacity and enhance transparency, the MCA has further strengthened the framework under the 2013 Act by amending the Companies (Audit and Auditors) Rules, 2014 and Schedule III to the 2013 Act by introducing reporting requirements for the auditors and by providing enabling disclosures in the financial statements, respectively. The new auditors’ requirements are summarised below:
  •  Whether the management has represented that, to the best of its knowledge and belief (other than as disclosed in the notes to the accounts):

– No funds have been advanced or loaned or invested (either from borrowed funds or share premium or any other sources or kinds of funds) by the company to or in 1Intermediaries;

– No funds have been received by the company from Funding Parties1 with the understanding, recorded in writing or otherwise, that the intermediary (or company – in case of receipt of funds) shall, whether directly or indirectly, lend or invest in Ultimate Beneficiaries2 or provide any guarantee, security or the like on behalf of the Ultimate Beneficiaries.

  • Based on audit procedures considered reasonable and appropriate by the auditor, nothing has come to his / her notice that has caused the auditor to believe that the above representations contain any material misstatement.

Through the above amendment, the MCA is attempting to unveil the ultimate beneficiary behind camouflaged funding where transactions relating to loans, investments, etc., are undertaken by a company for some identified beneficiary. The reporting requirements cover transactions that do not take place directly between the company and the ultimate beneficiary but are camouflaged by including a pass-through entity in order to hide the ultimate beneficiary. The pass-through entity acts on the instructions of the company for channelling the funds to the ultimate beneficiary as identified by the company. It might be noted that the reporting obligation includes inbound as well as outbound funding transactions. In a world where financial transactions are used for money-laundering transactions or other suspicious activities, carrying illicit transactions, it is important that the trail of financial transactions is transparent. Hence, it is important to unveil the identity of the end beneficiary and the amendments are a means to address this issue.

________________________________________________________________

1   Intermediaries / Funding
Parties means – any other person(s) or entity(ies), including foreign entities

2   Ultimate Beneficiaries
means – other persons or entities identified in any manner whatsoever by or on
behalf of the company

The auditor is required to obtain management representation that the management has not identified any camouflaged transactions other than those disclosed in the notes to the financial statements. Further, the auditor is also required to assess that the representation is not materially misstated by performance of appropriate audit procedures. Accordingly, MCA requires the auditor to not only obtain management representation but also independently assess that the representation provided by the management is appropriate. Such an assessment would require the use of judgement and professional scepticism by the auditor.

This article provides an overview of the new reporting requirements and attempts to highlight some of the key aspects in order to generate wider discussion among various stakeholders.

Applicability

The amendments to the Companies (Audit and Auditors) Rules, 2014 and Schedule III issued by the MCA state that these amendments will come into force with effect from 1st April, 2021. The amendment notification does not link these requirements to any particular financial year. One possible view could be that the financial statements should be prepared as per the requirements existing as at the year-end and the audit report should include comments on the reporting obligations which are applicable on the date of issuance of the audit report. It may be noted that the amended rules require the auditor to obtain management representations for transactions ‘other than as disclosed in the notes to the accounts’ thereby implying that relevant disclosures in the financial statements would be essential to enable the auditor to comply with the reporting obligations. Accordingly, if this view is taken then the implications of the above amendments, i.e., relevant disclosures, should be included in the financial statements and audit report for the financial year 2020-21.

Another possible view could be that these requirements would apply from the financial year beginning on or after 1st April, 2021. It has been observed that the MCA in the past has been consistently taking a view that the reporting requirements (or relaxations) do not apply to the year ending on or before the date of the notification of the new requirements / relaxations. For example, similar challenges arose when a large majority of the sections of the 2013 Act were made effective on 1st April, 2014. The MCA had clarified that these provisions would apply in respect of financial years commencing on or after 1st April, 2014. In another instance, the MCA had, in June, 2017, provided exemption to the auditor from reporting on internal financial controls of certain private companies. It clarified that this relaxation would apply from the financial years commencing on or after 1st April, 2016.

Pursuant to the consistent position of the MCA in the past it may be possible to take a view that the aforesaid reporting requirements and disclosures in the financial statements would apply from financial years beginning on or after 1st April, 2021.

In order to ensure consistency regarding the applicability and to support seamless implementation, a clarification from the MCA / Institute of Chartered Accountants of India (ICAI) may help the corporates and auditors.

The companies are required to make these disclosures in Schedule III as part of ‘Additional regulatory information’ and amendments have been made to Division I (Indian GAAP), Division II (Ind AS) and Division III (Non-Banking Financial Companies which are required to comply with Ind AS).

Class of companies on which these requirements would apply

The reporting requirements have been prescribed for auditors under the 2013 Act. Accordingly, auditors of all classes of companies, including section 8 companies, would be required to report on these matters. It might be worth mentioning that as per the Companies (Registration of Foreign Companies) Rules, 2014 the provisions of Audit and Auditors (i.e., Chapter X of the 2013 Act) and the Rules made thereunder apply, mutatis mutandis, to a foreign company. Accordingly, these new reporting requirements would be applicable to auditors of foreign companies as well.

Reporting in auditor’s report

In accordance with the requirements of section 143(2) of the 2013 Act, an auditor reports to the members of the company on the accounts examined by him / her and on every financial statement to be laid before the company in the general meeting. An auditor should prepare the report after considering the provisions of the 2013 Act and the requirements specified in the accounting and auditing standards.

Section 143 of the Act read with Rule 11 of the Audit Rules prescribes matters to be included in an auditor’s report. This additional reporting requirement is required under Rule 11 in the section titled ‘Report on Other Legal and Regulatory Requirements’ in the statutory audit report.

Pre-existing transactions

It may be noted that reporting obligations do not provide any transitional provision, i.e., whether these reporting obligations would apply to pre-existing transactions or whether these reporting requirements would apply to transactions initiated on or after 1st April, 2021. As these reporting requirements (and the corresponding disclosures in Schedule III) apply prospectively, it would be logical to argue that the reporting requirements would apply to transactions initiated from the date of notification of the requirements (i.e., 1st April, 2021).

Transactions covered

The funding transactions as envisaged would primarily include three steps: 1) A company raising funds from any source or any kind of fund, e.g., borrowings, share premium (i.e., lender); 2) Lender provides loan / invests funds in intermediary with an understanding that these would be used for the ultimate beneficiary; 3) Such funds are lent / invested by the intermediary to the ultimate beneficiary. The following is one such example:

 

The following key principles may be kept in mind to understand the transactions covered:

  •  The intent is to cover funding transactions. Accordingly, normal business transactions such as supplier advance would not be covered. However, advances in the nature of loans would be covered as these are in-substance loan transactions. Whether an advance is in the nature of a loan would depend upon the circumstances of each case, for example, a normal advance against an order in accordance with the normal trade practice would not be an advance in the nature of a loan. But if an advance is given for an amount that is far in excess of the value of an order or for a period which is far in excess of the period for which such advances are usually extended as per the normal trade practice, then such an advance may be in the nature of a loan to the extent of such excess.
  •  The ultimate beneficiary must have been identified by the lender at the inception itself. This is evident from the wording that the intermediary (or company – in the case of receipt of funds) ‘shall, whether, directly or indirectly’, lend, etc., in the ultimate beneficiaries.

  •  An understanding with the intermediary that it would transfer funds to the ultimate beneficiary should exist. The words ‘with the understanding, whether recorded in writing or otherwise’ makes it amply clear about such intent and emphasises that all forms of understanding (in writing or otherwise) should be considered by the auditor.

  •  In some cases, there might be a time gap between the receipt of funds by the intermediary and the transfer of funds to the ultimate beneficiary as illustrated below:

 

A narrow reading of the requirements might indicate that the reporting obligations envisage back-to-back funding transactions and hence the above transaction is not covered as there is a time gap. Such a reading may not be in line with the overall objective of the MCA of identifying camouflaged funding transactions. The time gap between the receipt of funds by the intermediary and providing loan, etc., to the ultimate beneficiary has no relevance while reporting under this clause.

Amount to be reported – whether discounted amount or nominal amount

Loans, guarantees, etc., should be understood from a legal perspective. The accounting requirements / definitions have no relevance while reporting under this clause, e.g., Ind AS 109, Financial Instruments which provides that accounting considerations for financial guarantee contracts should be ignored. Accordingly, amounts reported by the auditor (if any) should be the nominal amount and not the discounted amount as per the relevant Ind AS. This is also supported by the Guidance Note on CARO issued by ICAI which states that it may happen that under the Ind AS framework certain term loans (for example, mezzanine loans) may either be classified as equity or may be compound instruments and, therefore, are split into equity and debt components. However, such instruments will be classified as debt under the AS framework. It is clarified that the basic character of such loans is debt and accordingly the auditor should consider utilisation of the entire amount for the purpose of reporting under this clause irrespective of the accounting treatment.

Audit procedures – key considerations

The auditor is required to perform appropriate audit procedures and state that nothing has come to notice that has caused the auditor to believe that these representations contain any material misstatement. The inherent complexities in auditing camouflaged funding transactions might pose significant challenges to the auditor in conducting audit procedures, for example, the auditor is required to assess understanding of the company with the ultimate beneficiary (which may not be in writing in certain cases). This would require the auditor to perform additional audit procedures to obtain sufficient appropriate audit evidence. However, the auditor should consider that these procedures are to be performed in relation to audit of financial statements and should be in the course of performance of his duties as an auditor. It may be noted that u/s 143(9) read with section 143(10), the duty of the auditor, inter alia, in an audit is to comply with the Standards on Auditing (SAs). Further, section 143(2) requires the auditor to issue his / her report in accordance with the SAs and accordingly the auditor should consider the requirements of the SAs in planning and performing the audit procedures to address the risk of material misstatement as stated above. The auditor may perform the following auditing procedures:

  • Obtain representations from management that to the best of its knowledge and belief there are no camouflaged funding transactions other than those disclosed in the financial statements. These representations should be provided by those responsible for the preparation and presentation of the financial statements and knowledge of the matters concerned, for example, chief executive officer, chief financial officer.

  • Identification of sample funding transactions undertaken during the year (refer SA 530 Audit Sampling).

  • Critical assessment of the internal controls including controls regarding approval process and assessment of management’s rationale in approving the funding transaction, e.g., assessment of genuineness of funding needs of the borrower, clearly defined purpose for proposed use of the funds.

  • Relationship with the borrower, e.g., related party. If funding is provided to an unrelated party, then auditor is required to understand and evaluate the strategic reason for funding.


 

  • Financial credentials of the borrower.

  • Compliance with the approval matrix and compliance with applicable laws and regulations, such as section 185 / 186 of the 2013 Act and the relevant RBI norms.

  • Internal controls to track usage of funds, that is, whether periodic report obtained to indicate the usage of funds.

  • Written representations should be dated as near as practicable to, but not after, the date of the auditor’s report.

Applicability of reporting – if no instances identified

The auditor is required to obtain management representation for every audit report issued under the 2013 Act. This is evident from the words which state ‘Whether the management has represented that…’ Accordingly, the auditor would need to obtain management representations and assess its appropriateness even where no instances of camouflaged funding transactions have been identified by the management during the year under audit.

BOTTOM LINE


These new reporting obligations pose onerous responsibilities on the auditor. The auditor would need to carefully assess the implications as the ambit of the reporting matters is wide and covers all inbound and outbound funding transactions. It may be noted that section 186(4) requires a company to disclose in the financial statement the full particulars of the loans, etc., given and the purpose for which these are proposed to be utilised by the recipient. The amendment to Schedule III and auditors’ reporting obligations supplements the existing disclosure requirements. In order to meet these enhanced requirements, the management would need to establish an adequate internal control mechanism so that adequate information is made available to the auditor. These amendments further highlight the importance of establishing a proper mechanism to track the end use of the funds. Considering all these aspects, the auditor should engage with the stakeholders to iron out implementation challenges if any and ensure strict compliance with the reporting requirements.  

AUDIT: BUILDING PUBLIC TRUST

The spotlight has been sharply focused in the recent past on corporate failures and consequential loss of public trust. Various regulators and authorities, such as the Ministry of Corporate Affairs, the National Financial Reporting Authority, the Reserve Bank of India, SEBI’s Committee on Corporate Governance and Committees of the Institute of Chartered Accountants of India, have advised several measures with a clear focus on enhancing audit quality and improving the standards of corporate governance. In that context, this article traces various enablers relevant to audit quality.

ASSESS THE ECOSYSTEM

Audit framework and bridging the expectation gap on the role of an auditor
It is important to articulate what stakeholders should legitimately expect from the audit profession. This should be translated into an appropriate audit framework: should auditors merely opine in a limited manner on management’s financial statements, or should they go further and, if so, how far and which way? This will allow a course to be charted where the audit profession becomes a part of the national solution. It can contribute to fixing, maintaining and raising the standards of audit quality, as necessary, rather than being stigmatised as ‘guilty until proven innocent’.

The environment in which public company audits are conducted has changed drastically for several reasons, including increased business complexities, use of technology and intricate local and global regulations. However, the primary objective of an audit has remained the same over time, i.e., to provide stakeholders with a reasonable, though not absolute, assurance that the financial statements prepared by the management are fairly presented. The current audit framework continues to be based on the concept of watchdog and not bloodhound. However, the auditors’ responsibilities are continuously increasing and the expectation gap continues to remain unaddressed in terms of setting up or awareness of standards, and a level of audit outcome that is understood and acceptable to all concerned.

For creating trust, there is a need to educate the stakeholders, too. Some of the initiatives that may help bridge the gap include: (i) review of framework by the ICAI and mandatory inclusion of elements of technology and periodic forensic reviews, and auditors’ reporting thereon, (ii) disclosure of Audit Quality Indicators of an audit firm, (iii) a wider message that not every ‘business failure’ means that there was an ‘audit failure’, and (iv) an active platform between ICAI / auditors and various regulators to provide clarity in case of large-scale conflicts.

Enhanced role and accountability of audit committee

An audit committee, as a representative of the wider group of stakeholders, and not the management, is the client of the auditor. The audit committee should lead discussions around capability evaluation and, accordingly, decide on the appointment of auditors. In order to ensure transparency, disclosures to stakeholders may include detailed criteria for evaluation, selection and competitive analysis. The audit committee should monitor the auditor’s performance to ensure that auditors maintain professional scepticism, challenge management and deliver high quality audits. The audit committee should affirmatively confirm to the board periodically that the audit is adequately resourced, independent to undertake a quality audit, with commensurate fees.

Capacity-building and encouraging creation of large audit firms

There is a strong need to develop a forward-looking approach towards the growth of the audit profession in India. There is a need for larger and consolidated audit firms, with adequate skills, capacity, size and reach to deal with large corporations and conglomerates. The current capacity of audit firms in India is fragmented, with individual practitioners making the bulk and a minuscule number of large firms. It is important to encourage consolidation of the existing landscape of small and medium-sized firms. The current business / economic scenario and rapidly evolving technology in the country demand multiple skillsets for any business or regulatory propositions. Audit is not restricted to simple accounting and certainly needs support from specialised professionals skilled in the fields of law, taxation, information technology, forensics, cyber security and secretarial services. Given the environment, there is a strong need to encourage networking and consolidation. Multi-disciplinary firms, as already acknowledged by the Companies Act, 2013, will contribute immensely in this direction. Clarity of networking regulations for chartered accountants, including with overseas accounting firms, would also help in achieving this objective.

Centre of Excellence for Audit Quality

The creation of a Centre of Excellence for Audit Quality, with an objective to develop standards and parameters of audit quality, technology, tools, consistency of methodology and training to teach the highest levels of professional scepticism, would help in creating awareness and enhancing skills. The main objectives of the Centre could be to:

  • encourage and support capacity-building
  •  create opportunities to network and share best practices and views among firms
  •  enhance audit quality through use of technology, especially to provide better insights to stakeholders
  • knowledge dissemination to professionals on key matters
  •  contribute to harness talent and build relevant skills
  •  drive inclusive and balanced growth across the country
  •  enhance excellence in the audit profession.

Use of tools and technology in audits

The situation created by Covid-19 has established that technology can play a crucial role in any audit. The audit profession needs to evolve and respond to similar challenges by upskilling and adopting technology / tools and artificial intelligence in the audit process. Data & Analytics may play a significant role in achieving a higher satisfaction level in audits. In the current situation, even virtual audits may be as effective as traditional techniques. No doubt one has to be cautious, as would be the case in any technology-driven process. This also requires a shift in mindset to adopt technology and facilitate the process through extensive training programmes for practitioners.

There are two essential components for adopting technology in the audit process, viz., a Smart Audit Platform and a Data Analytics Tool. A Smart Audit Platform contains (i) an audit workflow; (ii) audit methodology, based on the regulatory framework; and (iii) document management system. A Data Analytics Tool helps in moving away from a limited sample testing to covering a larger population in many fields. Overall, this approach supports data extraction using scripts; smart analytics using the Tool; and exception reporting using visualisation techniques which helps assessing the existence / effectiveness of controls. To make it a success, we require a multi-disciplinary approach to invest in resources and related technology.

Auditor’s independence and conflict management

It is always presumed that any large-scale audit failure is due to the lack of independence of the auditors. While this may be true in certain cases, there may be a strong perception in many others. The existing statutory restrictions, comparable with international standards, are well established in this area. The new Code of Ethics issued by the ICAI is aligned to the International Code of Ethics issued by the IESBA. These, along with self-regulated safeguards exercised by auditors, monitoring by audit committees and enhanced disclosures required by SEBI should generally suffice to ensure independence.

Certain reforms and a strong monitoring mechanism to implement them would help in enhancing governance. For example, SEC requires every non-audit relationship with an audit client to be pre-approved by the audit committee. Further, instead of varying interpretations by stakeholders and regulators, clarity from the MCA on terms like Management Services would be appropriate. Any ambiguities in this area may be clarified by the ICAI through the Code of Ethics and Networking Guidelines. Certain regulators globally (such as PCAOB and SEC in the USA) have a process of regular interaction with the auditors / corporates. They do provide an opportunity to the auditors and corporates to objectively consult and provide guidance / solutions in case of issues of independence and professional conflicts. This consultative process is not only efficient and objective, it also creates an atmosphere of trust between the auditors and the regulators. It would be fruitful to have a similar arrangement here, instead of creating conflicting interpretations and prolonged legal resolution.

Strengthening whistle-blower mechanism

A strong whistle-blower mechanism with strong legal protection goes a long way in keeping a check on potential unethical and corrupt practices. Several corporate frauds have been unearthed based on a good whistle-blower mechanism.

Increasing the role, responsibility, independence and accountability of internal auditors
An internal audit function provides much needed assurance on the effectiveness and reliability of internal controls and governance in any company. The internal audit team is uniquely positioned to provide early warning signals of impending failures. The recent reinstatement in CARO requiring an auditor to evaluate the internal audit system of a company is a step in the right direction. Audit committees should be responsible to ensure that the function is robust, independent and adequately resourced, with the scope of the work sufficient to provide the desired level of assurance. Internal auditors’ scope should move away from a transactional approach to substantive matters like design and operating effectiveness of critical controls.

DEEP DIVE IN CRITICAL AREAS

Recent experiences indicate certain critical aspects that require a deep dive and critical evaluation by the auditors. There is no alternative to the diligence and continuous scepticism of an auditor. An auditor is expected to consider and evaluate the economic substance of transactions while carrying out an audit.

Accountability and extent of reliance placed on others and management representations
While discharging their duties, auditors must critically evaluate the extent of reliance they intend to place on various elements, e.g., Regulatory Oversight (such as inspections carried out by Banking or Market Regulators), Specialists (such as Valuation or Information Technology Experts), Joint and Component auditors, Credit Rating agencies and Internal Auditors. Auditors are obligated to assess and critically evaluate such evidence before placing reliance on them.

Further, while a written representation from the management may provide audit evidence, it may not be ‘sufficient appropriate audit evidence’ on its own. Unwillingness to provide underlying evidence, replaced by a management representation, may be treated as a red flag and auditors would need to exercise scepticism in such cases. Accordingly, auditors must evaluate a management representation critically and obtain sufficient and appropriate underlying evidence. While ICAI’s existing guidance deals with the matter, ICAI may consider issuing case studies to clarify situations and showcase that accepting a management representation is not an alternative to appropriate audit procedures.

Related party transactions
It is the responsibility of a company’s management to identify and ensure an appropriate mechanism for related party transactions. However, this has been a matter of concern and governance in many ways. There are enhanced reporting requirements in the recently amended CARO also, which support an objective and deeper evaluation of related party transactions.

In this context, there have been instances of (i) incorrect / incomplete identification of related parties, (ii) lack of economic substance in related party transactions, and (iii) consequent inadequate or lopsided disclosures. Irrespective of these anomalies, such transactions may meet the regulatory and disclosure requirements.

Audit committees and auditors are well equipped to address the root cause. For example, (i) auditors have an obligation to exercise a high degree of scepticism and challenge the management on the economic substance of a related party transaction; (ii) auditors of a component in a group must have visibility of transactions with the group companies; (iii) the audit committees should affirmatively confirm to the Board on identification and adequate evaluation of such transactions; and (iv) related party transactions should mandatorily be included in the scope covered by internal auditors’ review.

Going concern
The appropriateness of going concern assumption in any audit is a fundamental principle. This forms the foundation for any stakeholder to place reliance on a company before making any decisions. There is a responsibility on a company’s management to assess its position and on the auditors to challenge and obtain appropriate evidence to support the same. There have been instances where the auditors failed to assess and report such situations and companies failed soon thereafter. This may be attributable to several reasons, including lack of transparency, or inadequate skills to assess. Specific situations like Covid-19 continue to pose additional challenges, creating responsibility on the auditors to maintain an appropriate level of scepticism.

There are certain measures that may help address these concerns, e.g., (i) auditors are supposed to challenge management assumptions of future projections, to avoid fatal errors and consequent sudden downfall of a company; (ii) in case auditors do not have expertise to validate future assumptions, sector experts, as specialists in audit process, must be involved to address the issue; and (iii) composition and skills of independent directors and the audit committee to understand the business and challenge management.

All this would involve a cost and skill-set worth investing in.

Third party complaints / whistle-blow mechanism
While the prime responsibility of addressing whistle-blower complaints is of the management, for auditors such complaints may lead to additional information, critical to assess any assertion in the financial statement audit. Even if such complaints are anonymous, it would not be wise for an auditor to ignore them without logical conclusions. The recent amendment in CARO, requiring an auditor to consider whistle-blow complaints, is a step in the right direction.

Documentation of audit evidence
While appropriate audit diligence is essential, an auditor’s work cannot be demonstrated without adequate documentation of evidence. Each audit essentially requires a logical sequence of work papers, demonstrating the work carried out at each stage of an audit. These may primarily include audit eligibility / independence requirements, acceptance of audit engagement, adequacy of planning and timing of proposed audit steps, team composition and appropriate delegation of work according to skills, control and substantive testing procedures to obtain sufficient / appropriate evidence, evaluation of work of any experts or component auditors involved, legal consultations, recording of audit observations and their resolutions, communications with those charged with governance, minutes of meetings with management, engagement with quality control review steps, supervisory controls including accountability and review of work done, management confirmations / representations and final opinion.

The framework clearly recognises that ‘if the work has not been documented, it has not been done’. At the same time, excessive expectation, focusing merely on audit documentation, could have an adverse effect where auditors may focus more on gathering documentary evidence than exercising professional scepticism given the limited time available. A balanced approach in this regard is necessary.

ENABLERS, CONDUCIVE ENVIRONMENT AND ROLE OF REGULATORS


A constructive role of a regulator, with the focus on remediation instead of disproportionate punishment and prolonged litigation, is important. The regulatory regime should provide greater confidence through effective policy measures. The recent move to decriminalise certain offences will help create the basis for consultation and a compromise and settlement approach. In a profession with scattered capacity, undertaking rapid investigation and constructive resolution, including commensurate punitive measures and remediation, will encourage audit quality. Certainly, there is a need to distinguish between criminality and professional negligence. In addition, clarity on the role, jurisdiction and multiplicity of regulators needs re-evaluation.

There have been significant efforts by the Government in the past few years to assess the adequacy of the current Regulatory Framework and clarify overlaps or areas of needed coordination among the regulators. A few such examples are (i) Recommendation by the MCA’s Committee of Experts, pursuant to the Supreme Court’s order; (ii) Consultation Paper by the MCA to look at critical areas relating to auditors and auditor independence; and (iii) Formation of the National Financial Reporting Authority (NFRA) as a new audit regulator. These activities demonstrate much-needed regulatory attention. There is a need to implement some of the measures recommended and that have been awaited since long.

In substance, a few initiatives will help establish trust between the regulators and the auditors, e.g., (i) a balanced approach towards time-bound penal action proportionate to the offence and / or negotiated settlements so that deterrence may be accomplished with minimal disruption; (ii) coordination amongst various regulators governing the auditors to provide uniform guidance and to avoid multiplicity and overlap; (iii) implementation of well-deliberated recommendations of committees formed in the past; and (iv) time-bound clarity and guidance on matters of interpretation or conflicts.

While there are no alternatives to the professional scepticism and diligence of an auditor to ensure audit quality, an overall ecosystem and a constructive role of the regulators are essential enablers in that direction.

(The views expressed here are the personal views of the author)

CARO 2020 SERIES: NEW CLAUSES AND MODIFICATIONS PROPERTY, PLANT AND EQUIPMENT & INTANGIBLE ASSETS

CARO 2020 is applicable for the statutory
audit of financial statements for periods beginning on or after 1st
April, 2021. ICAI had issued a detailed Guidance Note (GN) on the same
in June, 2020. A module is also available on the ICAI Digital Learning
Hub. Schedule III was also recently amended inter alia to align the
reporting requirements under CARO 2020 by statutory auditors. BCAJ is
pleased to bring you a clause-by-clause analysis via a series of
articles authored by four audit practitioners who have been auditors all
their lives. Each article will zoom into a clause or two and provide a
‘commentary’ on reporting issues and practices, views, and perspectives
to supplement the broad guidance covered by the GN. The purpose of this
series is to bring out practical nuances to the reader. The series will
cover only new clauses and modifications and exclude those already
covered by CARO 2016. We hope this will steer and support the readers
towards better understanding and reporting. – Editor”

MODIFICATIONS / ADDITIONAL REPORTING REQUIREMENTS

The
clause on reporting in respect of fixed assets has been there in the
earlier versions, too. CARO 2020 has modified parts of the first clause
and added reporting requirements as given below:

Modifications
a. Change in the terminology to Property, Plant and Equipment (PPE) in line with Accounting Standards and Schedule III.

b. Separate reporting requirement on maintenance of proper records for Intangible Assets.
c.
No reporting required for non-availability of title deeds, where the
company is a lessee and the lease agreement is executed in favour of the
company.
d. In
cases where title deeds of immovable properties are not held in the
name of the company, additional details in a prescribed format as under
are required to be given:

Description of the property

Gross
carrying value

Held in
the name of

Whether
promoter, director, their relative or employee

Period
held –
indicate range where
appropriate

Reason
for not being held in the name of the company

(also
indicate if in dispute)


Additional reporting

a.
Whether the company has revalued its PPE (including Right of Use Assets)
or intangible assets or both during the year and, if so –
  •  whether the revaluation is based on valuation by a Registered Valuer, and
  •  if change is 10% or more in the aggregate of the net carrying value of each class of PPE or intangible assets.

b. Whether any proceedings have been initiated or are pending against the company for holding any benami property under the Benami Transactions (Prohibition) Act, 1988 and rules made thereunder; and if so, whether the company has appropriately disclosed the details in its financial statements.

SPECIFIC CONSIDERATIONS

Specific considerations to be kept in mind whilst reporting on the above changes are discussed under the following broad heads:

Additional disclosures under amended Schedule III

While reporting on these matters, the auditor will have to keep in mind the amended Schedule III disclosures as under:
a.
The auditor will have to ensure that there is no material inconsistency
between the financial statement disclosures and his reporting under the
Order. Disclosure of changes in the aggregate net carrying value due to revaluation of each class of PPE and Intangible Assets by 10% or more in the aggregate and whether revaluation is based on the valuation by a Registered Valuer as defined in Rule 2 of the Companies (Registered Valuer and Valuation) Rules, 2017.

b. The information as specified earlier in respect of title deeds of Immovable Properties not held in the name of the company, except that the
disclosure should be given in the aggregate for the following line
items in the Balance Sheet, separately for Land and Building
, as against the description of each individual property as per the Order:

 

  •  PPE
  •  Investment property
  •  PPE retired from active use and held for sale, non-current assets held for sale (Ind AS entities)
  •  Others

As disclosures under Schedule III are along the lines required to be given, it is imperative for the auditor to reconcile the information disclosed therein for completeness and accuracy.

c. In respect of proceedings initiated or pending in respect of benami property held, the following details are required to be disclosed:

i. Details of such property, including year of acquisition,
ii. Amount thereof,
iii. Details of beneficiaries,
iv. If held in the books, reference thereof to the item in the Balance Sheet,
v. If not held in the books, then the facts along with reasons thereof,
vi.
Where there are proceedings against the company as an abettor of the
transaction or as the transferor, details thereof shall be provided,
vii. Nature of proceedings, status thereof and company’s view of the same.

Practical challenges in reporting
The reporting requirements outlined above entail certain challenges which are discussed below:

a. In respect of properties owned jointly with others where the title deeds are not held in the name of the company, the above details are required to the extent of the company’s share.

b.
Similarly, if the company has changed its name, this will require
reporting under this clause till the new name is updated in the title
deed.

c. Identification of benami properties: The reporting on proceedings in respect of benami properties may pose challenges, especially if the properties are not reflected in the books.
In such cases, apart from the normal procedures like review of the
minutes, scrutiny of legal expenses, review of minutes of board of
directors, audit committee, risk management committee, other secretarial
records, listing of all pending litigations and also obtaining
management representation (which have been referred to in the Guidance
Note). The auditor may also obtain independent confirmation from the legal counsel as to whether any such proceedings, other than those in respect of properties reflected in the books are pending, as per SA 501 – Audit Evidence – Specific Considerations for Selected Items.

d. The reporting under this clause is required only in cases where proceedings are initiated or pending against the company as ‘benamidar
and not otherwise. Hence, even if notice is received but no proceedings
have been initiated, reporting is not warranted. The reporting is
required by the auditor of the company holding any benami property but not as an auditor of the company which is the beneficial owner.

e. Compilation of data for Intangible Assets: Since the requirement for reporting on maintenance of records for intangible assets has been newly introduced, many companies may not have a proper inventory thereof, except the details of the payments made or expenses capitalised on an individual basis. This could pose challenges to prepare a comprehensive itemised listing of all intangible assets and reconciling the same with the books. It is imperative that in such cases a one-time exercise is undertaken
to reconstruct the records and the nature of documentary evidence like
licences, agreements, internal SOPs (for internally generated
intangibles)
which is available is also specified. This would also
facilitate easy identification in future. Wherever required, an
appropriate management representation should be obtained regarding the completeness of the data.

f. Awareness of the legal requirements: There
are certain situations where the auditor would have to familiarise
himself with the legal requirements. These mainly pertain to the
following:

i. The provisions of the Benami Property Transactions Act, 1988 and the related Rules.
Though relevant extracts of current regulations are given in the ICAI
Guidance Note, the auditor will have to keep abreast with the changes
therein, if any.

ii. Identifying the list of promoters of the company and their relatives:
Promoter and Relative have not been defined under the Order. However,
amended Schedule III (for disclosures related to holder of title deeds)
states that both ‘Promoter’ and ‘Relative’ will be as defined under the Companies Act, 2013.
Though 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 affairs of the company directly or
indirectly, whether as a director or shareholder or otherwise, or in
accordance with whose advice, directions, or instructions the Board is
accustomed to act and can be considered as promoters. In case there is
no such party, even then a specific representation should be obtained.

iii.
Ascertaining whether the requirements under the Trade Mark, Copyright,
Patents, Designs and IT Acts as well as the licensing requirements under
telecom, aviation, pharma and other similar industries have been
complied with in respect of the Intangible Assets.

iv. Being aware of the laws dealing with registration of immovable properties, including those pertaining to specific states.

In case of doubt, the auditor should seek the views of the company’s legal counsel or their own expert. This will be in line with SA 500 – Audit Evidence regarding using the Managements’ Expert
(by assessing the complexity, materiality, risk, independence,
competence, capability and objectivity, amongst other matters) and SA
620 – Using the Work of an Auditors’ Expert (by assessing the
complexity, materiality, risk, adherence to quality procedures,
competence, capability and objectivity, amongst other matters),
respectively. In either case, the requirements of SA 250 – Consideration
of Laws and Regulations in an Audit of Financial Statements should be
complied with.

g. Business combinations and acquisitions: The following matters need to be considered in case of such situations:

i.
In case a company has acquired another entity and the same is merged in
terms of an approved scheme, immovable properties of the transferee
company are considered deemed to be transferred in the name of the
acquiring company. However, till the time the acquiring company complies
with local / state-specific procedures, including payment of stamp
duty, etc., it would not be actually transferred in the name of the
acquiring company and, hence, would require factual reporting.

ii. In case of business combination as per Ind AS 103, where the acquiring company has identified intangible assets acquired as
a part of the transaction, the nature, and basis, whether or not the
same is in the books of the transferor needs to be evaluated and
recorded. Further, for intangible assets recorded on consolidated
financial statements, though there is no requirement for reporting by
the auditor, as the Order is only applicable on standalone financial
statements, it would be a good practice for the company to separately
list them in the intangible asset register.

h. Revaluation:
As per the ICAI Guidance Note, this clause is applicable only to the
entity which adopts the revaluation model. Hence, fair valuation of PPE
on first-time adoption, acquisition of assets / business on slump sale
basis or under business combination, change in ROU asset due to lease
modification as per Ind AS 116, re-measurement due to changes in foreign
exchange rates, etc., will not require reporting under this clause.
Further, impairment of PPE accounted under cost model is outside the
purview of reporting.

In case an entity adopts the revaluation model for PPE and Intangible Assets, there could be two scenarios as under:

i. Valuation by an external valuer:
In such cases, the fact should be indicated and the auditor should
check the necessary documentation as to whether he is registered under
Rule 2 of the Valuation Rules specified earlier. In such cases, the
auditor needs to ensure that the management ensured that the principles
laid down in Ind AS 113 on Fair Valuation are adhered to by the valuer.
The auditor should keep in mind the requirements under SA 500 – Audit
Evidence regarding using the Managements’ Expert, indicated earlier.
ii. Internal valuation: The
Order does not seem to mandate that a company needs to get a valuation
done by an external valuer. In such cases, the auditor will have to
exercise a greater degree of professional scepticism and review
the basis and assumptions for arriving at the revised fair value keeping
in mind the requirements of Ind  AS 113 as indicated earlier,
irrespective of the accounting framework. The requirements under SA 540 –
Auditing Accounting Estimates, Including Fair Value Accounting
Estimates and Related Disclosures (covering the extent of use of market
specific inputs and their relevance, assessment of comparable
transactions, basis and justification of unobservable inputs, amongst
others) also need to be kept in mind. In case of any doubt, the auditor should seek the assistance of their own valuation expert keeping in mind the requirements under SA 620 – Using the Work of an Auditors’ Expert, discussed earlier.

CONCLUSION

The
above changes have cast onerous responsibilities on the auditors and in
many cases the auditors would need to go beyond what is stated in the
Order because the devil lies in the details!

CARO 2020 SERIES: NEW CLAUSES AND MODIFICATIONS NON-BANKING FINANCE COMPANIES (NBFCs) [INCLUDING CORE INVESTMENT COMPANIES]

(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!

NOCLAR (NON-COMPLIANCE WITH LAWS AND REGULATIONS) REPORTING

EMERGENCE OF NOCLAR
In the course of providing professional services to clients or carrying out professional activities for an employer, a Professional Accountant (PA) may come across an instance of Non-Compliance with Laws and Regulations (NOCLAR), or suspected NOCLAR committed, or about to be committed, by the client or the employer.

Recognising that such situations can often be difficult and stressful for the PAs, and accepting that he or she has a prima facie ethical responsibility not to turn a blind eye to the matter, NOCLAR was introduced to help and guide the PAs in dealing with such situations and in deciding how best to serve the public interest in these circumstances.

Considering the above, the International Ethics Standards Board for Accountants (IESBA) had made revisions to the International Code of Ethics for Professional Accountants to define their professional responsibility in relation to NOCLAR in the year 2017.

ICAI, being a member of the International Federation of Accountants (IFAC), has considered the revisions made by IESBA in the revised 12th edition of the Code of Ethics which has come into effect from 1st July, 2020 for its members. The Council of ICAI has decided that the provisions, namely, Responding to Non-Compliance with Laws and Regulations (NOCLAR) (Sections 260 and 360), contained in Volume I of the Code of Ethics, 2019, the applicability of which was deferred earlier, be made applicable and effective from 1st April, 2022.

These NOCLAR provisions, as introduced by ICAI, provide detailed guidance in assessing the implications for PAs on any actual or suspected non-compliances of laws and regulations and the possible course of action while responding to them. These provisions primarily cover the non-compliance with laws and regulations that may have an effect on:
a. the determination of material amounts and disclosures in the financial statements;
b. the compliances that may be fundamental to the entity’s business and operations, or to avoid material penalties.

Examples of laws and regulations

 
                    
Examples of other laws and regulations for consideration of PAs while evaluating NOCLAR
1) The real estate sector has remained widely unorganised till the introduction of The Real Estate (Regulation and Development) Act, 2016 (‘RERA’). Just as while discharging the duty of statutory auditor, for instance under the Companies Act, the auditor shall now be required to coordinate with the RERA professionals and also would require working knowledge of the RERA law to understand the Non-Compliance of Laws and Regulations (NOCLAR).
2) Impact due to Non-Compliance of Foreign Exchange Management Act law will also be covered in the above NOCLAR reporting.
3) Applicability of PF and ESIC laws – based on crossing prescribed number of employees / staff and compliance pertaining to the same.
4) Schedule III Disclosure and Compliance relating to relevant provisions of the Foreign Exchange Management Act, 1999 and the Companies Act, 2013 have been complied for transactions of advanced or loaned or invested funds and vice versa and the transactions are not violative of the Prevention of Money Laundering Act, 2002.
5) In case of regulated entities, the Regulations often require direct reporting to the Regulator (RBI directions in case of banks & NBFCs).

The PA should be more alert in case of susceptible industries, such as banks, diamond companies, the IT industry, the financial sector, hazardous Industries and companies dealing in cryptocurrencies.

The broad objectives of PAs in relation to NOCLAR are:
a. to comply with the principles of integrity and professional behaviour;
b. to alert management or where appropriate Those Charged with Governance (TCWG) of the client or employer, to enable them to rectify, remediate and mitigate the consequences of the identified or suspected non-compliance or deter the commission of the non-compliance where it has not yet occurred; and
c. to take such further action as appropriate in public interest.

APPLICABILITY AND SCOPE
Although the purpose of introducing NOCLAR was to provide assistance to PAs, for all their professional engagements, in case there is suspected or actual non-compliance of law and regulations, ICAI has at present made it effective only on:
a. auditors doing audit assignments of listed entities; and
b. employees of listed entities.

Further, the following matters are not included in the scope of NOCLAR:
1. Matters clearly inconsequential – Whether a matter is clearly inconsequential is to be judged with respect to its nature and its impact, financial or otherwise, on the employing organisation, its stakeholders and the general public. For instance, trying to cajole a traffic officer to ignore penalties for traffic violation;
2. Personal misconduct unrelated to the business activities of the client or employer – such as a top employee getting drunk or driving under the influence of alcohol;
3. Non-compliance other than by the client or employer, or those charged with governance, management – for example, circumstances where a professional accountant has been engaged by a client for conducting a due diligence assignment on a third-party entity and the identified or suspected non-compliance has been committed by that third party.

WHAT HAS CHANGED?

The ICAI, in its Code of Ethics-Revised 2019, has introduced new guidance for NOCLAR via section 360 for members in practice and section 260 for members in employment. Both these sections are further discussed in detail below:

Responding to Non-Compliance with Laws and Regulations during the course of Audit Engagements of Listed Entities – SECTION 360
The professional accountants will have to get ready for higher responsibility to identify and report violations which they come across while performing their work. Non-Compliance with Laws and Regulations comprises acts of omission or commission, intentional or unintentional, which are contrary to the prevailing laws or regulations committed by the client, those charged with governance of a client, management of a client or other individuals working for or under the direction of a client. When encountering such non-compliance or suspected non-compliance, the accountant shall obtain an understanding of those legal or regulatory provisions and comply with them, including any requirement to report the matter to an appropriate authority and any prohibition of alerting the client, for example, pursuant to anti-money laundering legislation.

Management, with the oversight of those charged with governance, is responsible for ensuring that the client’s business activities are conducted in accordance with the laws and regulations. Usually, corporates have an internal legal, compliance / tax department and also a team of internal / external legal counsel who assist management in complying with laws and regulations and compliances applicable to the company. The company may implement various policies and procedures like monitoring legal requirements and ensuring that operating procedures are designed to meet those requirements. Once the appropriate systems of internal control are operative, it will assist in prevention and detection of non-compliance with laws and regulations. In larger entities these policies may be supplemented by assigning responsibilities to the internal audit / audit committee / compliance function. Non-compliance might result in fines, litigation or other consequences for the client, potentially materially affecting its financial statements. Importantly, such non-compliance might have wider public interest implications in terms of potentially substantial harm to investors, creditors, employees or the general public. Examples of these include the perpetration of a fraud resulting in significant financial losses to investors and breaches of environmental laws and regulations, endangering the health or safety of the employees or the public. The auditor will have to suitably change the engagement letter going forward considering the new responsibilities on management and those charged with governance pertaining to NOCLAR.

When a PA in public practice becomes aware of non-compliance or suspected non-compliance, the following points are to be considered:
a) Obtain understanding of the matter (nature of the act and the circumstances), discuss it with management and where appropriate TCWG may seek legal counsel;
b) Addressing the matter (rectify, remediate, mitigate, deter, disclose);
c) Check whether management and TCWG understand their legal or regulatory responsibilities;
d) Communication with respect to groups (for financial statement audit);
e) Determining whether further action is needed (timely response, appropriate steps taken by the entity and based on professional judgment by the PA), consulting on a confidential basis with the Institute;
f) Determine whether to disclose the matter to the appropriate authority; and
g) Documentation of the matter.

The PA might determine that disclosure to an appropriate authority is an appropriate course of action in the following scenario:
• The entity is engaged in bribery (for example, of local or foreign government officials for purposes of securing large contracts);
• The entity is regulated and the matter is of such significance as to threaten its license to operate;
• The entity is listed on a securities exchange and the matter might result in adverse consequences to the fair and orderly market in the entity’s securities or pose a systemic risk to the financial markets;
• It is likely that the entity would sell products that are harmful to public health or safety;
• The entity is promoting a scheme to its clients to assist them in evading taxes.

The documentation for compliance related to ethical standards is in addition to complying with the documentation requirements under applicable auditing standards. In relation to non-compliance or suspected non-compliance that falls within the scope of this section, the professional accountant shall document in detail how his responsibility to act in public interest has been met.

Withdrawing from the engagement and the professional relationship is not a substitute for taking other actions that might be needed to achieve the professional accountant’s objectives under this section. However, there might be limitations as to the further actions available to the accountant. In such circumstances, withdrawal might be the only available course of action. The auditor may also refer to the Implementation Guide on Resignation / Withdrawal from an Engagement to Perform Audit of Financial Statements issued by the Auditing and Assurance Standards Board.

Responding to Non-Compliance with Laws and Regulations in case of Employment with Listed Entities – SECTION 260
It is the responsibility of employing organisations’ management and those charged with governance to ensure that their business activities are conducted in accordance with the laws and regulations and to identity and address any non-compliance. Non-compliance with laws and regulations comprises acts of omission or commission, intentional or unintentional, which are contrary to prevailing laws or regulations committed by the following parties:
a) The professional accountant’s employing organisation;
b) Those charged with governance of the employing organisation;
c) Management of the employing organisation; or
d) Other individuals working for or under the direction of the employing organisation.

When encountering such non-compliance or suspected non-compliance, the accountant shall obtain an understanding of those legal or regulatory provisions and comply with them, including any requirement to report the matter to an appropriate authority and any prohibition on alerting the relevant party.

If organisations have established protocols and procedures regarding how non-compliance or suspected non-compliance should be raised internally, the PA shall consider them in determining how to respond on timely basis to such non-compliance. For instance, the Ethics Policy or internal whistle-blowing mechanism. The Securities and Exchange Board of India decided recently to increase the maximum reward for whistle-blowers from Rs. 1 crore to Rs. 10 crores. Such protocols and procedures might allow matters to be reported anonymously through designated channels. Under CARO 2020, the auditor is required to report whether he has considered whistle-blower complaints, if any, received during the year by the company. The auditor should be mindful while performing the procedures under this clause and consider complaints received under the whistle-blower mechanism. The auditor should consider whether additional procedures are required to be performed under SA 240 in this regard.

When a senior PA in service becomes aware of non-compliance or suspected non-compliance, the following steps are to be taken:
a. Obtaining an understanding of the matter,
b. Addressing the matter,
c. Determining whether further action is needed,
d. Seeking advice,
e. Determining whether to disclose the matter to the appropriate authority – and the different scenarios, and
f. Documentation.

Senior professional accountants in service (SPAs) are Directors, officers or senior employees able to exert significant influence over, and make decisions regarding, the acquisition, deployment and control of the employing organisation’s human, financial, technological, physical and intangible resources.

Resigning from the employing organisation is not a substitute for taking other actions that might be needed to achieve the SPA’s objectives under this section. However, there might be limitations as to the further actions available to the accountant. In such circumstances, resignation might be the only available course of action.

When a Professional Accountant in service becomes aware of non-compliance or suspected non-compliance, the following steps are to be taken:
? Subject to established protocols and procedures, inform an immediate superior to enable the superior to take appropriate action;
? If the PA’s immediate superior appears to be involved in the matter, inform the next higher level of authority within the organisation;
? In exceptional circumstances, the PA may decide that disclosure of the matter to the appropriate authority is an appropriate course of action;
? Documentation of the matter, results of discussions, response by superior/s, course of action, the judgments made and the decisions that were taken.

INTERPLAY BETWEEN SA 250 AND NOCLAR
SA 250 requires the auditors to assess the financial implications on the financial statements in case there is a non-compliance of laws and regulations, which is equally applicable in case of NOCLAR. However, section 360 of the Code of Ethics requires the auditor to assess wider public interest implications, in case there is  NOCLAR in terms of potential harm to all the stakeholders of the company, whether financial or non-financial.

Further, SA 250 is required to be complied with by the auditors while doing the audit of entities, whether public or private, whereas NOCLAR is applicable to the audit of listed companies and to the PAs who are under employment of a listed entity.

THE BOTTOM LINE
NOCLAR would require organisations to make their compliances more robust from a financial statement disclosure perspective. If the violation is not appropriately reported, it may attract disciplinary action against the professional accountant. The reporting of NOCLAR is part of the global push towards greater accountability. Considering the various kinds of reporting involved, this might translate into more instances of whistle-blowing.  

ACCOUNTING TREATMENT OF CRYPTOCURRENCIES

The Parliamentary Standing Committee on Finance recently convened a meeting on cryptocurrencies which has attracted a lot of interest as well as concern in various quarters about their investment potential and risks. The Prime Minister also cautioned that cryptocurrencies may end up in the wrong hands and urged for more international co-operation.

Cryptocurrencies have emerged as alternative currencies / investment avenues and are being considered by many as the currency of the future. Cryptocurrencies such as Bitcoins, Ethereum and many others are being considered for a variety of purposes such as a means of exchange, a medium to access blockchain-related products and raising funds for an entity developing activities in these areas. Many large international companies such as Paypal, Tesla, Starbucks, Rakuten, Coca Cola, Burger King and Whole Foods now accept cryptocurrency transactions.

Since the last few months, the Covid-19 pandemic has catapulted the growth of contactless transactions and the growth of cryptocurrencies in India. The crypto culture is fast picking up in India. Many companies all over the world have started accepting or investing in virtual currencies. Concurrently, a new crypto-asset issuance wave has been visible in the start-up world for the purpose of fund-raising. Further, the appreciation in the value of cryptocurrencies (e.g., Bitcoin price has increased more than five times at the time of writing this article as compared to the price in January, 2020) and the price volatility has attracted the interest of investors. These developments have also sparked the interest of regulators around the world.

Cryptocurrencies are not controlled or regulated by a government. Regulators around the world have been concerned about cryptocurrencies. The Reserve Bank of India (RBI) has been concerned about investors’ protection and the anonymity of the transactions.

HOW DO CRYPTOCURRENCIES FUNCTION?
Cryptographic instruments work on the principles of cryptography, i.e., a method of protecting information and communications through the use of codes so that only those for whom the information is intended can read and process it. Crypto assets represent transferable digital illustrations that prohibit any duplication. These are based on the blockchain or distributed ledger technology that facilitates the transfer of cryptographic assets.

Cryptocurrencies are not backed by any sovereign promise as is the case with real currencies. However, digital assets are backed by something. Bitcoin, for example, is backed by the electricity that goes into validating and generating transactions on the network. Gold-backed cryptocurrencies also exist. And some are backed by US dollars.

Governments around the world (including India) have generally adopted a cautious evolution of regulatory approach towards cryptocurrencies. Some countries such as China have banned cryptocurrency, while others like El Salvador have welcomed them into the formal payments system.

It is believed that it is impossible to duplicate the transactions or involve counterfeit currency in the cryptocurrency mechanism. Many cryptocurrencies are decentralised networks based on blockchain technology; it is a list of records that is growing all the time. These are known as blocks that link and secure each type of cryptocurrency. Then there is a single network called mining in which all the funds are kept. In other words, the process by which the cryptocurrency is validated is called mining.

Transactions on public, permission-less blockchains such as the Bitcoin blockchain can be viewed by anyone. The ledger records ownership of Bitcoins and all transactions that have occurred upon it. One can track an activity to particular addresses and addresses to individuals or parties involved in the blockchain. Whenever a transfer is made, this public record is used to verify availability of funds. A new transaction is encoded into the ledger through the mining process. The ledger is virtually undisputable. These features minimise the risk of fraud or manipulation in participant-to-participant transactions on the blockchain itself. The distributed ledger technology has many possible uses that go beyond cryptocurrencies.

FINANCIAL REPORTING PERSPECTIVES
Cryptocurrencies have diverse features with a broad variety of features and bespoke nature. Further, these are emerging at rapid speed. Several new cryptocurrencies have emerged and today there is widespread talk about blockchain technology and cryptoassets.

These factors make it difficult to draw general conclusions on the accounting treatment. To determine which accounting standard applies to cryptocurrencies and assessing the related accounting issues it would be important to understand their characteristics and the intended use for which they are being held by the user. Similar types of cryptographic assets may be accounted for in a similar way.

CLASSIFICATION FOR THE PURPOSE OF ACCOUNTING
Since the emergence of cryptocurrencies is a new phenomenon, there is no specific guidance from accounting standard-setters and pronouncements that deal with the accounting of such assets from the holder’s perspective. Accounting for cryptocurrencies may potentially fall in a variety of different accounting standards. One must consider the purpose of holding the cryptocurrency to determine the accounting model.

Classification
of cryptocurrencies held for own account

Rationale

Classification as cash or cash currency

• No. Since these are not legal tender and are generally not
issued or backed by any sovereign / government; cryptocurrencies do not
directly affect the prices of goods / services

Classification as financial
instrument

• No. A cryptocurrency does not give
the holder a contractual right to receive cash or another financial asset.
Also, cryptocurrencies do not come into existence as a result of a
contractual relationship. Moreover, cryptocurrencies do not provide the
holder with a residual interest in the assets of an entity after deducting
all of its liabilities.

 

 (continued)

 

Therefore, currently the cryptocurrencies do not meet the
definition of a financial asset

Classification as property, plant
& equipment

• No. Since cryptocurrencies are not
tangible items

Classification as inventories

• Maybe. AS 2 / Ind AS 2 do not require inventories to be in
physical form, but inventory should consist of assets that are held for sale
in the ordinary course of business. Where cryptocurrencies are for sale in
the ordinary course of business (for example, in case of entities actively
trading in cryptocurrencies), inventory classification would be appropriate;
inventories are measured at the lower of cost and net realisable value

• It must be noted that Ind AS 2 scopes out commodity broker-traders
who measure their inventories at fair value less costs to sell. When such
inventories are measured at fair value less costs to sell, changes in fair
value less costs to sell are recognised in profit or loss in the period of
the change

• On the other hand, where cryptocurrencies are held for
investment / capital appreciation purposes over an extended period, the
definition of inventory would not be met

Classification as intangible assets

• Yes. If a cryptocurrency does not
meet the definition of inventories as stated above, it is likely that the
definition of an intangible asset under AS 26 / Ind AS 38 would be met since
it is an identifiable non-monetary resource controlled by an entity as a
result of past events and from which future economic benefits are expected to
flow to the entity with no physical form

• Purchased intangible assets are
initially recognised at cost

• AS 26 Amortisation of
Intangibles
is based on the rebuttable presumption that the useful life
of intangibles will not exceed ten years. Under Ind AS 38, the useful life of
an intangible can be assessed as finite or indefinite. Where the useful life
is assessed as finite, such useful life is

 

 (continued)

 

determined based on management’s estimate, reviewed at least
annually. An intangible can be assessed to have an indefinite useful life if
there is no foreseeable limit over which it is expected to generate economic
benefits for the company. Ind AS 38 gives an accounting policy choice of cost
or revaluation method for intangible assets but requires the existence of an
active market if the revaluation method is to be used

DEVELOPMENT FROM INTERNATIONAL STANDARD-SETTING BODIES
Internationally, the Accounting Standards Advisory Forum (ASAF), an IFRS Foundation advisory forum, discussed digital currencies at a meeting in December, 2016. The debate was focused on the classification of a cryptographic asset from the holder’s perspective. Conversations have continued in various accounting standards boards, but no formal guidance has been issued by the International Accounting Standards Board (IASB).

In July, 2018, the IASB requested the IFRS Interpretations Committee to consider guidance for the accounting of transactions involving cryptocurrencies. In June, 2019, the Committee concluded that IAS 2 Inventories applies to such assets where they are held for sale in the ordinary course of business. If IAS 2 is not applicable, an entity applies IAS 38 Intangible Assets to holdings of cryptocurrencies.

The Australian Accounting Standards Board (AASB) had put together a discussion paper on digital currencies.

On the other hand, the Accounting Standards Board of Japan (ASBJ) has issued an exposure draft for public comment on accounting for virtual currencies. In addition, the IASB discussed certain features of transactions involving digital currencies during its meeting in January, 2018 and will discuss in future whether to commence a research project in this area. The discussion paper concluded that, currently, digital currencies should not be considered as cash or cash equivalents since digital currency lacks broad acceptance as a means of exchange as it is not issued by a central bank. A digital currency is not a financial instrument, as defined in IAS 32, since there is no contractual relationship that results in a financial asset for one party and a financial liability for another.

A digital currency may meet the definition of intangible assets, as defined in IAS 38 or Ind AS 38, because a digital currency is an identifiable non-monetary asset without physical substance. The discussion paper stated that it is not necessarily clear how ‘held in the ordinary course of business’ should be interpreted in the context of digital currencies more broadly. For example, it is not necessarily clear whether entities that accept digital currencies as a means of payment should be considered to hold them for sale in the ordinary course of business. IAS 2 does not apply to the measurement of inventories held by commodity broker-traders who measure their inventories at fair value less costs to sell and recognise changes in fair value less costs to sell in profit or loss in the period of the change.

FAIR VALUATION
Valuation of cryptocurrencies would be required to be determined in several situations, for example:
*In order to determine the net realisable value under AS 2 / Ind AS 2 or to determine fair value less costs to sell if the broker-trader exception is applied under Ind AS 2;
*In order to determine the revaluation amount under Ind AS 38 when classified as an intangible asset;
*For the purpose of purchase price allocation under business combination under Ind AS 103 when acquired through an acquisition.

Ind AS 113 Fair Value Measurement defines fair value as the price that would be received on selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. There is a three-level hierarchy for fair value determination as follows:
Level 1: quoted active market price for identical assets or liabilities;
Level 2: observable inputs other than Level 1 inputs; and
Level 3: unobservable inputs.

Many large traditional shares with an average turnover rate on the Bombay Stock Exchange or the National Stock Exchange are generally considered to be traded in an active market if there are sufficient active trading days within a given period. Data available from CoinMarketCap1 (‘CMC’) for November, 2021 shows that the top five cryptographic assets with the highest market capitalisation have high percentages of average daily turnover ratios (in certain cases up to 50%) with active daily trading. Bitcoin, for example, has a daily trading volume in excess of US $30 billion since the past few months. Looking solely at these statistics, it may be possible to conclude that certain cryptocurrencies have an active market.

Currently, for the other cryptocurrencies, it would be difficult to get a Level 1 valuation for cryptocurrencies as an active market as defined under Ind AS 113 would not be available, although there may be observable inputs that can be used to value these assets. However, the manner and speed at which the cryptocurrencies are evolving, it seems that the fair value hierarchy may keep changing between Level 1, Level 2 and Level 3.

Given the complex nature of cryptocurrencies and relative lack of depth in the market, determining the valuation would not be a straightforward exercise. This is particularly so given the high volatility of prices and the large geographic market dynamics driving the prices. It may be noted that the time at which an entity determines the value of the cryptocurrencies might need careful consideration since the crypto markets may be trading 24/7. For instance,
*Is the valuation time 11:59 PM at the end of 31st March?
*How is the valuation time determined in case of foreign subsidiaries with different time zones?
*Whether the inputs underlying the valuation have been adequately reviewed / challenged given the circumstances existing at the time of closure of business hours?

Ind AS 113 requires the principal market to be determined based on the greatest volume and level of activity for the relevant item. For cryptocurrencies, while CMC includes data from several exchanges, many exchanges serve regional markets only and might not be accessible to entities / individuals in India. Ind AS 113 states that if there is no clear principal market, an entity shall determine fair value with reference to the most advantageous market within the group of active markets to which it has access with the highest activity levels. An entity need not undertake an exhaustive search of all possible markets to identify the principal market but it shall take into account all information that is reasonably available.

Another aspect to be considered for the purpose of determination of fair valuation of cryptocurrencies is whether the cryptocurrencies can be readily exchanged for a ‘real’ currency such as USD or INR. Ind AS 113 requires a Level 1 fair value input to be quoted (with) prices (unadjusted) in active markets for identical assets / liabilities that the entity can access at the measurement date. Certain cryptocurrencies are exchanged for other cryptocurrencies rather than being exchanged for real currencies. Crypto-to-crypto exchange rates are priced based on an implicit conversion of the cryptographic asset into real currencies.

Under Ind AS 113 it can be said that an active market for a cryptocurrency would exist only when crypto-to-real currency rates are published by reliable sources. It would be difficult to classify crypto-to-crypto exchange rates as an active market (and therefore Level 1 fair value). Further, the valuation would also have to be adjusted for illiquidity factors due to the lack of a ready market and the derivation of the prices based on a crypto-to-crypto exchange rate and a secondary crypto-to-real currency exchange.

Due to the factors discussed above, most of the cryptocurrencies will not have an active market and, therefore, they will need to be valued using a valuation technique. The appropriate valuation technique should consider how a market participant would determine the fair value of the cryptocurrency being measured.

Generally, the market approach will be the most appropriate technique for cryptocurrencies. The cost approach or the income approach is likely to be rare in practice. Since cryptocurrency markets are still emerging and not very matured, inputs and information based on discrete / bilateral transactions outside an active market may have to be used. For example, in April, 2021 there was a big crash in Bitcoin prices, reportedly due to tweets about the US regulators’ decision on cracking down on financial institutions for money laundering using cryptocurrencies. Based on CMC website data at the time of writing this article, it does appear that broker quotes are not widely used in this sector as yet. The cryptocurrency market is evolving rapidly and so valuation techniques are also likely to evolve.

FINAL REMARKS
Due to the large diversity in the features of various cryptocurrencies, the pace of innovation and the regulatory developments associated with cryptocurrencies, the facts and circumstances of each individual case will differ. This makes it difficult to determine the appropriate accounting treatment and acceptable valuation technique. And given the increasing acceptance of cryptocurrencies around the world, it is a matter of time before the accounting standard-setters around the world and in India come out with standards / application guidance for cryptocurrencies.  

CARO 2020 SERIES: NEW CLAUSES AND MODIFICATIONS FRAUDS AND UNRECORDED TRANSACTIONS

(This is the fifth article in the CARO 2020 series that started in June, 2021)

BACKGROUND

In the recent past regulators and other stakeholders have been increasingly concerned with the increase in frauds by companies and the perceived lack of attention by the auditors in respect thereof. This trust deficit is attempted to be bridged by CARO 2020 by significantly increasing the reporting responsibilities for auditors with regard to fraud and unreported transactions.

SCOPE OF REPORTING

The scope of reporting can be analysed under the following clauses:

Clause No.

Particulars

Nature of change, if any

Clause 3(xi)(a)

Frauds noticed or reported:

Enhanced Reporting

Whether any fraud by the
company or any fraud on the company has been noticed or reported during the
year; if yes, the nature and the amount involved is to be indicated

Clause 3(xi)(b)

Reporting on Frauds:

New Clause

Whether any report under
sub-section (12) of section 143 of the Companies Act has been filed by the
auditors in Form ADT-4 as prescribed under rule 13 of the Companies (Audit
and Auditors) Rules, 2014 with the Central Government

Clause 3(xi)(c)

Whistle-Blower Complaints:

New Clause

Whether the auditor has
considered whistle-blower complaints, if any, received during the year by the company

Clause 3(viii)

Unrecorded Transactions:

New Clause

Whether any transactions
not recorded in the books of accounts have been surrendered or disclosed as
income during the year in the tax assessments under the Income-tax Act, 1961
(43 of 1961); and if so, whether the previously unrecorded income has been
properly recorded in the books of accounts during the year

ANALYSIS OF ENHANCED REPORTING REQUIREMENTS

Frauds noticed or reported [Clause 3(xi)(a)]:
* The scope has been widened by removing the words ‘officers or employees’.

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

Frauds noticed or reported [Clause 3(xi)(a)]:
a) Conflict with responsibilities under SA 240:
For complying with SA 240, the auditor is primarily concerned with frauds which cause material misstatements to the financial statements, which are intentional and broadly cover misstatements from fraudulent financial reporting and misappropriation of assets. This is in conflict with the CARO requirements whereby the terms ‘noticed or reported’ are very wide. Accordingly, the auditor is required to report not only the frauds noted or detected by him pursuant to the procedures performed in terms of SA 240 and reported by him u/s 143(12), but also frauds detected by the management whilst reviewing the internal controls or internal audit or whistle-blower mechanism or Audit Committee and brought to the auditor’s notice.
b) Concept of materiality: Once a fraud is noticed, it appears that it needs to be reported irrespective of the materiality involved. Whilst there is no clarity in respect thereof in the Guidance Note under this Clause, para 37 of the Guidance Note specifies that whilst reporting on matters specified in the Order, the auditor should consider the materiality in accordance with the principles enunciated in SA 320. Accordingly, the auditors should apply appropriate judgement whilst reporting under this Clause. It may be noted that even the FRRB and QRB in the course of their review reports have not been favourably inclined to the concept of taking shelter under the garb of materiality for reporting under this Clause.
c) Challenges in detection: An auditor may find it difficult to detect acts by employees or others committed with an intent to injure the interest of the company or cause wrongful gain or loss, unless these are reflected in the books of accounts; examples include receiving payoffs from vendors and tampering with QR codes during the billing and collection process. In such cases the auditors would need to corroborate their inquiries based on their knowledge of the business / industry coupled with the results of the evaluation of the internal controls, the robustness of the code of conduct and ethics policies, instances of past transgressions in respect thereof, etc.

Reporting on Frauds [Clause 3(xi)(b)]:
Before proceeding further, it would be pertinent to note the following statutory requirements:

Section 143(12) of Companies Act, 2013
Notwithstanding anything contained in this section, if an auditor of a company, in the course of the performance of his duties as auditor, has reason to believe that an offence involving fraud is being or has been committed against the company by officers or employees of the company, he shall immediately report the matter to the Central Government within such time and in such manner as may be prescribed.

Rule 13 of the Companies (Audit and Auditors) Rules, 2014 deals with reporting of frauds by auditor and other matters:
(1) If an auditor of a company, in the course of the performance of his duties as statutory auditor has reason to believe that an offence of fraud, which involves or is expected to involve, individually an amount of rupees one crore or above, is being or has been committed against the company by its officers or employees, the auditor shall report the matter to the Central Government.

(2) The auditor shall report the matter to the Central Government as under:
(a) the auditor shall report the matter to the Board or the Audit Committee, as the case may be, immediately but not later than two days of his (acquiring) knowledge of the fraud, seeking their reply or observations within forty-five days;
(b) on receipt of such reply or observations, the auditor shall forward his report and the reply or observations of the Board or the Audit Committee along with his comments (on such reply or observations of the Board or the Audit Committee) to the Central Government within fifteen days from the date of receipt of such reply or observations;
(c) in case the auditor fails to get any reply or observations from the Board or the Audit Committee within the stipulated period of forty-five days, he shall forward his report to the Central Government along with a note containing the details of his report that was earlier forwarded to the Board or the Audit Committee for which he has not received any reply or observations;
(d) the report shall be sent to the Secretary, Ministry of Corporate Affairs in a sealed cover by Registered Post with Acknowledgement Due or by Speed Post followed by an e-mail in confirmation of the same;
(e) the report shall be on the letterhead of the auditor containing postal address, e-mail address and contact telephone number or mobile number and be signed by the auditor with his seal and shall indicate his Membership Number; and
(f) The report shall be in the form of a statement as specified in Form ADT-4.

(3) In case of a fraud involving lesser than the amount specified in sub-rule (1), the auditor shall report the matter to the Audit Committee constituted  u/s 177 or to the Board immediately but not later than two days of his knowledge of the fraud and he shall report the matter specifying the following:
(a) Nature of fraud with description;
(b) Approximate amount involved; and
(c) Parties involved.

(4) The following details of each of the frauds reported to the Audit Committee or the Board under sub-rule (3) during the year shall be disclosed in the Board’s Report:
(a) Nature of fraud with description;
(b) Approximate amount involved;
(c) Parties involved, if remedial action not taken; and
(d) Remedial actions taken.

(5) The provision of this rule shall also apply, mutatis mutandis, to a Cost Auditor and a Secretarial Auditor during the performance of his duties  u/s 148 and  u/s 204, respectively.

Form and content of Form ADT-4
a) Full details of suspected offence involving fraud (with documents in support),
b) Particulars of officers / employees who are suspected to be involved in the offence,
c) Basis on which fraud is suspected,
d) Period during which the suspected fraud has occurred,
e) Date of sending report to BOD / Audit Committee and date of reply, if any, received,
f) Whether auditor is satisfied with the reply / observations of the BOD / Audit Committee,
g) Estimated amount involved in the suspected fraud,
h) Steps taken by the company, if any, in this regard, with full details of references.

Guidance Note issued by ICAI
The ICAI has also published a Guidance Note on Reporting of Frauds u/s 143(12) of the Companies Act, 2013 to assist the auditors in discharging their responsibilities. Some of the main issues addressed by the Guidance Note are as under and which need to be kept in mind whilst discharging the responsibilities for reporting under this Clause:
* The requirement is to report only on frauds in the course of performance of duties as an auditor.
* Only frauds committed against the company by its officers or employees are required to be reported. Thus, frauds committed by vendors and outsourced service providers are not required to be reported. The requirements of SA 240 need to be kept in mind. Accordingly only frauds involving financial reporting or misappropriation of assets are covered Thus, the scope for reporting under this Clause is much narrower than under sub-clause (a) discussed earlier.
* If any frauds are detected during the course of other attest / non-attest functions like quarterly reporting and they are likely to have a material effect on the financial statements, the same would also need to be reported.
* There is no responsibility to report frauds if the same are already detected. However, in such cases the auditor should apply professional scepticism as to whether the fraud was genuinely detected through vigil / whistle-blower mechanism and review the follow-up in respect thereof. This could have an impact on reporting under sub-clause (c) discussed subsequently.
* Reporting is required only when there is sufficient reason to believe and there is sufficient knowledge (i.e., evidence) of occurrence. Mere suspicion is not sufficient.

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

a) Reporting by predecessor auditor: The requirement for reporting pertains to any report which has been filed during the financial year under audit. Accordingly, if the auditor has been appointed for the first time, he would need to consider whether the predecessor auditor has reported to the Central Government during the financial year prior to his term being concluded before the AGM. In such cases it is better that the incoming auditor seeks a specific clarification from the predecessor auditor and also obtains a management representation and makes a mention accordingly in his report.
b) Post-balance sheet events: If the auditor has identified the fraud and initiated the communication procedures outlined earlier before the year-end but has filed his report with the Central Government subsequent to year-end till the date of the report, he would need to report on the same specifically under this Clause. In such cases, he should also consider the impact on the financial statements and disclosures of Events subsequent to the balance sheet date under AS 4 and Ind AS 10, as applicable.
c) Monetarily immaterial frauds: Monetarily immaterial frauds below Rs. 1 crore have to be reported by the auditor to the Audit Committee constituted u/s 177. In cases where the Audit Committee is not required to be constituted u/s 177, then the auditor shall report monetarily immaterial frauds to the Board of Directors. In either case, a disclosure needs to be made in the Board Report as outlined earlier. Though there is no specific reporting responsibility under this Clause, it would be a good practice to make a reference to the same under this Clause.
d) Cost audit and secretarial audit: Reporting on fraud u/s 143(12) is required even by the cost auditor and the secretarial auditor of the company and it is possible that a suspected offence involving fraud may have been reported by them even before the auditor became aware of the fraud in the course of his audit procedures under SA 240. In such cases, if a suspected offence of fraud has already been reported by the cost auditor and the secretarial auditor, he need not report the same to the Audit Committee u/s 177 or the Board of Directors and thereafter, where applicable, to the Central Government, since he has not per se identified the suspected offence of fraud. It is, however, advisable that the report factually clarifies the position.

Whistle-Blower Complaints [Clause 3(xi)(c)]:
The establishment of a whistle-blower mechanism is mandatory for certain class of companies and therefore the auditor should consider the requirements prescribed in the Act and in SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (SEBI LODR Regulations) in this regard. Section 177(9) of the Act requires certain class of companies to establish a vigil mechanism for their Directors and employees to report their genuine concerns or grievances:

Requirements under Companies Act, 2013
Section 177(9) read with Rule 7 of the Companies (Meetings of Board and its Powers) Rules, 2014 provides for establishment of a vigil mechanism.

(1) Every listed company and the companies belonging to the following class or classes shall establish a vigil mechanism for their Directors and employees to report their genuine concerns or grievances:
(a) the companies which accept deposits from the public;
(b) the companies which have borrowed money from banks and public financial institutions in excess of fifty crore rupees.
(2) The companies which are required to constitute an Audit Committee shall oversee the vigil mechanism through the committee and if any of the members of the committee have a conflict of interest in a given case, they should recuse themselves and the others on the committee would deal with the matter on hand.
(3) In case of other companies, the Board of Directors shall nominate a Director to play the role of an Audit Committee for the purpose of vigil mechanism to whom other Directors and employees may report their concerns.
(4) The vigil mechanism shall provide for adequate safeguards against victimisation of employees and Directors who avail of the vigil mechanism and also provide for direct access to the Chairperson of the Audit Committee or the Director nominated to play the role of Audit Committee, as the case may be, in exceptional cases.
(5) In case of repeated frivolous complaints being filed by a Director or an employee, the Audit Committee or the Director nominated to play the role of Audit Committee may take suitable action against the Director or employee concerned, including reprimand.

Requirements under SEBI LODR
Regulation 4(2)(d) of the SEBI LODR Regulations also mandates all listed entities to devise an effective whistle-blower mechanism enabling Directors, employees or any other person to freely communicate their concerns about illegal or unethical practices.

Regulation 46(2)(e) of SEBI LODR Regulations requires a listed company to disseminate on its website details of establishment of its vigil mechanism / whistle-blower policy. Further, the role of the Audit Committee also includes review of the functioning of the whistle-blower mechanism.

Keeping in mind the above reporting requirements, the following are some of the practical challenges that could arise in reporting under this Clause:
a) Anonymous complaints:
The auditor needs to consider every complaint received by the company including anonymous complaints while deciding the nature, timing and extent of audit procedures. The auditor should also evaluate whether such complaints are investigated and resolved by the company in an appropriate and timely manner. Further, in case of anonymous complaints he needs to exercise greater degree of professional scepticism to ascertain whether they are frivolous or motivated. Also, any other information which is available in the public domain should also be considered.
b) Companies not covered under the Regulatory Framework: The reporting requirements under this Clause do not distinguish between listed, public interest entities and other entities, including those in the SME sector where there is no regulatory requirement to establish a formal whistle-blower / vigil mechanism. In such cases the auditor needs to make specific inquiries and obtain appropriate representation which needs to be corroborated for adequacy and appropriateness based on the understanding obtained about the entity and its operating and governance environment. Finally, any information which is available in the public domain should also be considered.
c) Forensic investigations: In case a forensic audit /investigation has been initiated pursuant to a whistle-blower complaint, the auditor needs to check the reports issued and discuss the observations and conclusions with the auditor / investigation agency if required and report accordingly.
d) Outsourcing arrangements: The auditor should perform independent procedures, including getting direct confirmation for whistle-blower complaints received which are managed by a third party like an external internal audit firm.

Unrecorded Transactions [Clause 3(viii)]:
Before proceeding further, it would be pertinent to note the following statutory requirements:

Undisclosed income under the Income-tax Act, 1961
‘Undisclosed income’ as per section 158B includes any money, bullion, jewellery or other valuable article or thing or any income based on any entry in the books of accounts or other documents or transactions, where such money, bullion, jewellery, valuable article, thing, entry in the books of accounts or other document or transaction represents wholly or partly income or property which has not been or would not have been disclosed for the purposes of this Act, or any expense, deduction or allowance claimed under this Act which is found to be false.

Vivad Se Vishwas Scheme
The Union Budget 2020 was presented by the Finance Minister on 1st February, 2020 with an underlying objective to support the Government’s target of making India a $5 trillion economy by 2025. Several policy and tax-related announcements were made with primary focus on improving the ease of living and the ease of doing business in India. One of the key proposals was introduction of a direct tax dispute resolution scheme, namely, Vivad Se Vishwas Scheme which translates to ‘From Dispute towards Trust’, i.e., trust as the basis of partnering with the taxpayers towards building the nation. The Scheme proposes to settle direct tax disputes relating to personal income tax and corporate tax between taxpayers and the tax Department. The Government of India enacted the Direct Tax Vivad Se Vishwas Act, 2020 (‘the Act’) on 17th March, 2020 to give effect to this Scheme.

An overview of the Scheme:
* If a taxpayer elects to take recourse under the Scheme, a proportion of the total tax along with interest and penalty needs to be paid (depending on the type of the pending dispute) for full and final settlement.
* The scheme confers immunity from prosecution, penalty and interest in respect of proceedings for which the taxpayer has opted to avail the Scheme.
* The Act also provides that the tax disputes so settled cannot be reopened in any other proceeding by the Income Tax Department or any other designated authority.

Keeping in mind the above reporting requirements, the following are some of the practical challenges that could arise in reporting under this Clause:
a) Scope: The emphasis is on the words surrendered or disclosed which implies that the company must have voluntarily admitted to the addition of such income in the income tax returns filed by the company. What constitutes voluntary admission poses several challenges especially where the company has pending tax assessments which have been decided up to a particular stage and the company chooses not to file an appeal. In such cases, the auditor needs to review the submissions and statements filed in the course of assessment to ascertain whether the additions to income were as a consequence of certain transactions not recorded in the books. This would involve use of professional judgement and consideration of the materiality factor.
b) Submissions under the Vivad Se Vishwas Scheme: In case the company has opted for disclosures under the said Scheme, a view can be taken that the same constitutes voluntary surrender and disclosure and hence needs to be reported under this Clause with appropriate factual disclosures.

CONCLUSION
Frauds are now an inherent part of corporate life and the auditors will have to live with them. The reporting requirements outlined above will hopefully provide them with the necessary tools to cope with them and provide greater comfort to the various stakeholders. In conclusion, life will never be cushy for the auditors and they would always be on the razor’s edge!

AUDITOR’S EVALUATION OF GOING CONCERN ASSESSMENT

(This is the second article of the two-part series on Going Concern.
The first part appeared in the BCAJ edition of October, 2021.)

The first part of this article on Going Concern had touched upon the various aspects of going concern assessment by management; this part will attempt to highlight the various factors that an auditor should consider while evaluating the going concern assessment performed by the management, disclosure in the financial statements based on the outcome of the evaluation, and reporting considerations under various scenarios in the auditors’ report.

The Covid-19 pandemic and the on-going economic developments have changed the traditional way of doing business and have created significant challenges for some of the industries to save their existence and to survive in the present economic environment.

Our regulators have also acknowledged the criticality of the situation and, to save the interest of investors and users of the financial statements, have increased their focus on the disclosures and reporting requirements related to going concern assumption used in the preparation of financial statements, and introduced new provisions in the reporting requirement wherever needed.

The Institute of Chartered Accountants of India has also introduced guidance with respect to the assessment and evaluation of the going concern assumption in the present economic environment and also an implementation guide to assist auditors to comply with the additional reporting requirements.

Although the above amendments and additional guidance were introduced to assist auditors in discharging their responsibilities and to save the interest of the users of the financial statements, they have significantly increased the responsibilities of the auditors and the criticality of their role in the true and fair reporting of the financial statements.

SA 570 (Revised) states that the auditor’s responsibilities are to obtain sufficient audit evidence on the appropriateness of management’s use of the going concern basis of accounting in the preparation of the financial statements and to conclude, based on the audit evidence obtained, whether a material uncertainty exists about the entity’s ability to continue as a going concern.

The auditor needs to be cognizant of this responsibility to obtain sufficient appropriate audit evidence on the appropriateness of the going concern assumption throughout the audit, and should start this evaluation from the audit planning stage, while understanding the entity’s business and assessing the risks of material misstatement in accordance with SA 315 Identifying and Assessing the Risks of Material Misstatement Through Understanding the Entity and its Environment, by considering whether there are any conditions or events that, individually or in aggregate, raise significant doubt about an entity’s ability to continue as a going concern for a reasonable period of time and, if so, whether any preliminary assessment has been done by the management for those identified events and conditions.

If any such events or conditions are identified by the auditor at the audit planning stage or at any time thereafter, for instance, defaults on repayment of borrowings, legal action taken by creditors due to long outstanding, penalty imposed by regulators due to non-compliance that have a significant effect on the cash flows of the company, etc., then the auditor should also consider the possible effect of it on the identified Risks of Material Misstatements for other account captions and, accordingly, needs to plan and perform additional audit procedures to address them. For instance, the auditor may need to increase the risk of material misstatements for related account captions like creditors, borrowings, contingent liabilities, earlier cash flow projections, impairment of inventory or intangibles, etc., and perform extended audit procedures either by increasing the sample size or additional audit steps to address the risk identified from the development.

In the case of events and conditions that are identified and for which going concern assessment is performed by the management, the auditor is required to perform adequate audit procedures, if the other audit procedures performed as part of the audit are not sufficient to enable the auditor to conclude whether management’s use of the going concern basis of accounting is appropriate in the circumstances.

AUDIT PROCEDURES FOR EVALUATION OF GOING CONCERN ASSESSMENT
Given below are examples of some of the audit steps that can be considered for evaluating the appropriateness of management’s assessment of going concern:
– Understanding the specific conditions and events considered by the management and their possible financial implications,
– Indicators or events that may be identified by the auditors during the audit and their possible financial implications on the cash flow projections,
– Ensuring that the possible cash inflows and outflows from business, during the projection period, are reasonable and are in line with the management’s future business projections that were approved by the Board earlier,
– Whether Covid consideration has been taken into account by the management while taking the critical assumptions like revenue growth rate, discount rate, timing of cash inflows and outflows, and if yes, the evidence considered by the management to support them,
– Sensitivity analysis on the assumptions made by the management,
– One-off cash inflows should be supported by adequate documentation to substantiate that realisation is certain,
– Adequate provisions have been made towards any future contingencies and events,
– Guarantees and commitments to related and non-related parties and to their creditors or lenders,
– Any subsequent events that may have an impact on the going concern assessment made by the management,
– Inquire with the management as to its knowledge of events or conditions beyond the period of management’s assessment that may cast significant doubt on the entity’s ability to continue as a going concern,
– Where an auditor relies on a ‘support letter’ as evidence, the auditor should also evaluate the financial strength and capability of the parent or group company issuing the support letter to evaluate whether the parent or group company has the financial ability to discharge the obligations of the company. Further, the support letter should cover at least twelve months from the date of the financial statements and should be executed in a way so as to create a legal binding on the parent or group company to provide financial support when needed,
– Written representations from management regarding their plans for future action and the feasibility of these plans

Going concern evaluation considerations for small and medium enterprises
In case of small and medium enterprises, there can be a situation where the management has not performed a detailed, documented going concern assessment; in such cases the auditor should discuss with management the basis for the intended use of the going concern basis of accounting and whether events or conditions exist that, individually or collectively, may cast significant doubt on the entity’s ability to continue as a going concern. The auditor should also remain alert throughout the audit for audit evidence of events or conditions that may cast significant doubt on the entity’s ability to continue as a going concern.

GOING CONCERN EVALUATION CONSIDERATIONS FOR CONSOLIDATED FINANCIAL STATEMENTS
In case of consolidated financial statements, the auditor of the parent entity is also required to report on the going concern assumption used by the management for the preparation of consolidated financial statements. In this case, the auditor of the parent entity needs to perform the evaluation of going concern assumption of the entities that are getting consolidated, by placing reliance on the audit report issued and work performed by the component auditors (if the parent auditor is not the auditor for all components).

However, the auditor needs to perform adequate audit procedures, in accordance with the guidance given in SA 600 Using the Work of Another Auditor, on the work performed by the component auditors such as review of work papers of going concern evaluation, minutes of meetings with management and component auditors, subsequent events, etc., before concluding the evaluation of going concern assumption for the consolidated financial statements.

Period covered for going concern assessment
Ind AS 1 Presentation of Financial Statements requires management to consider at least twelve months from the end of the reporting period for the going concern assessment; similar guidance is given in SA 570 (Revised) as well.

Here it is important to highlight that twelve months is the minimum period prescribed both by Ind AS 1 and SA 570 (Revised), and if the auditor, based on the audit evidence obtained, believes that the period of assessment should be extended beyond twelve months from the date of the financial statements, then the auditor should request management to do so.

However, if management is unwilling to make or extend its assessment, a qualified opinion, or a disclaimer of opinion in the auditor’s report may be appropriate, because it may not be possible for the auditor to obtain sufficient appropriate audit evidence regarding management’s use of the going concern basis of accounting in the preparation of the financial statements.

One example for the above scenario could be an entity whose license to do business is expiring in the thirteenth month from the end of the financial year and the cost of renewing the license is substantially high; in this case, the auditor may need to request management to extend its going concern assessment beyond twelve months to assess the certainty to renew the license and the source of finance to fund its renewal fees.

Reporting considerations
Based on the audit evidence obtained, the auditor needs to conclude whether in his judgement a material uncertainty exists related to events or conditions that, individually or collectively, may cast significant doubt on the entity’s ability to continue as a going concern, and accordingly needs to ensure the compliances with respect to the disclosures in the financial statements and reporting in the auditors’ report.

The Table below lists the scenarios and the related disclosure and reporting requirements as per Ind AS 1 and SA 570 (Revised) that the auditor needs to ensure:

Scenarios*

Events or conditions
have been identified and a material uncertainty exists

Events or conditions
have been identified but no material uncertainty exists

Financial statements

Disclosure in the financial statements

• Principal events or conditions and management’s evaluation of
the significance of those events or conditions

• Principal events or conditions and management’s evaluation of
the significance of those events or conditions

 

(continued)

• Management’s plans to deal with these events or conditions

• Fact that there is a material uncertainty related to these
events or conditions that cast significant doubt on the entity’s ability to
continue as a going concern

(continued)

• Management’s plans that mitigate the effect of these events or
conditions

• Significant judgements made by management as part of its
assessment

*Reference can be made to the Annual Reports referred to in the first part of the Going Concern article to gain a practical understanding of the disclosures required to be made in the financial statements under various scenarios.

Like the Ind AS 1, AS 1 also does not provide any specific disclosure guidance on the material uncertainty and requires specific disclosures only when the entity has intentions or requirement to liquidate or curtail materially the scale of its operation, and as a result of which the financial statement needs to be prepared on an alternate basis.

(b) Scenarios for reporting in the auditor’s report:

Scenarios*

Events or conditions
have been identified and a material uncertainty exists*

Auditors’ report

Management’s use of the going concern basis of accounting in the
financial statements is inappropriate

Auditor to express an adverse opinion regardless of whether or
not the financial statements include disclosure of the inappropriateness of
management’s use of the going concern basis of accounting, and reporting of
it under u/s 143(3)(f);

Reference can be drawn to the Annual Report of Mercator Limited
for the year ended 31st March, 2020

Going concern basis of accounting is
appropriate, but a material uncertainty relating to going concern exists

Separate section in the auditors’
report
with a heading that includes reference to the fact that a material
uncertainty related to going concern exists, and reporting of it u/s
143(3)(f);

Reference can be made to the Annual
Reports of:

• Vodafone Idea Limited for the year
ended 31st March, 2021

• SpiceJet Limited for the year ended
31st March, 2020

Scenarios*

Events or conditions
have been identified and a material uncertainty exists*

Going concern basis of accounting is appropriate but adequate
disclosure of material uncertainty is not made in the financial statements

Qualified or adverse opinion, based on the pervasiveness of the
inadequacy of disclosure, and reporting of it u/s 143(3)(f) when sufficient
appropriate audit evidence regarding the appropriateness of the management’s
use of the going concern is obtained, but adequate disclosure of a material
uncertainty is not made in the financial statements

Management concluded going concern
basis of accounting is not appropriate and considered alternate basis of
accounting

Emphasis of Matter paragraph, to draw
the user’s attention, when the alternate basis of accounting is acceptable to
auditor

*As per the requirement of CARO 2020 clause (xix), the auditor is also required to comment on the material uncertainties, with respect to the company’s ability to honour its obligation existing at the balance sheet date and that are due for payment within a period of one year.

It is worth mentioning here that the auditor should not consider communicating key audit matters as a substitute for reporting in accordance with SA 570 (Revised) when a material uncertainty exists. Accordingly, a separate heading that includes reference to the material uncertainty related to going concern needs to be included before key audit matters as per the Appendix of SA 570 (Revised).

PROFESSIONAL JUDGEMENT
Just as going concern assessment requires significant judgement by management, the evaluation of going concern assessment also requires significant professional judgement by the auditors. The example below demonstrates one such scenario:

Illustration
Company A is into the business of providing e-learning solutions and had started its operations two years back with a share capital of Rs. 50 lakhs. The company received the first round of funding of Rs. 50 crores from a PE investor in the first year of its operations; however, due to significant spend on advertising and e-learning content development, the company is running into significant losses.

The company is in the third year of its operations and expected to start generating positive cash flows by the end of the fifth year. The historical year-on-year revenue growth is 100% and the promoter is in discussion with the PE investors for the second round of funding. The company is not able to borrow from bankers due to unavailability of asset base and adequate guarantee.

The management strongly believes that the second round of funding is going to happen within the next few months considering past revenue growth and positive future outlook in the e-learning sector.

Analysis
In the present scenario, there are events and conditions that cast significant doubt on the entity’s ability to continue as a going concern; however, the management based on evidence like growth potential in the industry, past revenue trends and current negotiations with PE investors, has concluded that the going concern assumption holds good.

Based on the above conclusion of management, the auditor may consider the following points for evaluating the management’s assessment:
(a) Industry analysts’ research reports on the growth potential of the industry,
(b) Evidence of negotiations with potential investors to assess the progress of the next round of funding, like non-binding term sheets, email communications, etc.,
(c) Normal gestation period in similar industries to generate positive cash flows,
(d) Evidence to support future projections and cash flows that may include sales orders, inquiries from present and prospective customers, reasonability of assumptions like growth rate, estimated expenditure to run operations, etc.,
(e) Sensitivity analysis on the assumptions to see the implications in case there is a deviation,
(f) Present litigations against the company, if any, specifically on account of non-payment of dues,
(g) Alternate plan with management, in case the funding does not take place.

Considering the above facts, the auditor needs to conclude whether a material uncertainty exists regarding the going concern assumption for the preparation of financial statements and accordingly should exercise his professional judgement on the basis of the available evidence to conclude whether the going concern basis of accounting is appropriate.

Based on the above evaluation, the auditor needs to ensure the adequacy of relevant disclosures made by the management in the financial statements and appropriate reporting of going concern in the auditors’ report.

Documentation
As discussed in the preceding paragraphs, the evaluation of going concern assessment requires significant professional judgement and involves various critical factors that require detailed evaluation and discussion with management before drawing a conclusion, and as such it becomes very critical for the auditor to ensure adequate audit documentation demonstrating the audit procedures performed and evidence obtained by the audit team, to conclude the going concern assumption.

Given below are the main points that the auditor should consider while documenting the going concern evaluation:
– Events and conditions identified during the audit that the auditor believes may cast significant doubt on the entity’s ability to continue on a going concern basis;
– Minutes of meetings with management, discussing all such identified events and conditions and management responses addressing those events and conditions. Here it is important to highlight that the audit team while documenting these minutes of meetings should also ensure that such documentation should also cover the date and place of the meeting, the names of the participants and their designations, and acknowledgment from the participants of the matters discussed therein;
– Details of the business plan and other factors considered by the management to support the going concern assumption;
– Audit procedures performed and evidence obtained by the audit team to validate the management plan and assumptions;
– Minutes of meetings of any discussion / consultation held by the audit team with the senior audit partners or industry experts within the firm;
– Adequate documentation demonstrating the reliance placed on the Subject Matter Experts and audit procedures performed in accordance with the guidance given in SA 260 Using the Work of an Expert;
– Conclusion drawn by the auditor based on the audit procedures performed and evidence obtained;
– Disclosure implications in the financial statements, based on the conclusion drawn and whether it has been complied by the management while preparing the financial statements;
– Reporting implications in the auditors’ report based on the above evaluation and disclosures made in the financial statements;
– In cases where the auditor concludes that an emphasis of matter or a modified opinion is required to be issued, evidences of communication with Those Charged With Governance should also be documented as part of audit documentation.

TO SUMMARISE
The above discussion highlights that the evaluation of going concern assessment has become more critical and complex in the present economic environment and the auditor needs to adopt a more vigilant approach to address it effectively. The auditor, along with the various guidances that have been issued by the Institute of Chartered Accountants of India to assist the auditors to address the challenges in going concern, should also draw reference from other audits, of events and conditions that have raised significant doubts on the entity’s ability to continue as a going concern with their possible outcome, while concluding the evaluation of going concern assessment.

 

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

BACKGROUND
Companies need funds on a regular basis and tap various sources for the same, from retail / small depositors (commonly referred to as public deposits) to large lenders. In respect of public deposits there are stringent guidelines laid down by the RBI and the MCA which need to be complied with, including for amounts which are deemed to be in the nature of deposits. Further, the lenders and depositors also need an assurance that the companies are using the same for the stated purposes and not as a funding tool within group entities and would be able to repay the same as per the stipulated terms as well as an assurance about the future stability and liquidity of the company. The Companies Act, 2013 (‘the Act’) has also laid down stringent provisions to regulate the same, especially in respect of non-financial companies. CARO 2020 has also accordingly enhanced the reporting requirements substantially.

SCOPE OF REPORTING

The scope of reporting can be analysed under the following clauses:

Clause No.

Particulars

Nature of change, if any

Clause 3(v)

Deemed Deposits:

Enhanced Reporting

In respect of deposits accepted by the company or amounts which are deemed to be deposits:

• Whether the directives issued by the Reserve
Bank of India and the provisions of sections 73 to 76 or any other relevant
provisions of the Companies Act and the rules made thereunder, where
applicable, have been complied with;

• In case of any contraventions

 

in respect of the above, the nature of such
contraventions be stated;

• If an order has been passed by the Company Law
Board or the National Company Law Tribunal or the Reserve Bank of India or
any court or any other tribunal, whether the same has been complied with or
not;

 

Clause 3(ix)(a)

Default in repayment of loans / other borrowings
and interest:

Enhanced Reporting

• Whether the company has defaulted in repayment
of loans or other borrowings or in
the payment of interest thereon to any lender;

• If yes, the period and the amount of default to
be reported as per the format below:

• Nature of borrowing including debt securities

• Name of lender*

• Amount not paid on due date
• Whether principal or interest

• No. of days delay or unpaid
• Remarks, if any

* lender-wise details to be provided in case of
defaults to banks, financial institutions and Government
           

Clause 3(ix)(b)

Wilful defaulter:

New Clause

Whether the company is
declared a wilful defaulter by any bank or financial institution or other
lender.

Clause 3(ix)(c)

Application of term loans for prescribed
purposes:

New Clause

• Whether term loans were applied
for the purpose for which the loans were obtained;

• If not, the amount of
loan so

 

(continued)

diverted and the purpose
for which it is used may be reported.

 

Clause 3(ix)(d)

Short-term funds utilised for long-term purposes:

New Clause

• Whether funds raised on
short-term basis have been utilised for long-term purposes;

• If yes, the nature and
amount to be indicated.

Clause 3(ix)(e)

Funds borrowed for meeting obligations of group
companies:

New Clause

• Whether the company has
taken any funds from any entity or person on account of or to meet the
obligations of its subsidiaries, associates or joint ventures;

• If so, details thereof
with nature of such transactions and the amount in each case.

Clause 3(ix)(f)

Loans raised against pledge of securities of
group companies:

New Clause

• Whether the company has
raised loans during the year on the pledge of securities held in its
subsidiaries, joint ventures or associate companies;

• If so, give details
thereof; and

• Report if the company has
defaulted in repayment of such loans raised.

 

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:

Nature
of exception / deviation

Possible
impact on the audit report / opinion

The company has not complied with the RBI
directives or sections 73 to 76 or other applicable provisions of the Act or
relevant Rules or orders of any statutory authority which may have
implications on the main audit

• Modified opinion under SA 706

• Key audit matter under SA 701

 

(continued)

report due to non-compliance with the
following SAs:

• Consideration of laws and regulations (SA
250)

• Fraud (SA 240).

[Clause 3(v)]

 

• In extreme cases, where there are
continuing defaults in repayment of loans / borrowings by the company, there
may be uncertainties around the appropriateness of Going Concern assumption
in the financial statements. The auditor shall follow the requirements of SA
570 (Revised) Going Concern in such cases.

• Restructuring of loan subsequent to the
balance sheet date but before the date of auditor’s report.

[Clause 3(ix)(a)]

• Modified opinion under SA
706

• Emphasis of matter under
SA 705

• Key audit matter under SA
701 (in case of restructuring subsequent to the Balance Sheet date)

 

Where the company has been declared a
wilful defaulter, there may be uncertainties around the appropriateness of
Going Concern assumption in the financial statements. The auditor shall
follow the requirements of SA 570 (Revised) Going Concern in such
cases

[Clause 3(ix)(b)]

• Modified opinion under SA 706

• Key audit matter under SA 701 (where the
Company is disputing the same)

Where the company has not applied term
loans for the purpose for which the loans were obtained, there may be
uncertainties around the appropriateness of Going Concern assumption in the
financial statements. The auditor shall follow the requirements of auditing
standards, in particular SA 240 The Auditor’s Responsibilities Relating to
Fraud in an Audit of Financial Statements

[Clause 3(ix)(c)]

Modified opinion under SA 706

Where the company has taken any funds from
any entity or person on account of or to meet the obligations of its
subsidiaries,  associates or joint
ventures, the

Modified opinion under SA 706

(continued)

auditor may have to consider   the impact of impairment or provisioning
and whether the same is consistent with the purpose of loans taken by the
company and whether there is a breach in the loan covenants. The auditor
shall consider requirements of the auditing standards, in particular SA 240 The
Auditor’s Responsibilities Relating to Fraud in an Audit of Financial
Statements

[Clause 3(ix)(e)]

 

Where the company has raised loans during
the year on the pledge of securities held in its subsidiaries, joint ventures
or associate companies and if the company has defaulted in repayment of such
loans, the auditor may have to consider audit issues such as requirements of
the auditing standards, in particular SA 570 Going Concern and SA 240 The
Auditor’s Responsibilities Relating to Fraud in an Audit of Financial
Statements

[Clause 3(ix)(f)]

Modified opinion under SA 706

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.

COVID IMPACT ON INTERNAL CONTROLS OVER FINANCIAL REPORTING

Yes, you read it right. Just as humans are affected by Covid, internal controls over financial reporting, too, are affected by Covid. As we all know by now, Covid attacks when the immune system is weak. Similarly, operations, and therefore the performance of companies, get affected when their internal controls have deficiencies and weaknesses. When the tide will go down is uncertain. But there are many interrelated implications on financial reporting arising from the pandemic. The way of carrying out operations has changed significantly for a lot of companies either due to the nature of their own operations, or due to the impact felt by their suppliers or customers.

This article highlights how Covid might have impacted the internal controls of companies. Needless to say, when the internal controls have been affected by the pandemic, the auditors of such companies need to consider its impact on their reporting on the adequacy and operating effectiveness of internal controls with reference to financial statements as prescribed u/s 143(3)(i) of the Companies Act, 2013.

The pandemic has hit all organisations globally and India is no exception. Considering this, the Securities and Exchange Board of India (SEBI) issued a Circular dated 20th May, 2020 encouraging listed entities to make timely disclosures about the impact of Covid on their companies. One of the items in the list of information that the Circular states listed companies may consider disclosing is internal financial reporting and controls.

The users of the financial statements, various stakeholders, including investors, lenders, suppliers and customers, Government agencies and so on, are keen to know to what extent the company has been affected by the pandemic. As stated in the ‘Guidance Note on Audit of Internal Financial Controls over Financial Reporting’ issued by The Institute of Chartered Accountants of India (GN on IFC) for the purpose of auditor’s reporting u/s 143(3)(i) of the Companies Act, 2013, ‘internal financial controls over financial reporting’ shall mean ‘a process designed to provide a reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.’ Therefore, to prepare reliable financial statements, internal controls over financial reporting are imperative. If such internal controls are affected by Covid and if the company has not taken adequate steps, the financial statements prepared may not be reliable for external purposes and the stakeholders will lose confidence in the entity’s financial reporting. From the governance perspective, it is important for the Audit Committee and management that new processes for financial statements closure and reporting of results and financial / operational controls are appropriately documented.

EXTENDED REPORTING TIMELINES

SEBI has given extended timelines to listed entities to report their results in 2020 as well as for the 2021 year-end. This was brought out considering that companies were facing challenges to complete the preparation of financial information due to the impact of Covid on their people and processes. However, the question is was the challenge faced by the companies related only to reduced manpower at work to complete the tasks, or did the company effectively use the additional time to ensure that its procedures as required by its internal control framework were completed like in any other year? If it is the latter, it will show how the company is impacted by Covid, how it has assessed such impact and reacted to it. But if the companies have used the extended timeline for slowing down the pace, it shows that the company has not assessed the impact of Covid on its processes.

IMPACT ON FINANCIAL CLOSURES


The shift to remote working is testing the operational endurance and the resilience of critical processes across companies. The financial close is no exception which is facing multiple problems in conducting an efficient and effective close process. The financial closure process of a company is a combination of various documents and components. As explained in the GN on IFC, control activities may be categorised as policies and procedures that pertain to:
(A) Performance reviews
(B) Information processing
(C) Physical controls
(D) Segregation of duties

(A) Performance reviews refer to overall analytical procedures of actual performance with budgets, forecasts, etc. However, it is very likely that the budgets, forecasts, prior period actuals, etc., did not include the impact of Covid at all, or had considered its impact based on information available at that time. In the absence of the robustness of a performance review, what controls does the company need to establish to ensure the reliability of financial information? Let’s understand this by way of an example. A company manufactures white goods such as dishwashers, washing machines, etc. Its volume of production in a given period is predictable as the company had established its plant many years ago. For F.Y. 2019-20, the company was able to run its normal operations throughout the year, except the last week near the year-end due to the lockdown. However, in F.Y. 2020-21, the lockdown was extended and therefore production was completely shut for part of the year. While reviewing the performance of F.Y. 2020-21 and comparing the same with the previous year, the variance can be quantified for that attributable to the period when the plant was shut.

(B) Information processing controls are application controls and general IT controls. Before Covid, these controls were usually based on the assumption that applications were being accessed by users through LAN. This identifies the user and has security firewalls to protect the data in the system to ensure its reliability. In the period of the pandemic, where many organisations had to close their offices and allow employees to work from home, IT systems are being accessed by employees through their home networks. The reduced number of employees may result in reduced controls being adhered to. Vulnerability of security for data protection and its unauthorised access pose a significant threat to the reliability of the financial close process. Further, there is heightened risk of data leakage. For example, a company has IT security through which tenders submitted by potential suppliers can be accessed by the procurement department only through the office LAN. During Covid, when staff is working on their home networks, such control cannot be implemented and needs to be modified without compromising on the security of the data. IT processes or controls that have an increased volume or that need to be performed differently due to changes in work environment or personnel, are likely to have additional risks in areas such as the following:

Access termination – Increased number of access termination requests and fewer people available to process them – this may increase the risk of unauthorised access due to terminated personnel not being removed in time. In many organisations, there is an exit form which the employee fills and after approval from the HR it is handed over to IT to ensure that all access given to that employee is terminated and confirmed by IT by signing the same form showing the date and time of termination. In the Covid scenario, the exiting personnel, HR staff and IT staff are all at different locations. To ensure coordination amongst them for terminating the access immediately when the employee leaves, different controls need to be put in place.

Change management – Verbal approvals may be accepted rather than waiting for approvals to be documented through a ticketing system, and thus there may be increased use of emergency IDs which may not be subject to the same degree or timeliness of monitoring as usually occurs. Whenever any change is required in the IT environment, many companies have a hard copy documentation system showing the requester, the approver and details of the changes made, followed by subsequent testing and implementation. During Covid, such hard copy documentation may not be possible given that the requester, approver, programme writer, testing team and implementation team are at different locations. This may require modification of the existing IT change management controls.

Execution of review controls – The questions to be answered are:
(a) What changes are made to the review process of access control, change management and other IT environment processes?
(b) To what extent are the company’s IT risks affected by the new way of working and what are the mitigating controls introduced to deal with the security threat to the IT systems that process financial data?

Many organisations are changing their strategies to take advantage of digital technology, such as storing data on cloud which can be accessed from anywhere by the authorised personnel. Even if the employee working on such data is not able to access the company’s server from her remote location, such data need not be copied on the workstation of the employee when it is available on cloud. With such changes in strategy, it is obvious that the relevant risk control matrix of the company will undergo a change. The new risks identified will be because the majority of employees are working from different locations. Controls to mitigate such risks, for example, data security risk as discussed above, will be plotted against each of such processes.

(C) Physical controls relate to the existence of assets and authorisations for their access. In the Covid scenario, such authorised person holding custody of the physical assets is away from the office or location of the assets for prolonged periods. How does the company ensure the existence of its assets when the person entrusted with their physical custody no longer has their custody? How has the company changed its internal controls which earlier were physical controls? For example, during partial lockdown, earlier internal controls might have been modified in respect of frequency of physical verification, the authority performing such verification, etc. Such modified controls may also consider any new digital technology implemented by the company or any supplemental controls to the original pre-Covid controls.

Safeguarding inventory
Safeguarding inventories is the responsibility of the management which is required to establish procedures to ensure the existence, condition and support valuation of all inventory. There may be transactions as at the yearend where the company has transferred the control of assets, but where physical possession is with the company such as bill-and-hold arrangements. The internal control framework relating to safeguarding and monitoring of inventories would need to include these considerations, e.g., assessing the inventory shrinkage by location, product type, or other disaggregated basis, comparing the actual inventory value of each location to an expected range, and investigate any individual locations that are outside of the expected range.

Further, with scenarios like localised lockdown, travel restrictions, etc., physical inventory counting would be challenging and in some cases impractical. In certain situations where the conventional method of physical verification is not practicable, management may establish internal controls to undertake physical verification remotely via video calls with the help of technology.

Environmental and safety norms
Companies may be using sensitive chemicals and industrial gases for producing goods. Some of these items are required to be stored in temperature-controlled containers and to be continuously monitored. If there is any leakage of hazardous gases or chemicals, the implications on the company could be very severe and even lead to closure of the factory, thereby affecting the going-concern assessment. Localised lockdowns imposed by various State Governments might induce stress on the monitoring mechanism relating to compliance with environmental and safety norms.

(D) Segregation of duties as a control was put in place by companies to ensure that employees preparing the information, authorising the information, recording the information and holding the custody of the documents are different. In the Covid scenario, the flow of physical documents to different employees performing these different roles is not possible. Further, many organisations had severe staff absences for prolonged periods as even the staff was affected by the pandemic. This requires delegating their responsibility to other staff and modifying internal controls around it. Has the company modified its internal control system and does the revised internal control system ensure effective segregation of duties, this is the question that companies need to answer.

Fraud risks
Fraud risks change in such a time of crisis, as new opportunities are created for internal as well as external parties. Incentives for committing fraud – both misappropriation of assets and financial reporting fraud – may also be heightened, especially if significant terminations are likely or employees suffer significant personal financial stress. As stated in the GN on IFC, ‘When planning and performing the audit of internal financial controls, the auditor should take into account the results of his or her fraud risk assessment.’ In the years when the company is hit by the Covid pandemic, fraud risk assessment of the auditor is expected to be different from the earlier years. The risk of fraud has increased significantly due to changes in the way of working. Such risks can range from the basic documentation process where scanned documents are being relied upon, which can be forged, as against the original signed documents; to frauds in complex transactions where significant estimation is involved such as fair valuation, etc., since these estimates are also significantly impacted by Covid. Some of the areas where fraud risk has increased are:

(i) Physical document approvals are replaced by email approvals in the Covid period. Such approvals carry the risk of emails being compromised.
(ii) Due to the new style of working, the demand for certain goods and services has significantly increased. This has created an opportunity in procurement fraud.
(iii) Owing to lockdown situations, many customers may be facing financial difficulties to pay their dues within the credit period. This increases the risk of financial reporting fraud by resorting to unethical means of recording receipts from debtors which are not genuine.

The auditors, while planning and performing the audit of internal financial control, will need to take into account as well as document how their audit plan is different from the earlier years due to higher risks of fraud, i.e., what is their audit response to such risks.

ASSUMPTIONS FOR THE FUTURE
Ind AS 1 requires the entity to disclose information about the assumptions it makes about the future, at the end of the reporting period, that have a significant risk of resulting in a material adjustment to the carrying amounts of assets and liabilities within the next financial year. In the Covid scenario, the future holds a lot of uncertainty and it will need the company to demonstrate its internal controls for arriving at the estimates, or its estimation process. It may have an impact inter alia on going-concern assessment, impairment of assets, fair valuation, etc., that is, financial statement items that are based on assumptions of the future. Companies faced difficulties in estimating the impact of Covid on their operations beyond the short term. This is an inherent risk because of uncertainty about the future which was never experienced before in history and has resulted from the global pandemic. Due to the disrupted supply chain and distribution models, uncertainty over pricing, etc., projecting future cash flows with acceptable precision is not possible for many companies. Coordination with management experts, such as those heading the strategy department, valuation specialists, etc., when performing impairment tests, assessing fair values of assets such as investment properties, investments, etc., and performing actuarial calculations and analyses, can be more challenging. Many auditors have considered these matters as key audit matters for their audit of the financial year ended 31st March, 2021. The question is do internal controls over the estimation process of the company consider the uncertainty brought by Covid?

Exceptions identified during control testing
It is likely that management will identify exceptions during its testing of controls because controls were designed for a totally different environment. To ensure that sufficient time is available for remediation before the year-end, management will need to modify the design of existing controls and test the operative effectiveness of the new controls during the year. If such remediation does not take place by the year-end, it will have consequences of communication with audit committees and modification in the auditor’s report. Further, in the absence of controls being effective, auditors may need to modify their strategy to evaluate the impact of ineffective controls. Therefore, companies should change their plan of testing controls affected by Covid earlier than usual in the year. If the company has had to incorporate new controls during the year, these controls should be documented in its internal control documentation and appropriately tested.

Planned changes in RCM
Each entity’s internal controls will be uniquely impacted by Covid, e.g., entities with significant dependence on technology will have different challenges to address than those with a more manual control environment. With a majority of staff working from home, manual controls maintained through hard copy documents cannot be adhered to. Technology-dependent controls may need revision with new technology suitable for the new environment. Hence, it is imperative that on a holistic basis the potential changes or shifts in focus, both in terms of scoping and risk assessment, testing approaches, etc., are made and additional controls or control modifications of existing controls are undertaken to address the risks arising from Covid. Based on the experience of Covid, companies will start making changes in their risk control matrix. It will include identification of additional risks posed by Covid, new controls to mitigate those risks, modification to existing controls in view of the ‘new normal’ and removal of some controls which have become redundant. This might include automation of all key manual controls to reduce dependency on people and physical access to the work environment, increased use of continuous monitoring and detection and defining indicators which would suggest that controls may not be operating effectively.

Changes to the design of management’s control may also require the auditor to alter the combination of testing procedures (i.e., inquiry, inspection, observation and re-performance). This includes making inquiries on the changes in the company’s mode of carrying out operations in response to Covid. For example, changes due to people working remotely, and consequently the change in the company’s policies and procedures, including execution of controls, segregation of duties, etc. This would also include evaluating the electronic or digital evidence made available by management, and the controls around the same, specifically with reference to review, reliability, security and storage of such evidence by the management.

Enhancing disclosures
The pandemic would also have wide-ranging implications on the financial statements. Hence, it is crucial that the management adequately presents their ‘side of the story’ in detail. Disclosures might include entity-specific information on the past and expected future impact of Covid on the strategic orientation and targets, operations, performance of the entity as well as any mitigating actions put in place to address the effects of the pandemic. Updating the information included in the latest annual accounts to adequately inform stakeholders of the impact of Covid, in particular in relation to significant uncertainties and risks, going-concern, impairment of non-financial assets and presentation in the statement of profit or loss, have garnered renewed focus.

SNAPSHOT
In short, the way Covid has impacted internal controls over financial reporting of companies is as follows:
a) New normal – The way companies carry out day-to-day transactions from initiation to closure that involves authorisations, recording, cash receipts or payments, etc., has changed. Given that these processes have undergone changes, all pre-Covid controls may not be relevant and new controls may be needed.
b) Risks change due to Covid – Not only are the new processes susceptible to new risks, but existing risks may also be heightened due to the change in the environment. In addition to this, there are certain inherent risks of dealing with the ‘unknown’, i.e., how long the pandemic will continue, what will be its severity and the resulting impact on the organisation, etc.
c) Controls must also change accordingly – Companies will need to thoroughly review their risk control matrix in light of the new risks. It will require addition of new controls (e.g., those relevant to new technology), changes in the existing controls (such as approval process through emails or physical verification of assets through virtual means, etc.), or removal of some of the irrelevant controls (like those related to physical documentation).
d) Audit of internal controls over financial reporting – With the new risk-control matrix, the auditors will need to plan their integrated audits in light of the changed processes of the client, the revised design of controls and testing their operating effectiveness. The auditors will need to evaluate ‘what could go wrong’ with increased audit scepticism considering the high fraud risk in the new reality, the risk of non-compliance with laws and regulations, the impact of uncertainty on the estimation process of the company, and so on.



NEXT STEPS

Companies establish criteria for internal controls over financial reporting. These are dynamic in nature and as the circumstances change, companies need to revisit internal controls on identified risks. The impact of Covid will require them to relook at their existing criteria and identify what changes are required to be carried out to achieve the objective. Many companies have prepared their own checklists to ensure that the internal controls criteria are updated based on the current environment.

At the same time, auditors need to be aware of what changes are being carried out by their clients in their criteria for internal controls and plan their audits accordingly. This may require the auditor to obtain samples of the period when operations were severely affected by Covid (and  therefore have a modified design of internal controls) and when operations were running normally.

A dialogue between the clients and auditors is imperative to discuss the exceptions observed in management testing, changes being made in internal controls, effective date of incorporating the changes, plan of management testing of such controls and ensuring that those are operating effectively.

(The views expressed in this article are the personal views of the author)

CARO 2020 SERIES: NEW CLAUSES AND MODIFICATIONS INVENTORIES AND OTHER CURRENT ASSETS

(This is the second article in the CARO 2020 series that started in June, 2021)

NEW CLAUSES AND MODIFICATIONS

Whilst the clause on reporting in respect of inventories has been present in the earlier versions, too, CARO 2020 has modified parts of the first clause and added certain reporting requirements in respect of current assets which are given below.

Modifications
a. Whether in the opinion of the auditor the coverage and procedure for physical verification of inventories is appropriate;
b. Whether any discrepancy in excess of 10% or more in the aggregate for each class of inventory was noticed and the same was properly dealt with in the books of accounts.

Additional Reporting
a. Whether at any point of time during the year the company has been sanctioned working capital limits in excess of Rs. 5 crores in aggregate from banks or financial institutions, on the basis of security of current assets;
b. Whether the quarterly returns or statements filed by the company with such banks or financial institutions are in agreement with the books of accounts and if not, to give details.

PRACTICAL CHALLENGES IN REPORTING
The reporting requirements outlined above entail certain practical challenges which are discussed below:

Verification of inventory:
a. On the appropriateness of coverage and procedure for physical verification of inventory, the auditor will have to observe the performance of the management’s physical count taking procedure, control over movement of inventory, adequacy of design and effective operations of internal controls.

b. Apart from ensuring that proper written instructions are issued, it is also incumbent for the auditor to point out specific areas where the instructions are not clear or other procedural lapses like inadequate segregation of duties, cut-off procedures not adhered to especially for sales and work-in-progress in continuous process industries, as may be observed. It is important for the auditor to comment on the specific areas where he feels that the procedures are not adequate rather than commenting that the ‘procedures are generally adequate’.

c. Covid-19: The onset of Covid-19 has caused significant disruptions in the business operations of companies which could pose challenges in conducting physical verification of inventories. This, in turn, would make it difficult for auditors to ensure compliance with SA 501, Audit Evidence-Specific Considerations for Selected Items, which requires the auditor to obtain sufficient appropriate audit evidence regarding the existence and conditions of inventories. SA 501 requires attendance at location/s of physical inventory count, unless impracticable, and performing audit procedures on inventory records to determine whether the records accurately reflect actual inventory count results. Some of the challenges may be broadly analysed under the following situations:

Management does not conduct an inventory count (not even any alternative audit procedure) on the balance sheet date:
In such cases, as per Key Audit Considerations amid Covid-19 issued by ICAI on physical inventory (ICAI’s Covid guidance), the management should inform the auditors and those charged with governance about the reasons for the same. However, if carrying out a count is not feasible, the auditor would need to evaluate the reasonableness of the circumstances and the internal controls with respect to the existence and condition of inventory. Depending upon the materiality, the auditor may use his judgement to modify his audit report in accordance with SA 705 (Revised) Modifications to the Opinion in the Independent Auditor’s Report. Further, its impact on auditor’s opinion on internal financial controls u/s 143(3)(i) of the Companies Act, 2013 (‘ICFR’) also needs to be evaluated, in addition to reporting under this clause regarding coverage of physical verification of inventory.

Physical verification conducted at a date other than the balance sheet date:
In such cases, the design and operating effectiveness of controls over inventory would need to be evaluated before reporting. Further, the following considerations are also relevant:
i.    Whether the inventory records are properly maintained;
ii.    Understanding reasons for differences in the physical verification count and the inventory records;
iii.    Performing roll-backward procedures, if the inventory count is done after the year-end or roll-forward procedures, if inventory count is done during the interim period;
iv.    Evaluating whether any adjustment is required in roll-forward or roll-backward procedures due to differences observed as in (ii) above;
v.    To consider whether the time between inventory count date and balance sheet date reflects appropriate assessment of the physical condition of the inventory.

Impracticable for auditor to attend the physical count:
This issue is relevant for the auditor to issue an audit opinion on the financial statements and not on CARO 2020. However, in order to have complete discussion on physical verification of inventory, specifically its increased importance during Covid pandemic times, the same is also discussed here.

  •  In the event that it is impractical for the auditor to physically attend the inventory count process, the auditor can perform alternative audit procedures to obtain sufficient appropriate audit evidence regarding the existence and condition of the inventory. In addition, to evaluate design and test the operating effectiveness of internal control over physical verification of inventory, the following may be considered:

i. Prepare a document substantiating the impracticality and unreasonableness of observing the count in person, given the Covid-19 situation;
ii. Use of web or mobile-based video-conferencing technologies (i.e., Microsoft Teams, Facetime, WhatsApp). In this case, care should be taken by the auditor that if inventory items cannot be identified with a unique reference number, etc., there is no chance of replacement of inventory during / after the count to avoid double counting. It would be advisable to retain the recording thereof as part of the audit documentation;
iii.    Consider using an external party, e.g., an independent CA firm in that location (ICA) or Internal Auditor (IA), in which case the auditor needs to evaluate
a. Objectivity and independence of ICA / IA;
b. Inquire for any relationships that may create a threat to their objectivity;
c. Evaluate their level of competence;
d. Determine the nature and extent of work to be assigned;
e. Communicate planned use of ICA / CA with those charged with governance;
f. Obtain written agreements from the entity for the use of ICA / IA for providing direct assistance;
g. Direct, supervise and review the work performed by ICA / IA providing direct assistance, including provide instruction / work programme, including sample selection, communicate management’s inventory count instructions, etc., and, if possible, supervise the count while it is in progress.

When inventory is under the custody and control of a third party, e.g., bonded warehouse, job worker / contractor, etc., the auditor shall verify the procedures undertaken by the management to evaluate the existence and condition of that inventory. This could be by way of obtaining confirmation from the third party as to the quantities and condition of inventory held on behalf of the entity and / or perform inspection or other procedures appropriate in the circumstances. The auditor needs to focus on whether inventory with third party is for a longer than normal period and obtain reasons for the same.

In the event the entity has specialised inventory where inventory count is not based on a normal physical verification process but on the confirmation of quantity / quality by an expert, the auditor will review the certification obtained by the entity and compare it with the book records. For example, in the case of coal, tonnage is calculated by considering the height, width, length of the stock yard and the moisture content in the coal to arrive at its tonnage. The entity will normally take the help of engineers in this process who would be internal or external experts.

a. Appropriate coverage: Even if the company has instituted proper procedures for physical verification, it is imperative that the coverage thereof is adequate and appropriate with respect to the nature, size, materiality, location, feasibility of conducting physical verification and risk of material mis-statement involved. This could involve significant judgement and an interplay of several factors, some of which are discussed hereunder:

• Classification of inventory – This is important for assessing the extent of coverage as also for evaluating the impact of discrepancies. Whilst the class of inventory is broadly specified in the Accounting Standards for manufacturing and trading companies, the same is not clear for service companies since all of it may not be amenable for quantification. Further, even if the classification for manufacturing and trading companies is appropriate to determine the adequacy of verification, an A-B-C analysis is desirable for which the basis would need to be evaluated for reasonableness. Further, the auditor also needs to examine whether there is a control system in place to identify and mark slow-moving, obsolete or damaged inventory.

• Periodicity of verification – The auditor would need to verify the periodicity of such verification and whether all the material items of inventory have been covered at least once in a year or as per the systematic plan as designed by the management. This would depend upon the nature of inventory, the A-B-C classification discussed above and the number of locations involved.

b. Dealing with discrepancies: The auditor should, based on his understanding of the business and operating effectiveness of internal controls, verify explanations provided by the management for discrepancies between inventory as per the books and as physically verified and steps taken by them to reconcile. Some of the common causes for discrepancies are:
• Incorrect data entry on receipt
• Issues not recorded
• Misplaced stocks
• Loss due to theft or natural calamity
• Human errors or incorrect unit of measurement used
• Inventory records not updated
• Supplier frauds
• Goods distributed as free samples
• Weight loss / gain due to passage of time

Under the modified (changed) reporting requirement, the auditor will have to report on any discrepancy noticed in excess of 10% or more in the aggregate for each class of inventory. Each class of inventory will have to be identified as per AS 2, ‘Valuation of Inventories’ / Indian Accounting Standard (Ind AS) 2, ‘Inventories’ and the internal policies of the management. The count at the time of physical verification will have to be compared with the book records and discrepancies in excess of 10% or more in the aggregate for each class will have to be reported. It may be worth it to note that the threshold limit of discrepancies of 10% should be applied to the value and not to the quantity. Hence, if the inventory has been valued other than at cost, e.g., net realisable value (NRV), the discrepancy of 10% needs to be compared with NRV.

It is worthwhile to note that this clause deals with discrepancies observed during physical verification only and not with discrepancies observed during audit. Further, even if the management has a valid explanation for the discrepancies, the fact needs to be brought out while reporting under this clause.

Working capital facilities:
a. This is a new reporting requirement wherein the auditor has to review quarterly returns or statements filed by the company with banks and financial institutions in case the sanctioned working capital limits with them are in excess of Rs. 5 crores in aggregate and to report if these are not in agreement with the books of accounts.

b. Collation of all working capital facilities: For calculating the limit of Rs. 5 crores, it is important to note that sanctioned amounts (not disbursed amounts) and both fund and non-fund-based amounts are required to be considered at any point of time during the year (as against only at the year-end) on the basis of security of current assets. This could present challenges in identifying the completeness thereof since sanctioned facilities as well as non-fund-based facilities are not reflected in the books of accounts. Accordingly, the auditor would need to make specific inquiries and obtain a representation and corroborate the same with the requisite documentary evidence like sanctioned letters, confirmations from the lenders, review of the minutes, ROC filings for charge created, etc. The aggregate of the sanctioned limit from all banks and financial institutions is also required to be collated. In case of a company which operates from multiple locations and working capital facilities are negotiated locally, care should be taken to ensure that all such sanctioned facilities are combined for the purpose of reporting under this clause. The auditor will also have to cross-verify the same with the relevant disclosures, if any, in the financial statements.

c. This clause is not applicable to unsecured sanctions or sanctions on the basis of security other than current assets or withdrawals above the sanctioned limit, e.g., in case the company has a combined sanctioned working capital limit of Rs. 4.75 crores but the same is overdrawn by Rs. 0.30 crore. In this case, the total outstanding working capital facility is in excess of Rs. 5 crores, however, since the aggregate sanctioned limit is less than Rs. 5 crores, this clause would not be applicable.

d. Considering the discussion in paragraphs (b) and (c) above, in case the sanctioned working capital limit exceeds Rs. 5 crores, the auditor is required to review quarterly returns and statements filed by the company with such banks / financial institutions and report if they are in agreement with the books of accounts and, if not, give details thereof.

The auditor will have to consider materiality of discrepancies, its relevance to the users of financial statements and their professional judgement while reporting discrepancies.

e. Each bank and financial institution may have its own requirements of submission of statements and returns. These submissions may be monthly, quarterly, yearly or of any other frequency, including event-based. However, for the purpose of reporting under this clause only quarterly statements / returns and that too which have relevance with the books of accounts of the company need to be considered, compared and reported.

Though this clause is applicable only if sanctioned working capital limits are provided based on the security of current assets, however, the responsibility of the auditor is to compare all the information provided in the quarterly statements / returns which can be compared with the books of accounts and is not restricted only to current assets. Such information may include aging of inventory and receivables, trade payable, property plant and equipment, other information, etc. So long as information can be compared with the books of accounts, it will be the responsibility of the auditor to report.

f. Challenges for MSMEs: Reconciliation of the details of statements / returns submitted to the lenders with the books of accounts on a quarterly basis could pose difficulties in case of MSMEs since they may not be regular in updating their accounting records. These MSMEs will have to keep their books of accounts updated based on which statements / returns submitted to banks and financial institutions can be compared, failing which their auditor will issue a disclaimer while reporting under this clause.

g. It is hoped that the introduction of this reporting requirement would lead to better discipline and improvement in internal controls which would result in a win-win situation for companies, lenders and auditors.

IMPACT ON THE AUDIT OPINION

Whilst reporting under these clauses, the auditor may come across several situations where he may need to report exceptions / deviations. In each of these cases, he would need to carefully evaluate the impact and exercise his professional judgement keeping in mind materiality and relevance to the users of financial statements, not only for reporting under these clauses but also on his opinion on ICFR and / or audit opinion on the financial statements, too. These are broadly examined hereunder:

Nature of exception /
deviation

Possible impact on the
audit report / opinion

The coverage and procedure for physical verification of
inventory is not adequate and / or appropriate

• Modification of opinion on ICFR;

 

• Depending on the facts and circumstances of the case, audit
opinion on financial statements

Physical verification of inventory not conducted by the company

• Modification of opinion on ICFR;

 

• Depending on the facts and circumstances of the case, audit
opinion on financial statements

Discrepancies in the returns / statements submitted to banks /
financial institutions

• Depending upon the nature of the discrepancy, modification on
audit opinion or reporting on ICFR reporting, if the discrepancy is in the
books of accounts

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 will not be any factual inconsistency between the two if, in the auditor’s judgement, the matter / observation may have any adverse effect on the functioning of the company.

CONCLUSION


The above changes have cast onerous responsibilities on the auditors by making them indirectly responsible to the lenders. Hence, they would also need to go beyond what is stated in the order since the devil lies in the details!

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

(This is the third article in the CARO 2020 series that started in June, 2021)

BACKGROUND

Investments, loans and advances and guarantees play an important role in commercial dealings and also expose companies to greater risk due to the possibilities of defaults which in turn can have an impact on the financial position and solvency of companies. The Companies Act, 2013 (‘the Act’) has laid down stringent provisions to regulate the same, especially in respect of non-financial companies. Although the earlier versions of CARO dealt with specific aspects thereof, CARO 2020 has substantially enhanced the reporting requirements.

SCOPE OF REPORTING

The scope of reporting can be analysed under the following clauses:

 
*Not discussed further

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:

Following disclosures shall
be made where loans or advances in the nature of loans are granted to promoters,
directors, KMPs and the related parties (as defined under the Companies Act,
2013),
either severally or jointly with any other person that are:

(a) repayable on demand
or

(b) without specifying
any terms or period of repayment

Type of
borrower

Amount
of loan or advance in the nature of loan outstanding

Percentage
to the total Loans and Advances in the nature of loans

Promoters

 

 

Directors

 

 

KMPs

 

 

Related Parties

 

 

 

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:

Nature
of Exception / Deviation

Possible
Impact on the Audit Report / Opinion

The company has not maintained records to
identify and compile data required for reporting under Clause 3(iii)(a)

Reporting on
Internal Financial controls over Financial Reporting

Investments made, guarantees provided,
security given and the terms and conditions of the grant of all loans and
advances in the nature of loans and guarantees are prejudicial to the
company’s interest, there may be implications on the main audit report due to
non-compliance with the following SAs:

Consideration of laws and regulations (SA
250)

Fraud (SA 240)

Related party transactions (SA 550)

Modified
opinion under SA 706

Loans and advances on the basis of security
have not been properly secured and the terms thereof are prejudicial to the
interests of the company

Disclosure in the audit
report u/s 143(1) of the Act

If the auditor concludes that there are
loans or advances in the nature of loan granted which have fallen due during
the year have been renewed or extended or fresh loans granted to settle the overdues
of existing loans given to the same parties, there may be implications on the
main audit report, such as consideration of fraud risk factors as per SA 240

Modified
opinion under SA 706

If the auditor concludes that the company
has granted loans or advances in the nature of loans either repayable on
demand or without specifying any terms or period of repayment, there may be
implications on the main audit report due to non-compliance with the
following SAs:

Consideration of laws and regulations (SA
250)

Fraud (SA 240)

Related party transactions (SA 550)

Modified
opinion under SA 706

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 for various critical aspects of movement of funds as under:
• Evaluating design and operating effectiveness of internal controls around specified investment and loan transactions, whether with related parties or otherwise, including layering and round-tripping of funds, etc., if any.
• Detailed analysis of financing transactions, including advances in the nature of loans.
• Identifying sticky specified transactions and reporting.
Accordingly, it needs to be seen whether an audit remains an audit or becomes more of an investigative exercise requiring greater forensic skills!

 

GOING CONCERN ASSESSMENT BY MANAGEMENT

(This article is the first of a two-part series on Going Concern)
The concept of going concern is understood as the ability of an entity to continue in the foreseeable future and is also one of the assumptions which management needs to make for the preparation of its general-purpose financial statements as per the requirement of Ind AS 1 Presentation of Financial Statements as also fundamental accounting assumptions prescribed in AS 1 Disclosure of Accounting Policies.

Ind AS 1 states that an entity shall prepare its financial statements on a going concern basis unless management either intends to liquidate the entity or to cease trading, or has no realistic alternative but to do so. However, to prepare its financial statements on a going concern basis, the management first needs to assess the entity’s ability to continue as a going concern.

The above requirement of Ind AS 1 acts as a trigger for performing going concern assessment by management through ascertaining whether the existing events and conditions are favourable enough to justify the going concern assumption for the preparation of its financial statements. When the use of the going concern basis of accounting is appropriate, assets and liabilities are recorded on the basis that the entity will be able to realise its assets and discharge its liabilities in the normal course of business.

The going concern assessment and reporting thereof require a high degree of professional judgement and has become more relevant and complex in the present Covid-19 pandemic, that has created greater economic uncertainty and due to which many organisations are seeing downturns in their revenue, profitability and cash flows.

 

This article attempts to explain

a) how management should do the going concern assessment by highlighting the events or conditions that may cast significant doubt on the entity’s ability to continue as a going concern and the evidence that management should consider to conclude the assessment, in case any such events or conditions are identified; and

b) scenarios that require disclosures in the financial statements.

 Preparers of financial statements, those charged with governance, users of the financial statements and their auditors may find this article helpful in understanding the concept of going concern and implications when the entity has a doubt about its ability to continue as a going concern.

 
Evaluation of going concern assessment by the auditor and reporting considerations in the audit report will be covered in the second part of this article.

 

GOING CONCERN ASSESSMENT UNDERSTANDING

Before initiating a going concern assessment, one must first understand how the going concern assessment needs to be performed, i.e., what kind of events and conditions should be considered, what should be the period covered for making this assessment, and how to assess such events and conditions once identified, to conclude.

 
Ind AS 1 outlines the principle for performing the going concern assessment but does not provide an explicit guidance to address all the above questions; it states that the management should consider all available information about the future, which is at least, but not limited to, twelve months from the end of the reporting period and the degree of consideration depends on the facts in each case. For example, when:

 

Scenario

Assessment

The entity has a history of profitable operations and ready
access to financial resources

The entity may reach a conclusion that the going concern basis
of accounting is appropriate without detailed analysis, unless there are any
other indicators to the contrary

Other cases

Management may need to consider a wide range of factors relating
to:

 

(continued)

• current and expected profitability,

• debt repayment schedules, and


potential sources of replacement financing

before it can satisfy itself that the going concern basis is
appropriate

Considering limited guidance in Ind AS 1, management can draw reference from SA 570 (Revised) Going Concern, which illustrates events or conditions much in detail and, if they existed, may cast significant doubt on the entity’s ability to continue as a going concern.

 

Apart from the guidance given in SA 570, reference can also be drawn from some of the following recent industry-specific events and conditions:

 

Industry

Particulars

Examples

Telecom

• Supreme Court judgment on telecom license fees

• Vodafone Idea Limited for the year ended 31st
March, 2021;

Aviation, Hospitality, Automobile, Logistics, Retail, etc.

• Covid-19 pandemic

• SpiceJet Limited for the year ended 31st March,
2021;

• The Indian Hotels Limited for the year ended 31st
March, 2021;

• Future Retail Limited for the year ended 31st
March, 2020;

• Allcargo Logistics for the year ended 31st March,
2020

Real estate

• Significant inventory due to economic slowdown

• Delayed completion of projects due to Covid-19 pandemic

• Jaypee Infratech Limited for the year ended 31st
March, 2021;

• Peninsula Land Limited for the year ended 31st
March, 2021;

Automobile

• Amendments in government policies, and restrictions on using
specific technology

• Supreme Court judgment for banning BS3 and BS4 vehicles;

• Government policies with respect to electronic vehicles that
may adversely affect the present product line;

Banking

• Significant NPAs

• Yes Bank Limited for the year ended 31st March,
2020

Mining and Chemicals

• Restrictions imposed due to environmental issues

Vedanta’s subsidiary Sterlite Copper Smelter Plant shutdown

 

EVIDENCE TO ASSESS THE EVENTS AND CONDITIONS

Once the events and conditions are identified, management needs to assess the financial implications of these events and conditions to conclude the entity’s ability to continue as a going concern. Given herein below are examples of some of the evidence that management should consider while performing going concern assessment:

 

  •   Cash flow projections that show an ability to pay debts as and when they fall due after factoring realistic assumptions in the current market conditions;

  •   If current conditions deteriorate further, detailed business plans covering the period under consideration;

  •   Entity’s ability to obtain new funding upon the maturity of existing funding arrangements;

  •   Evidence that debt covenants have been assessed and any risk of breaching them has been managed, such that they do not provide significant risk;

  •   Ability to obtain a ‘financial support letter’ from the parent company for the next twelve months from the date of the latest balance sheet. However, a mere ‘Support Letter’ or ‘Comfort Letter’ will generally not constitute sufficient evidence to conclude on the appropriateness of going concern basis of accounting, unless the subsidiary’s operations are entirely dependent on the parent;

  •   Financial ratios like current ratio, debt-service coverage ratios, etc., indicating inadequate profit or liquidity position of the company;

  •   Covid-19 specific considerations1:

 

  1.  Whether the entity is operating in a sector which is highly impacted,

2.  Whether the entity has plans and ability to restructure its debt obligations if required to ensure short-term solvency,

3. Assessing the financial health of key / critical suppliers and customers and their impact on the entity’s operations,

4. Government policies and measures in the countries in which the company operates,

5. Changes in the entity’s access to capital, impacted by measures taken by regulators (industry and / or financial) or banks,

6. The entity’s ability to prepare timely financial statements or other required information / filings, including delays in receiving financial data from operations in other countries, or material investees for consolidated financial statement,

7. The ability of the business model to operate under current Covid-19 restrictions and whether the business model will be sustainable post-Covid.

 
Although all the above illustrative events, conditions and evidences give a fair idea to address the what and how questions, yet going concern assessment requires a significant management judgement while concluding in the real-world situation, and with the pandemic in place, concluding going concern assessment has become more challenging.

 
Ind AS 1 though do not provide detailed guidance on the going concern assessment, but it does make management’s job a little easy by requiring adequate disclosures of the events and conditions identified, the assumption used, and judgement made to conclude the going concern assessment.

 
The principle is to give clear visibility to the readers of the financial statements so that they can make their own interpretations with the help of the disclosures. Also, these disclosures are of greater relevance in the present economic environment where the regulators like Securities and Exchange Board of India, Ministry of Corporate Affairs, European Securities and Markets Authority, Securities and Exchange Commission, etc., have placed significant focus on the going concern of the entities.

 
DISCLOSURE IN THE FINANCIAL STATEMENTS

The Table below summarises the broad category of scenarios and their disclosure requirement in the financial statements as per the requirement of Ind AS 12:

 

Scenario

Basis of preparation

Disclosure for material uncertainties

Disclosure for management assumptions

Events or conditions challenging going
concern do not exist

Going concern

Not applicable

Not applicable

Events or conditions challenging

Going concern

None

Significant management assumptions

(continued)

going concern exist but no material uncertainty concluded after
considering mitigating actions (e.g., strong turnaround strategy of
management that has started showing sufficient evidence of success, including
identifying feasible alternative sources of financing)

 

 

(continued)

and judgement

Significant doubts about going concern but
mitigating actions judged sufficient to make going concern appropriate.

Material uncertainties about going concern remain
after considering mitigating actions (e.g., considerable uncertainty about
the outcome of the management’s turnaround strategy to address the reduced
demand and to renew or replace funding)

Going concern

Material uncertainties

Significant management assumptions and judgement

Entity intends to liquidate or to cease trading, or no realistic
alternative but to do so

Alternate basis

(Not going concern)

Specific disclosure on why the entity should not be regarded as
a going concern

 

Further, section 134(5) of the Companies Act, 2013 also requires the Board of Directors to comment on the going concern assumption for the preparation of financial statements, as part of the Directors’ responsibility statement.

 
Similar to the Ind AS 1, AS 1 does not provide any such disclosure guidance on the material uncertainty and requires specific disclosure only in case the entity has intentions or requirement to liquidate or curtail materially the scale of its operation, and as a result of which the financial statement needs to be prepared on an alternate basis.

 Let us take an example to see the application of the above scenarios:

 
Illustration

Company A  is in the hotel business and known for its luxury hotels across the globe. The company is successfully serving its customers and running its operations for several decades. However, the Covid-19 pandemic and resultant global lockdown had a severe adverse effect on its operations.

 
Some of the key points reflecting the current financial position and business of the company are as under:

 
(a) There was no sale in the first nine months of the current financial year due to the lockdown and there was minimal sale in the remaining three months due to the Government advisory of lifting the lockdown in a few of the cities where the company has its properties;

(b) The company has significant borrowings, a portion of which is due for payment in the next financial year; the company has not defaulted in any of its borrowings so far. The management is in discussion with bankers to increase the moratorium period for a few of its term loans;

(c) The company has not retrenched its work force; however, a pay cut of 25% has been made by the management considering the present cash flow position;

(d) Management is expecting to incur a significant cost for ensuring continuous sanitization of its properties globally;

(e) Management at present is focusing on its restaurant business by introducing home delivery services. It has also introduced catering services for organisations that are covered under essential services, such as hospitals, pharmaceutical companies, manufacturing units of essentials commodities, etc.;

(f) Governments in various countries are imposing lockdowns on an intermittent basis considering the number of Covid-19 cases, and at present there is no visibility about how long the pandemic will continue.

 
ANALYSIS

In the given scenario it is evident that the pandemic is the event that cast significant doubt on the company’s ability to continue as a going concern and hence a detailed assessment is required to be performed to conclude on the going concern assumption.

Let us see the step-by-step approach that management needs to take to perform the assessment.

Step 1: Identification of events and conditions

In the present case, the pandemic is the identified event that has resulted in a significant deficiency in the regular cash flow of the company and thus created a question about how it will realise its assets and honour its liabilities in the foreseeable future.

 Step 2: Assessing the evidence to evaluate going concern

Under this step, management needs to assess the following points to conclude the going concern assessment:

(a) Cash flow projection from operations, i.e., with the present situation, how much cash flow the company will be able to generate from its operations in the next 12 months and whether it will be sufficient to meet its contractual obligations. In order to do the said projection, the management needs to make certain assumptions like:

  •  sales volume from restaurant business due to new home delivery and from catering services introduced by the management;

  •  transportation cost for home delivery;

  •  expenditure to develop a digital platform for placing online orders;

  •  estimate of sales from the room rent for properties where the lockdown is removed;

  •  estimate of additional cost that needs to be incurred to ensure sanitization;

  •  advertising cost for the new initiatives taken by the management;

  •  other operational costs;

  •  Recoverability slippages in the receivables; and

  •  Probability of getting additional credit period from the creditors.

 

The management also needs to be conscious that the above assumptions and projections should be based on the expected future trends and limited reliance should be placed on the historical performance and data. Given hereinbelow are the examples of evidence that management should consider to estimate the future trends:

  •  consider research reports of analysts and third parties on the hotel industry,

  •   data from World Health Organization or local institutions explaining the expected progression of the Covid-19 outbreak in the countries, and

  •   data from government agencies about the severity and estimated duration of the economic downturn in the country and the actions that government may take to mitigate the effects.

 

(b) Quantum of borrowings that are due in the next 12 months, and status of extending moratorium period with banks;

(c) Probability of getting additional borrowings from banks for working capital management;

(d) Additional capital infusion that can be done by the promoters;

(e) Losses due to assets like investments, that are measured at fair value through profit and loss;

(f) Any other contractual liabilities, like derivative contracts that are due for settlement in the next twelve months.

 

Step 3: Preparation of financial statements and disclosures

Based on the outcome of the assessment performed in Step 2, management may need to conclude on two aspects:

– whether the material uncertainty exists, and if yes, then

– whether going concern assumption holds good.

 
In the given scenario, if the company is able to get additional funding from the promoter group or banks to run its operations for at least the next twelve months, then the management may conclude that the material uncertainty does not exist and hence the going concern assumption holds good. Accordingly, management needs to prepare the financial statements on going concern basis and adequate disclosure will be made with respect to judgement made by the management to mitigate the material uncertainties.

 
On the other hand, if the company is unable to obtain additional or sufficient funding from the promoter group or banks and it has to depend on the materialisation of its present business plan and drawing additional credit period from the creditors and bankers, then it may conclude that the material uncertainty does exist and it may or may not be mitigated. Accordingly, management might prepare financial statements on going concern basis along with adequate disclosures with respect to material uncertainties, management turnaround plan and significant judgement and assumptions taken for concluding going concern assumption.

 
However, in rare circumstances, the management may also decide that the going concern assumption does not hold good. This may happen if the management believes that the bankers and creditors will not provide any extension for the payment of their contractual dues and the present business plan will not generate adequate cash flows to meet its contractual obligations in their entirety, when due, and to run its day-to-day operations.

 
In that case, management needs to use an alternative basis of accounting for the preparation of its financial statements, e.g., liquidation basis, and the disclosure of that fact and the reason thereof needs to be disclosed in the financial statements.

 

TO SUMMARISE

The presence of Covid-19 has created economic instability across industries and has made the going concern assessment more critical and challenging. However, this challenge can be countered effectively if management do the identification and assessment of all the possible events and conditions that may cast significant doubt on the entity’s ability to continue as a going concern, in the light of the available guidance on financial reporting, and support their conclusion with sufficient appropriate evidence.

 
Once the management is done with its going concern assessment, the second step will be the evaluation of the going concern assessment by the auditors and reporting thereof in the auditors’ report.

 
The said aspect of going concern will be covered in the second part of this article that will touch upon the various factors that an auditor should consider while evaluating the going concern assessment performed by the management, disclosure in the financial statements based on the outcome of the evaluation, and reporting considerations under various scenarios in the auditors’ report.

 

References

Readers should also refer to the Annual Reports as referenced above in different industries to gain a practical understanding of the disclosures required to be made in the financial statements under various scenarios.

THE LONG FORM AUDIT REPORT FOR BANKS GETS EVEN LONGER

INTRODUCTION

The Long Form Audit Report (LFAR) has for long been used as a tool by the RBI through the Statutory Auditors to identify and assess gaps and vulnerable areas in the working of banks. According to the RBI, the objective of the LFAR is to identify and assess the gaps and vulnerable areas in the business operations, risk management, compliance and efficacy of internal audit and provide an independent opinion on the same to the Board of the bank.

As recently as on 5th September, 2020, RBI notified a revised format of the LFAR, applicable from the financial year 2020-21, which repeals the earlier format and other instructions issued on 17th April, 2002. Whilst almost all the earlier requirements have been retained, there have been several specific matters which have been included for reporting keeping in mind the large-scale changes in the size, complexities, risks and business models related to banking operations in the last two decades.

The LFAR is an integral part of the statutory audit of banks which needs to be factored right from the planning to the reporting stage of the audit process. In designing the audit strategy and plan, the auditor should consider the LFAR requirements and conduct need-based limited transaction testing.

The following are the main sources of information for the purpose of compiling the information for LFAR reporting:
a) Audited financial statements and the related groupings, trial balances and account analysis / schedules;
b) Minutes of the meetings of the Board and the various committees;
c) Internal and concurrent and other audit reports;
d) RBI inspection reports;
e) Other supporting MIS data / information produced by the entity which should be verified for accuracy /completeness as per the normally accepted audit procedures in terms of the SAs;
f) Policies and procedures laid down by the management.

This article attempts to provide an overview of the major changes in the reporting so as to sensitise both the Central Statutory Auditors and the Branch Auditors.


COVERAGE

As was the case with the earlier format, the indicative areas of coverage are separately indicated for the Central Statutory Auditors and the Branch Auditors. However, in cases where there is only one Statutory Auditor, which is generally the case with private sector banks or the branches of foreign banks, the auditors should ensure that the contents under both the sections are read harmoniously such that nothing significant is missed out. Since the areas to be covered are only indicative, the RBI in its Circular has made it clear that any material additions / changes in the scope may be done by giving specific justification and with prior intimation to the Audit Committee. Accordingly, the auditors should not adopt a boilerplate approach.

Major changes in the indicative content are discussed and analysed in the subsequent sections.


FOR CENTRAL STATUTORY AUDITORS

Credit Risk areas
Credit Risk in the context of banking refers to the risk of default or non-payment or non-adherence to contractual obligations by a borrower. The revenue of banks comes primarily from interest on loans and thus loans form a major source of credit risk. Whilst the basic reporting requirements are the same as before, there are several additional areas which need to be reported / commented upon and which can be broadly categorised as under:

Area

 

Additional areas to be
commented / reported upon

 be commented / reported
upon

Loan policy

Specific observations are required regarding the business model /
business strategy as per the policy as against the actual business / income
flow of the bank

Review / monitoring / post-sanction follow-up / supervision

The following are some of the additional matters requiring
specific comments / reporting:

      Comments on the overall effectiveness of
credit monitoring system
covering both on-balance sheet and off-balance
sheet exposures, along with the quality of reporting both within the bank and
to outside agencies (like RBI, CRILC,
CIBIL
),
etc.

     
Comments on the functioning and effectiveness of the system of
identifying and reporting of Red-Flagged Accounts based on Early
Warning System (EWS) indicators
for which reference should be made to the
Master Directions on Frauds-Classification and Reporting dated 1st
July, 2016 issued by the RBI
(also applicable to Branch Auditors)

Restructuring / resolution of stressed accounts

This is an entirely new section which has been introduced
keeping in mind the emphasis on restructuring in the backdrop of the enhanced
level of stressed assets in the banking system. The specific matters on which
comments are required are summarised hereunder:

     
Deviations observed in restructured accounts / stressed accounts under
resolution with reference to internal / RBI guidelines

    
Special emphasis should be given on the stance of the bank with
respect to the following matters:

a)   
formulation of board-approved policies including timelines for resolution;

b)    the
manner in which decisions are taken during review period;

c)   
board-approved policies regarding recovery, compromise settlements,
exit of exposure through sale of stressed assets, mechanism of deciding
whether a concession granted to a borrower would have to be treated as
restructuring or not, implementation of resolution in accordance with the
laid-down conditions, among others;

Special attention would have to be paid in the current financial
year regarding the relaxations and concessions provided as a result of
COVID-19

Asset quality (also applicable to branch auditors)

This is also an entirely new section given the emphasis
on asset classification and the consequential provisioning and attempts by banks
and borrowers to subvert the same. The specific matters on which comments are
required are summarised as below:

       
Continuous monitoring of classification of accounts into Standard,
SMA, Sub-standard, Doubtful or Loss as per the Income Recognition and Asset
Classification Norms by the system, preferably without manual intervention,
determining the effectiveness of identifying the consequential NPAs and the
appropriate income recognition and provisioning thereof;

Asset quality (continued)

     Procedure followed by the bank in
upgradation of NPAs, updation of the value of securities with reference to
RBI regulations and compliance by the bank with divergences observed during
earlier RBI inspection(s) with requisite examples of deviations, if any

It is imperative for the auditors to thoroughly review the
latest RBI Guidelines and Circulars and also read the latest RBI inspection
reports since greater granularity in reporting is now expected vis-a-vis
the earlier reporting requirements

Recovery policy (also applicable to branch auditors)

The following are some of the additional matters requiring
specific comments / reporting dealing with the Insolvency and Bankruptcy
Resolution Process:

     
System of monitoring accounts under Insolvency and Bankruptcy Code,
2016 (IBC)

     
Verifying the list of accounts where insolvency proceedings had been
initiated under IBC, but subsequently were taken out of insolvency u/s 12A of
the
IBC by the Adjudicating Authority based
on the approval of 90% of the creditors.
The auditors may satisfy themselves regarding the reasons of the creditors,
especially the bank concerned, to agree to exiting the insolvency resolution
process, and may comment upon deficiencies observed, if any

Large advances

The Guidelines now specifically require comments on adverse
features considered significant in top 50 standard large advances and the
accounts which need management’s attention.
In respect of advances below
the threshold, the process needs to be checked and commented upon, based on a
sample testing. This is a very onerous responsibility which has been
cast on the auditors and needs to be factored in whilst selecting their
sample for testing. Earlier there was no specific quantitative threshold laid
down for reporting. Care should be taken to ensure that the sample which is
selected also covers cases beyond the top 50 standard accounts. Further, it
appears that this threshold is for the bank as a whole

(Attention is also invited to the reporting requirements for
Branch Auditors discussed subsequently wherein different quantitative
thresholds are specified for individual branches)

Audit reports

Major adverse features observed in the reports of all audits / inspections,
internal or external, carried out at the credit department during the
financial year should be suitably incorporated in the LFAR, if found
persisting

Market risk areas
Market risk mostly occurs from a bank’s activities in capital markets, commodities markets and dealings in foreign currencies. This is due to the unpredictability of equity markets, movement of exchange and interest rates, commodity prices and credit spreads. The major components of a bank’s market risk include interest rate risk, equity risk, commodity price risk and foreign exchange risk.

This section covers reporting on investments and derivatives (the latter being specifically added) apart from CRR / SLR and ALM reporting requirements. Some of the specific additional areas requiring comments / reporting are as under:

•    Merit of investment policy and adherence to the RBI guidelines.
•    Deviations from the RBI directives and guidelines issued by FIMMDA / FIBIL / FEDAI which primarily deal with valuation of investments and foreign exchange exposures should be suitably highlighted.
•    With respect to the RBI directives, special focus should be placed on compliance with exposure norms, classification of investments into HTM / AFS / HFT category and inter-category shifting of securities.
•    Veracity of liquidity characteristics of different investments in the books, as claimed by the bank in different regulatory / statutory statements.
•    The internal control system, including all audits and inspections, IT and software being used by the bank for investment operations should be examined in detail.

Since there is a lot of emphasis on compliance with the RBI guidelines, it is important for auditors to be aware of the relevant guidelines dealing with investments and derivatives, the important ones being as under:

•    Master Circular – Prudential Norms for Classification, Valuation and Operation of Investment Portfolio by Banks dated 1st July, 2015 and other related matters.
•    General Guidelines for Derivative Transactions vide RBI Circulars dated 20th April, 2007, 2nd August, 2011 and 2nd November, 2011 together with specific operational guidelines for Currency Option, Exchange Traded Interest Rate Futures, Interest Rate Options and Commodity Hedging vide separate Master Directions.
•    Guidelines for Inter-Bank Foreign Exchange Dealings vide Master Directions on Risk Management and Inter-Bank Dealings dated 5th July, 2016.

 Governance, assurance functions and operational risk areas

This is a new section introduced in place of the existing section on Internal Controls. Whilst the basic reporting requirements are the same as before, there are several additional areas which need to be reported / commented upon and which can be broadly categorised as under:

Area

Additional areas to be commented /
reported upon

Governance and assurance functions

This is an entirely new section given the emphasis on
proper and robust governance and risk management keeping in mind the large-scale
changes in the business model of banks. The specific matters on which
comments are required are summarised hereunder:

     
Observations on governance, policy and implementation of
business strategy
and its adequacy vis-à-vis the risk
appetite statement
of the bank

     
Comments on the effectiveness of assurance functions (risk management,
compliance and internal audit)

     
Comments on the adequacy of risk-awareness, risk-taking and
risk-management, risk and compliance culture

 

The following are some of the specific matters which are
relevant for an effective governance, assurance and risk management system in
a bank:

a)    Oversight
and involvement in the control process by the Board, Audit Committee and
Those Charged With Governance,
some of which are specifically mandated
by the RBI, like framing of policies on specific areas,
constitution of specific Board Level Committees and undertaking calendar of
reviews.

b)    Mandatory
Risk Based Internal Audit vide RBI Circular Ref: DBS.CO.PP.BC.
10/11.01.005/2002-03, 27th December, 2002.

c)    Mandatory
Concurrent Audit vide RBI Circular Ref: DBS.CO.ARS. No. BC.
2/08.91.021/2015-16 dated 16th July, 2015

Balancing of books / Reconciliation of control and subsidiary
records

Item-wise details of system-generated transitory accounts not
nullified at the year-end should be given separately with ageing of such
items

Inter-branch reconciliation, suspense accounts, sundry deposits,
etc.

The following are some of the additional matters requiring
specific comments / reporting:

     
Sufficiency of audit trail with respect to entries in such accounts

     
Age-wise analysis of unreconciled entries for each type of entry as on
balance sheet date along with subsequent clearance thereof, if any, should be
provided

Frauds / vigilance (also applicable to branch auditors)

Special focus should be given to the potential risk areas which
might lead to perpetuation of fraud. For this purpose, reference should be
made to Early Warning System (EWS) indicators as per the Master Directions
on Frauds-Classification and Reporting dated 1st July, 2016 issued
by the RBI

KYC / AML requirements (also applicable to branch auditors)

This is also an entirely new section given the need and
importance for banks to comply with various AML regulations and also
regulations countering the financing of terrorism and to prevent them from
becoming involved with criminal or terrorist activity. The specific matters on
which comments are required are summarised hereunder:

     
Whether the bank has duly updated and approved KYC and AML policies in
synchronisation with RBI circulars / guidelines.

     
Whether the said policies are effectively implemented by the bank.

       
Assessment of the effectiveness of provisions for preventing money
laundering and terrorist financing.

The KYC and AML Guidelines are prescribed in the Master
Directions on KYC dated 8th December, 2016 as amended from time to
time issued by the RBI.

As per the directions, all banks are required to frame a KYC
policy which must contain at least the following key elements as laid down in
the Master Directions:

a)    
Customer Acceptance Policy.

b)    Risk
Management.

c)    Customer Identification Procedures.

d)   
Monitoring of Transactions.

e)   
Maintenance of Records under the PML Act.

f)    
Reporting Requirements to Financial Intelligence Unit – India and
sharing of information.

Para-banking activities

There is now a separate section which has been included in
respect of such activities which are specifically permitted to be undertaken
by the RBI, either departmentally or through subsidiaries. These activities
are generally non-fund based and are a major source of revenue for banks. The
specific matters on which comments are required are summarised hereunder:

     
Whether the bank has an effective internal control system with respect
to para-banking activities undertaken by it.

        A
list of such para-banking activities undertaken by the bank should also be
provided.

The RBI has issued a Master Circular dated 1st July,
2015 as amended from time to time on such activities.
Some of the main
para-banking activities which banks are permitted to undertake either
departmentally or through subsidiaries in terms of the aforesaid Circular are
Equipment Leasing, Hire Purchase and Factoring, Primary

Para-banking activities (continued)

Dealership Business, Mutual Fund Business, Insurance Business,
etc.


CAPITAL ADEQUACY

Whilst the existing requirement of attaching the Capital Adequacy computation certificate in accordance with the BASEL III guidelines along with the comments on the effectiveness of the system of calculating the same and reporting of any concerns relating thereto are retained, there is now an additional requirement to give certain comments with regard to the International Capital Adequacy Assessment Process (ICAAP) Document, which is briefly discussed hereunder.

ICAAP Document

ICAAP is a process which needs to be undertaken by banks in terms of BASEL III under Pillar 2 Supervisory Review Process (SRP), which envisages the establishment of suitable risk management systems in banks and their review by the RBI. One of the principles under SRP envisages that the RBI would review and evaluate banks’ internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with the regulatory capital ratios which gets reflected in the ICAAP document, which is required to be submitted to the Board of Directors for review and then forwarded to the RBI based on which it would take appropriate supervisory action if they are not satisfied with the result of this process. In this context, the following matters are required to be specifically commented upon:
•    Whether stress test is done as per RBI Guidelines;
•    Whether assumptions made in the document are realistic, encompassing all relevant risks;
•    Whether the banks’ strategies are aligned with their Board-approved Risk Appetite Statement.

The ICAAP requirements are part of the BASEL III Guidelines as prescribed in the Master Circular dated 1st July, 2015 as amended from time to time issued by the RBI.


GOING CONCERN AND LIQUIDITY RISK ASSESSMENT

Going concern assessment
This is an entirely new section which has been introduced keeping in mind the specific reporting responsibilities and considerations under the SAs. The matters which need to be commented upon are as under:
•    Whether the going concern basis of preparation of financial statements is appropriate;
•    Evaluation of the bank’s assessment of its ability to continue to meet its obligations for the foreseeable future (for at least 12 months after the date of the financial statements) with reasonable assurance for the same;
•    Any material uncertainties relating to going concern.

For considering the above matters the auditors should consider the guidance in SA-570 (Revised), Going Concern, issued by the ICAI. Further, an important indicator to assess the Going Concern assumption is whether the bank has been placed under the Prompt Corrective Action (PCA) framework as laid down under the RBI guidelines vide RBI Circular Ref: RBI/2016-17/276 DBS.CO.PPD.BC. No. 8/11.01.005/2016-17 dated 13th April, 2017 which gets triggered on breach of certain thresholds on Capital Adequacy, Profitability and Leverage Ratio. The auditors should verify the correspondence with the RBI and other documentary evidence to ensure / identify the status of the supervisory actions indicated / initiated by the RBI, as per the above-referred Circular.

Liquidity assessment

This is also an entirely new section which has been introduced considering its linkage with the going concern assessment and the recent guidelines framed by the RBI relating to Liquidity Coverage Ratio (LCR) and Net Stability Funding Ratio (NSFR). The matters which need to be commented upon are as under:
•    As a part of the assessment of the bank on going concern basis, the auditor should consider the robustness of the bank’s liquidity risk management systems and controls for managing liquidity;
•    Identifying any external indicators that reveal liquidity or funding concerns;
•    Availability of short-term liquidity support;
•    Compliance with norms relating to LCR and NSFR (as and when applicable).

The RBI has issued Guidelines for Maintenance of LCR vide RBI Circular Ref: RBI/2013-14/635 DBOD.BP.BC. No. 120 / 21.04.098/2013-14 dated 9th June, 2014 and related Circulars in terms of which banks are required to maintain an LCR, computed as the ratio of HIGH QUALITY LIQUID ASSETS TO THE NET CASH OUTFLOW OVER THE NEXT 30 DAYS which should be >= 100% effective 1st January, 2019.


INFORMATION SYSTEMS

The reporting under this section has been modified to include comments and reporting on certain specific matters, in addition to the existing requirements. These are briefly indicated hereunder:

Robustness of IT Systems:
•    Whether the software used by the bank were subjected to Information System & Security Audit, Application Function testing and any other audit mandated by RBI.
•    Adequacy of IS Audit, migration audit (as and where applicable) and any other audit relating to IT and the cyber security system.
•    Compliance with the findings of the above audits.

The following are the main RBI Circulars which are relevant in the context of the above reporting:
•    RBI Circular Ref: DBS.CO.OS MOS.BC. /11/33.01.029 / 2003-04 dated 30th April, 2004 on Information System Audit;
•    RBI Circular Ref: DBS.CO.ITC.BC. No. 6/31.02.008/2010-11 dated 29th April, 2011 Guidelines for IS Audit.

IT Security Policy (Including Cyber Security Policy)
•    Whether the bank has a duly updated and approved IT Security and IS Policy;
•    Whether the bank has complied with the RBI advisory / directives relating to IS environment / cyber security issued from time to time.

The following are the main RBI Circulars which are relevant in the context of the above reporting:
•    RBI Circular Ref: DBS.CO.ITC.BC. No. 6/31.02.008/2010-11 dated 29th April, 2011 (covering the IT Security Framework);
•    RBI Circular Ref: RBI/2015-16/418 DBS.CO/CSITE/BC. 11/33.01.001/2015-16 dated 2nd June, 2016 (covering the Cyber Security Framework).

Critical systems / processes
•    Whether there is an effective system of inter-linkage including seamless flow of data under Straight Through Process (STP) amongst various software / packages deployed.
•    Outsourced activities – Special emphasis has been placed on outsourced activities and bank’s control over them, including bank’s own internal policy for outsourced activities. In determining the reporting obligations in respect of outsourcing activities, the auditors should refer to the RBI Circular Ref: RBI/2006/167 DBOD.NO.BP. 40/ 21.04.158/ 2006-07 dated 3rd November, 2006. The said Circular requires the bank to put in place a comprehensive outsourcing policy, duly approved by the Board, which needs to cover the following aspects:
    a) Selection of activities;
  b) To ensure that core management functions including Internal Audit, Compliance function and decision-making functions like determining compliance with KYC norms for opening deposit accounts, according sanction for loans (including retail loans) and management of investment portfolio are not outsourced;
    c) Selection of service providers;
    d) Parameters for defining material outsourcing;
    e) Delegation of authority depending on risks and materiality;
    f) Systems to monitor and review the operations.

OTHER MATTERS
The specific additional areas requiring comments / reporting are as under:
Depositor Education and Awareness Fund (DEAF) Scheme 2014
Specific comments are required on the system related to compliance with the DEAF norms, which are laid down in the RBI Circular Ref: DBOD. DEAF Cell. BC. No. 101/ 30.01.002/2013-14 dated 21st March, 2014 the salient features of which are as under:
(a) Under the provisions of section 26A of the Banking Regulation Act, 1949 the amount to the credit of any account in India with any bank which has not been operated upon for a period of ten years or any deposit or any amount remaining unclaimed for more than ten years shall be credited to the Fund, within a period of three months from the expiry of the said period of ten years;
(b) The Fund shall be utilised for promotion of depositors’ interests and for such other purposes which may be necessary for the promotion of depositors’ interests as specified by RBI from time to time;
(c) The depositor would, however, be entitled to claim from the bank the deposit or any other unclaimed amount or operate the account after the expiry of ten years, even after such amount has been transferred to the Fund;
(d) The bank would be liable to pay the amount to the depositor / claimant and claim refund of such amount from the Fund.

Customer Services
Specific comments are required on business conduct including customer service by the bank describing instances, if any, of wrong debit of charges from customer accounts (also applicable to Branch Auditors), mis-selling, ineffective complaint disposal mechanism, etc. In this context, reference should be made to the RBI Master Circular on Customer Service in Banks dated 1st July, 2015 in terms of which banks are required to have a proper Customer Services Governance Framework coupled with Board Approved Customer Service Policies on specific aspects like Deposits, Cheque Collection, Customer Compensation, Grievance Redressal, amongst others.

In respect of all the above matters, involving compliance with the specific RBI guidelines, it is imperative for the auditors to thoroughly review the latest RBI Guidelines and Master Circulars / Directions and also read the latest RBI Inspection reports since greater granularity in reporting is now expected vis-a-vis the earlier reporting requirements.


FOR BRANCH AUDITORS

Whilst the basic reporting requirements are similar to those before, there are several additional areas which need to be reported / commented upon which can be broadly categorised as under:

Area

Additional areas to be commented /
reported upon

Cash, balances with the RBI, SBI and other banks

     
Reconciliation of the balance in the branch books in respect of cash
with its ATMs with the respective ATMs, based on the year-end scrolls
generated and differences, if any

      
Bank Reconciliation entries remaining unresponded for more than 15
days

     
Unresponded entries with respect to currency chest operations

Large advances

 

 

 

 

 

 

 

     
Details in the specified format for all outstanding advances in
excess of 10% (earlier 5%)
of outstanding aggregate balance of fund-based
and non-fund-based advances of the branch or Rs. 10 crores (earlier Rs. 2
crores),
whichever is less

    
Comment on adverse features considered significant in top 5
standard large advances
and which need management’s attention

Credit appraisal

      
Cases of quick mortality in accounts, where the facility became
non-performing within a period of 12 months from the date of first sanction;

       
Whether the applicable rate of interest is correctly fed into the
system;

Credit appraisal (continued)

     
Whether the interest rate is reviewed periodically as per the
guidelines applicable to floating rate loans linked to MCLR / EBLR

      
(External Benchmark Lending Rate). [Refer to RBI Circular Ref: RBI
/2019-20/53 DBR. DIR. BC. No. 14/13.03.00/2019-20 dated 4th September,
2019 for Benchmark-Based Lending].

     
Whether correct and valid credit rating,
if available, of the credit facilities of
bank’s borrowers from RBI accredited Credit Rating Agencies has been fed into
the system

Deposits

     
Whether the scheme of automatic renewal of deposits applies to FCNR(B)
deposits;

     
Where such deposits have been renewed, whether the branch has
satisfied itself as to the ‘non-resident status’ of the depositor and whether
the renewal is made as per the applicable regulatory guidelines and the
original receipts / soft copy have been dispatched

Gold / bullion

      Does
the system ensure that gold / bullion is in effective joint custody of two or
more officials, as per the instructions of the controlling authorities;

Gold / bullion (continued)

      Does
the branch maintain adequate and regular records for receipts, issues and
balances of gold / bullion.

      Does
the periodic verification reveal
any excess / shortage of stocks as
compared to book records which have been promptly reported to the controlling
authorities

Books and records

     
Details of any software / systems (manual or  otherwise) used at the branch which are not
integrated with the CBS;

     Any
adverse feature in the IS audit having an impact on the branch accounts;

    
Prompt generation and expeditious
clearance of entries in the exception reports generated



CONCLUSION

The amendments / additional reporting requirements seem to reflect the mindset of the regulators to place enhanced responsibilities and expectations on the auditors in the already existing long list of reporting requirements in the LFAR which has become longer and more onerous with correspondingly longer sleepless nights!

 

Neediness: The need to be approved by others highlights the
fact that you do not approve of yourself
– Strategic Revolt

We don’t control our body, property, reputation, position,
and, in a word, everything not of our own doing
– Epictetus

FRAUD RISK MANAGEMENT IN INTERNAL AUDIT

BACKGROUND

The incidence of fraud is increasing every day. With more frauds and their consequences befalling the stakeholders (shareholders, employees and the government, among others), the regulators are increasing the level of regulation, including disclosures to either prevent or get red flags at an early stage, or to highlight cases to set examples to deter others. The current environment is increasing the pressure on the internal auditor.

In this article we shall discuss the current regulations in India and the steps to be taken by the internal auditor to manage the ‘fraud risk’ and add value to the internal audit function.

In our opinion, frauds may be classified into two types – first, a fraud perpetrated by owners / top management and, second, all cases other than the first one. In case the internal auditor encounters a fraud perpetrated by management, he or she has few options – either become a whistle-blower and report the fraud, or walk away. Each action of the internal auditor will have consequences which he / she may have to decide based on choice and circumstances. Failure to act with integrity and to be just a bystander, or become knowingly or unknowingly a part of the management fraud, has its own set of risks and consequences.

We have a number of cases which have been discussed in the public domain to understand the above, some of the major cases being the ‘Satyam case’, ‘Cox & Kings’ and so on. One major high-profile case cited for an internal auditor to be a whistle-blower is that of ‘Enron’.

FRAUD DEFINITION

As per Webster’s Dictionary, a fraud is (a) deceit, trickery, specifically: intentional perversion of truth in order to induce another to part with something of value or to surrender a legal right; (b) an act of deceiving or misrepresenting.

Fraud is defined by Black’s Law Dictionary as A knowing misrepresentation of the truth or concealment of a material fact to induce another to act to his or her detriment.

Consequently, fraud includes any intentional or deliberate act to deprive another of property or money by guile, deception or other unfair means.


Types of fraud

The Association of Certified Fraud Examiners (ACFE) has given the following classification for ‘types of fraud’ which summarises the various types as follows –

Fraud against a company can be committed either internally by employees, managers, officers or owners of the company, or externally by customers, vendors and other parties. Other schemes defraud individuals rather than organisations.

Internal fraud

Internal fraud, also called occupational fraud, can be defined as ‘the use of one’s occupation for personal enrichment through the deliberate misuse or misapplication of the organisation’s resources or assets.’ Simply stated, this type of fraud occurs when an employee, manager or executive commits fraud against his or her employer.

Although perpetrators are increasingly embracing technology and new approaches in the commitment and concealment of occupational fraud schemes, the methodologies used in such frauds generally fall into clear, time-tested categories.

External fraud

External fraud against a company covers a broad range of schemes. Dishonest vendors might engage in bid-rigging schemes, bill the company for goods or services not provided, or demand bribes from employees. Likewise, dishonest customers might submit bad cheques, falsified account information for payment, or might attempt to return stolen or knock-off products for a refund. In addition, organisations also face threats of security breaches and theft of intellectual property perpetrated by unknown third parties. Other examples of fraud committed by external third parties include hacking, theft of proprietary information, tax fraud, bankruptcy fraud, insurance fraud, healthcare fraud and loan fraud.

Fraud against individuals

Numerous fraudsters have also devised schemes to defraud individuals. Identity theft, Ponzi schemes, phishing schemes and advance fee frauds are just a few of the ways criminals have found to steal money from unsuspecting victims.

Regulatory drivers in India necessitating action by internal auditors

Irrespective of the regulations given below, the internal auditor has to work along with management towards building a structure for prevention and / or detection of fraud in an organisation and build fraud prevention and / or detection objectives in the internal audit programmes.

The Companies Act, 2013 has introduced a requirement under sub-section 12 of section 143 which requires the statutory auditors to report to the Central Government about the fraud / suspected fraud committed against the company by the officers or employees of the company. It states, ‘Notwithstanding anything contained in this section, if an auditor of a company, in the course of the performance of his duties as auditor, has reason to believe that an offence involving fraud is being or has been committed against the company by officers or employees of the company, he shall immediately report the matter to the Central Government within such time and in such manner as may be prescribed.’

The procedures for reporting to the Board or the Audit Committee, reporting to the Central Government, replies and observations of the Board or the Audit Committee and reporting to the Central Government with the external auditor’s comments and other procedures are laid out in the law.

Primary responsibility for the prevention and detection of fraud rests with both those charged with governance of the entity and the management. In the context of the 2013 Act, this position is reiterated in section 134(5) which states that the Board report shall include a responsibility statement, inter alia, that the directors had taken proper and sufficient care for safeguarding the assets of the company and for preventing and detecting fraud and other irregularities.

Requirement of CARO 2020 With Respect to Fraud – According to a clause in CARO 2020 with regard to fraud and whistle-blower complaints, an auditor needs to report whether any fraud on or by the company has been noticed or reported during the year; if yes, the nature and amount involved is to be indicated; in case of receipt of whistle-blower complaints, whether the complaints have been considered by the auditor.

The Securities and Exchange Board of India has issued the SEBI (Listing Obligations and Disclosure Requirements) (Third Amendment) Regulations, 2020 w.e.f. 8th October, 2020 whereby, inter alia, in case of initiation of forensic audit (by whatever name called) a listed company is required to make the following disclosures to the stock exchange:

Initiation of a forensic audit along with the name of the entity initiating the audit and reasons for the same, if available; and

Final forensic audit report (other than for forensic audit initiated by regulatory / enforcement agencies) on receipt by the listed entity along with the comments of the management, if any.

This has been included under events which shall be disclosed without any application of the guidelines for materiality. Enhancing disclosure requirements is one more step by the regulator, done with a view to disclose potential financial mismanagement to the stock market and the public at large.

Institute of Chartered Accountants of India (ICAI) to come out with Forensic Accounting and Investigation Standards

The Digital Accounting and Assurance Board of the ICAI has issued Exposure Drafts on Standard on Forensic Accounting and Investigation (FAIS) such as FAIS-110 – Understanding the Nature of Engagement; FAIS-120 – Understanding Fraud Risk, and a number of others. These would naturally be the standard in times to come.

As we can see, the regulators are increasing the regulations with the increase in the incidence of fraud. Since the statutory / external auditors are required to report on fraud they necessarily look to internal auditors and expect them to have fraud prevention and / or detection built into their internal audit programmes.

FRAUD RISK MANAGEMENT BY INTERNAL AUDITOR

We have discussed the regulatory drivers but at the same time the Audit Committee and top management does not like any surprise on this count. It is not unheard of now to look to the internal auditor if any untoward incident is uncovered. It is seen that the questions immediately raised are…

When was this area last internal audited?

What was the sample size or why was the entire universe not covered?

Why a particular test could not be built into the internal audit programme to prevent the same?

Why a particular control was not suggested to be designed to prevent such an incident?

What is the size of the incident and for how long is this continuing?

(And many such questions.)

 

We are sure that the internal auditor also would not like any surprises. Frauds cannot be totally prevented but adequate care can be taken to ensure that unless the fraud is a complex one which would have been difficult to be detected under reasonable circumstances, an internal audit exercise should be able to take care of raising the red flag.

 

We would classify the action to be taken by the internal auditor in two parts. First, where the internal auditor is independent but part of the top management team and has a consulting role to play. He or she has negotiated the role of internal auditor as a business adviser to the enterprise. The internal auditor would then be part of designing or testing the design of policies / controls on anti-fraud, etc., which we shall discuss below. The second part is where the internal auditor may not be sufficiently high up but would still have to use / build fraud analytics and other tests into the audit programmes.

 

Where the internal auditor is part of the top management team, he or she would take an active part in designing or testing the design and reviewing the mechanism for anti-fraud controls which would work like a bulwark and deter incidence of fraud or help in raising early warning signals / red flags. Some policies / controls and the mechanisms in place would be –

 

Code of conduct;

Continuous data monitoring / analysis;

Surprise audits;

Regular system of management review;

Anti-fraud policy;

Fraud training for employees;

Job rotation / compulsory vacation;

Whistle-blower policy and rewards for whistle-blowers;

Proper design and review of key controls in ‘Internal Controls over Financial Reporting’.

For internal controls and risk management, the COSO Internal Control and Risk Management guidelines (both are separate guidelines) would be a good source to start looking at understanding and building internal controls, including building anti-fraud controls. The five components of an internal control framework are: control environment, risk assessment, control activities, information and communication, and monitoring.

Each business would have specific controls but to repeat the generic COSO internal control guidelines would be a healthy starting point to understand, build and review internal controls for an internal auditor.

Let us now move to the second part on operational internal auditing where fraud analytic tests based on data analytics are built into each and every individual programme for the internal auditor.

WHAT IS FRAUD ANALYTICS?

Fraud analytics combines analytic technology and techniques with human interaction to help detect potential improper transactions, such as those based on fraud and / or bribery, either before the transactions are completed or after they occur. The process of fraud analytics involves gathering and storing relevant data and mining it for patterns, discrepancies and anomalies. The findings are then translated into insights that can allow a company to manage potential threats before they occur as well as develop a proactive fraud and bribery detection environment.

Case study of a payroll internal audit using Fraud Analytics

The main objective of Fraud Analytics in Payroll is to test the validity and existence of employees and the correctness of pay elements.

 

An illustrative listing of Fraud Analytics in Payroll is –

  •      Map the payroll transaction file to payroll master file to determine if there are ‘ghost’ employees on record and being paid;

  •      Sort employees by name, address, location and other master fields to identify conflict-of-interest scenarios where managers (supervisors) have relatives working for them;

  •     Check for duplicate employees in the master list of employees by name, date of birth, address, bank account number, permanent account number (PAN No.) as a combination of fields or even independent field level duplicate checks;

  •      Perform a pattern-based fuzzy duplicate match in the master list of employees by name and address to identify potential pattern matches on employee name and address;

  •      Compute plant-wise, machine centre-wise, location-wise, correlation score between wage (pay element outgoes) and overtime payments to identify centres with negative correlation scores like falling wage outgoes and rising overtime payouts;

  •      Extract all payroll payments where the gross amount exceeds the set grade threshold limits as per masters;

  •      Compare time-card (attendance) entries to payroll and check for variances like unaccounted ‘leave without pay’;

  •      De-dup checks to identify employees getting the same net pay at multiple locations of the company in the same month;

  •      Profile employees who have not availed any leave in the last one year;

  •      Isolate individuals continuing to get payroll benefits after retirement;

  •      Detect employees getting signing-on bonus payments and leaving before the minimum service period, where signing-on bonus is not recovered;

  •      Filter out payroll payments to employees where nil deductions (including statutory deductions) have been made;

  •      Employees who have re-joined after leaving and continue to get retirement benefits with standard payroll payments;

  •      Inconsistent payroll master allowances within the same groups like grade, designation, location, etc.;

  •      Inconsistent payroll master deductions within the same groups such as grade, designation, location, etc.;

  •      Capture payments to active employees where leave availed is more than the leave balance on hand;

  •     Outliers in payroll payments where the ratio of the highest to the next highest net payroll payment to employees is irregular and excessive;

  •     Locate employees getting multiple increments and bonus payments within the same payroll period;

  •      Compare vendor addresses / phone numbers and employee addresses / phone numbers to identify conflict-of-interest situations.

 

It is important to note that though fraud analytics plays an important role today in any tests to be performed for an internal audit area like payroll, procure to pay cycle, etc., the other activities like interviews, meetings with vendors and employees, physical verification, etc., play an equally important role. Soft issues like body language of the auditee and dealing with auditees and others to understand the issues at hand for the area under audit, are quite important for an internal auditor.

CONCLUSION

It is clear that the responsibility with regard to fraud prevention and detection is increasing for the internal auditor. The regulators are increasing disclosure requirements and the Audit Committee and top management expect that the internal auditor be on guard to continuously help build and review the controls to prevent any incidence of fraud. In case any fraud incident/s does take place, the management would like to have it detected at an early stage.

A proactive internal auditor has to be on top of all this at all times and would most likely have a good fraud risk management programme to –

– increase the bottom line for the organisation (add value to corporate performance);

– ensure compliance with laid-down policies (internal), laws and regulations (external);

– send a clear anti-fraud message;

– enhance the organisation’s image and reputation; and

– get early warning signals / red flags to take pre-emptive action/s.

CARO 2020 – ENHANCED AUDITOR REPORTING REQUIREMENTS

BACKGROUND

The MCA in
exercise of the powers conferred on it under sub-section (11) of section 143 of
the Companies Act, 2013 has issued Companies (Auditor’s Report) Order, 2020
(hereinafter referred to as ‘CARO 2020’) on 25th February, 2020
which was initially applicable for audit reports relating to F.Y. 2019-2020.
However, the corona pandemic rescued the CA’s as its applicability has been
deferred to the financial years starting on or after 1st April,
2020. The legacy of such reporting by auditors dates back to 1988 when it first
started with reporting on about 24 clauses under the Manufacturing and Other
Companies (Auditors Report) Order, 1988. However, with the passage of time,
such reporting has seen many amendments; the reporting was reduced to 12
clauses in 2015 but then increased to 16 in 2016. With the changing
environment, increasing corporate scams and misstatements in financial
reporting by corporates, the authorities felt the need for the auditors of
companies to provide greater insight and information to the stakeholders and
users on specific matters relating to financial statements and business, which
has given rise to CARO 2020. The order now requires auditors to report on
various matters contained in 21 clauses and 38 sub-clauses.

 

APPLICABILITY

The applicability and exemptions
to certain classes of companies remain the same as in the predecessor CARO
2016. The non-applicability of CARO reporting to consolidated financial
statements also remains the same with only one change which requires
reporting by the auditor of the parent company of adverse comments in CARO
reports of all the companies forming part of its consolidation.

 

ANALYSIS OF
AMENDMENTS IN CARO 2020

There are mainly 30 changes
which consist of four new clauses, three clauses reintroduced
from earlier versions of CARO, 14 new sub-clauses and nine
modifications to existing clauses.
The Table below gives
details of all such clauses along with the responsibility of the auditor for
auditing and reporting in brief which is based on the guidance note issued by
ICAI.

 

 

Sr.
No.

Clause
of CARO 2020 (New / Modified / Reintroduced)

New
/ Modified Reporting requirements

Guidance
by ICAI for auditing / reporting on
new requirements

1

3(i)(a)(A)
& (B)Modified and split into two
sub-clauses

(A)
Whether the company is maintaining proper records showing full particulars
including quantitative details and situation of property, plant &
equipment (PPE).

(B)
Whether the company is maintaining proper records showing full particulars
of Intangible Assets.

(i)
There is effectively no change here except for change in terminology to make
it compliant with revised Schedule III terminology (i.e., from fixed assets
to PPE and
Intangible Assets)

 

(ii)
Right of use assets (‘ROU’) as defined in Ind AS 116 – Leases, Investment
property
as per Ind AS 40 and non-current assets held for sale as per Ind
AS 105 are required to be considered for the purpose of reporting under this
clause

(Page
17 & 18 of GN)

2

3(i)(c)
Modified

Whether
title deeds of immovable properties are held in the name of the company

The
revision in the clause requires the following additional
details in cases where title deed is not in the name of the company:


Name of the person as per title deed and whether he is promoter, director,
their relative, or employee of the company


Period (range) for which the property is held by above person


Reason for not being held in the name of the company (also indicate if any
dispute)

Documents
which are generally referred to for checking the owner in case of immovable
property are registered sale deed / transfer deed / conveyance deed, etc.

 

In
case of mortgaged immovable properties, auditor may obtain confirmation from
Banks / FI with whom the
 same is mortgaged

 

 

 

 

(Page
33 of GN)

Sr.
No.

Clause
of CARO 2020 (New / Modified / Reintroduced)

New
/ Modified Reporting requirements

Guidance
by ICAI for auditing / reporting on
new requirements

3

3(i)(d)
New

Whether
company has revalued its PPE, ROU, Intangible Assets. If yes, whether such
revaluation is based on valuation by registered valuer. Also, auditor is required
to specify the change in amounts if it is 10% or more of net block of
respective class of PPE or Intangible Assets

It
may be noted that reporting under this clause would be limited to revaluation
model since under cost model revaluation is not permitted. Further, reporting
under this clause will cover both upward and downward revaluation under
revaluation model. Changes to ROU assets due to lease modifications under Ind
AS 116 are not considered as revaluation and hence not required to be reported

 

(Page
37 of GN)

4

3(i)(e)
New

Whether
any proceedings have been initiated or are pending against the company for
holding any benami property under The Benami Transactions
(Prohibition) Act, 1988 and rules made thereunder. If so, whether the company
has appropriately disclosed the details in Financial Statements

Following
audit procedures are mainly required for purposes of reporting under the said
clause:


Management inquiries


MRL


Review of legal and professional fees ledger


Minutes of various committee meetings

 

Following
disclosures are required to be given in financial statements with respect to benami
properties:


Nature


Carrying value


Status of proceedings


Consequential impact on financials including liability that may arise in case
proceedings are decided against the company (also, if liability is required
to be provided or shown as contingent liability)

 

The
reporting is not required if the company is the beneficial owner of the benami
property

 

(Page
40 of GN)

5

3(ii)(a)
Modified

Whether
the coverage and procedure of physical verification of
inventories by management is appropriate in the
opinion of the auditor

 

Whether
discrepancies of 10% or more were noticed in the aggregate for each
class of inventory during its physical verification and, if so, whether they
have been properly dealt with in the books of accounts

This
is reintroduced from legacy reporting

 

The
10% criterion is to be looked at from value perspective only. All
discrepancies of 10% or more in value for each class of inventory are to be
reported irrespective of materiality threshold for the company

 

 

 

(Page
45 of GN)

6

3(ii)(b)
New

Whether
during any point of time of the year the company has been sanctioned working
capital limits in excess of Rs. 5 crores in aggregate from banks or financial
institutions on the basis of security of the current assets

 

Whether
quarterly returns or statements filed by the company with such banks or
financial institutions are in agreement with the books of accounts of the
company; if not, give details

 


Sanctioned limit (fresh / renewed) is to be considered and not utilised
limits


Non-fund-based limits like LC, BG, etc., are considered as working capital


If utilised limits exceed Rs. 5 crores with sanction below Rs. 5 crores, the
same is not required to be reported


Any unsecured sanctioned limit is to be excluded from reporting


The auditor is just required to match the inventory value as reported in
quarterly returns / statements submitted to banks / FI with value as per
books of accounts and report disagreement, if any. The auditor is not
required to audit the accuracy of the inventory values reported


Quarterly returns / statements to be verified include stock statements, book
debt statements, credit monitoring arrangement reports, ageing analysis of
debtors or other receivables and other financial information to be submitted
to Banks / FI

 

(Page
50 of GN)

Sr.
No.

Clause
of CARO 2020 (New / Modified / Reintroduced)

New
/ Modified Reporting requirements

Guidance
by ICAI for auditing / reporting on
new requirements

7

3(iii)(a)(A)
& (B) – Modified

Whether
company has provided loans or advances in nature of loans or stood guarantee
or provided security to any other entity and, if so, indicate aggregate
amounts of transactions during the year and outstanding as at balance sheet
date for subsidiaries, JV, associates and others

Reporting
under this clause is not applicable to companies whose principal business is
to give loans

The
better way would be to disclose the requisite details in financial statements
and give reference in CARO

 

The
format of reporting is given in GN issued by ICAI on page 60

 

 

(Page
54 of GN)

8

3(iii)(e)
New

Whether
any loans or advance in nature of loans granted which have fallen due during
the year, have been renewed or extended or fresh loans granted to settle the
overdues. If so, specify aggregate amounts of such fresh / renewed loans
granted and % of such loans to total loans as at balance
sheet date.

Reporting
under this clause is not applicable to companies whose principal business is
to give loans

The
objective of reporting on this clause is to identify instances of
ever-greening of loans / advances in
nature of loans

 

The auditor should obtain list of all parties to whom
loan or advance in nature of loan has been granted and check for dues with
respect to such loans. The auditor would be required to inquire with respect
to uncleared dues on such loans, if any. If the same are renewed or extended,
it would require reporting under this clause. If they are settled through
receipt of fresh loan, the same would be visible in party’s ledger in the
form of inflow first and outflow thereafter.

Format
for reporting is specified on page 68 of GN

 

(Page
55 of GN)

9

3(iii)(f)
New

Whether
company has granted any loans or advances in nature of loans either repayable
on demand or without specifying any terms or period of repayment, if so,
specify the aggregate amount, % to total loans and aggregate loans granted to
promoters, related parties as defined in section 2(76) of Companies Act, 2013

The auditor should prepare master file containing
party-wise details of various terms and conditions of loans or advances in
nature of loans given and the same should be updated as and when required.
The parties can be tagged as promoter or related party as per definition of
2(69) or 2(76) of the Companies Act, respectively

Format for reporting is specified on page 69 of GN

 

(Page
55 of GN)

10

3(v)
Modified

In
respect of deposits accepted or amounts which are deemed to be deposits,
whether RBI directives or Companies Act sections 73 to 76 have been complied
with. If not, nature of contraventions to be stated along with compliance of
order, if any, passed by CLB / NCLT / RBI etc.

Deemed
deposits as defined under Rule 2(1)(c) of the Companies (Acceptance of
Deposits) Rules, 2014 defines deposits to include any receipt of money by way
of deposit or loan or in any other form, by a company but does not include
amounts specified therein

 

Examine
form DPT-3 filed by the company

 

(Page
75 of GN)

11

3(vii)(a)&(b)
Modified

Whether
company is regular in depositing undisputed statutory dues including
GST
and if not, the extent of arrears of outstanding dues, or if not
deposited on account of dispute, then the amounts involved and the forum
where the dispute is pending shall be mentioned

The
modification is only to the extent of reporting on GST along with other
statutory dues

 

 

(Page
84 of GN)

12

3(viii)
New

Whether
any transactions not recorded in the books of accounts have been surrendered
or disclosed as income during the year in tax assessments under the Income
Tax Act, 1961, if so, whether the previously unrecorded income has been
properly recorded in the books of accounts during the year

Reporting
is required only if the company has voluntarily disclosed in its return or
surrendered during search / seizure. Thus, if addition is made by IT
authorities and the company has disputed such additions, reporting under this
clause is not required

Review
all tax assessments completed during the year and subsequent to balance sheet
date but before signing of auditor’s report

Reporting is also required for adequate disclosure in
financial statements or impact as per AS / Ind AS after due consideration to
exceptional items, materiality, prior period errors, etc.

(Page
98 of GN)

Sr.
No.

Clause
of CARO 2020 (New / Modified / Reintroduced)

New
/ Modified Reporting requirements

Guidance
by ICAI for auditing / reporting on
new requirements

13

3(ix)(a)
Modified

Whether
the company has defaulted in repayment of loans or other borrowings or in the
payment of interest thereon to any lender, if yes, the period and
amount of default to be reported

Preference
share capital would not be considered as borrowings for reporting under this
clause

 

Whether
ICD taken would be considered as borrowings for the purpose of reporting
under this clause will require evaluation

 

(Page
101 of GN)

14

3(ix)(b)
New

Whether
company is a declared wilful defaulter by any bank or FI or other lender

Reporting
under this clause is restricted to wilful defaulter declared by banks or FI
or any other lender (irrespective of whether such bank / FI has lent to the
company) as the same are governed by RBI Master Circular RBI/2014
-15/73DBR.No.CID.BC.57/20.16.003/2014-15 dated 1st July, 2014 on
wilful defaulters

 

The
GN clarifies that such declaration should be restricted to the relevant
financial year under audit till the date of audit report

 

With
respect to wilful defaults to other lenders, the same would be reported only
if the government authority declares the company as wilful defaulter

 

Auditor
may check information on websites of credit information companies like CIBIL,
CRIF, Equifax and Experian. Auditors may also check RBI websites, CRICIL
database and information available in public domain

 

(Page
106 of GN)

15

3(ix)(d)
Reintroduced

Whether
funds raised on short-term basis have been utilised for long-term purposes,
if yes, the nature and amount to be indicated

Practical
approach to verify such a possibility is to analyse the cash flow position
containing overall sources and application of funds. Also, certain companies
do follow the Asset Liability Management department which tracks the maturity
lifecycle of different assets and liabilities

 

Review
of bank statements specifically during the period of receipt of short-term
loans / working capital loans and its application thereafter can sometimes
provide direct nexus between receipts and application

 

(Page
114 of GN)

16

3(ix)(e)
New

Whether
the company has taken any funds from an entity or person on account of or to
meet obligations of its subsidiaries, associates, or JV, if so, details thereof
with nature of such transactions and amount in each case

First
check point would be whether loans or advances are given during the year or
investments (equity or debt) are made in order to meet obligations of
subsidiaries, associates, or JV. Reporting under this clause would cover
funds taken from all entities and not restricted to banks and FIs. The
reference details could be disclosure of related party transactions

Format
for reporting is specified on page 120 of GN

 

(Page
117 of GN)

17

3(ix)(f)
New

Whether
the company has raised loans during the year on pledge of securities held in
its subsidiaries, JV, associates, if so, give details thereof and also report
if the company has defaulted in repayment of such loans

The
reporting may be cross-referenced to
reporting under 3(ix)(a)

Format
for reporting is specified on page 123-124 of GN

 

(Page
120 of GN)

18

3(xi)
– Modified

Whether
any fraud by the company or any fraud on the company has been noticed or
reported during the year, if yes, the nature and amount involved to be
indicated

The
modification has widened the reporting responsibility of the auditor by
removing the specific requirement of reporting on frauds by the officers or
employees of the company. Thus, all frauds by the company or on the company
should be reported here

The
auditor is not responsible to discover the fraud. His responsibility is
limited to reporting on frauds if he has noticed any during the course of his
audit or if management has identified and reported

Auditor
should review minutes of meetings of various committees, internal auditors
report, etc., to identify if frauds were discussed or reported. Additionally,
the auditor will also have to obtain written representations from management
while reporting under this clause

Reporting
under this clause will not relieve the auditor from complying with section
143(12) of the Companies Act which is specifically covered by new clause
3(xi)(b) as given below

 

(Page
138 of GN)

19

3(xi)(b)
– New

Whether
any report is filed under 143(12) by the auditors in Form ADT-4 as prescribed
in Rule 13 of the Companies (Audit & Auditors) Rules, 2014 with the
Central Government

The
objective of reporting under this clause is to check and report on the
compliance of section 143(12) in terms of reporting of frauds noticed by the
auditors in the company committed by officers or employees of the company to
the Central Government in Form ADT-4 after seeking comments from board /
audit committee (if the amount of fraud exceeds Rs. 1 crore)

 

The
reporting liability under 143(12) also lies with the company secretary
performing secretarial audit, cost accountant doing cost audit and thus
statutory auditor is required to report under this clause reporting by
aforesaid professionals on frauds noticed by them during their audits

 

(Page
144 of GN)

20

3(xi)(c)
– New

Whether
the auditor has considered whistle-blower complaints, if any, received during
the year by the company

The
objective of reporting under this clause is to make the auditor confirm that
he has gone through all whistle-blower complaints and performed / planned his
audit procedure accordingly, thereby addressing financial statements
presentation or disclosure-related concerns raised by whistle-blowers

 

Check
whether requirement of whistle-blower mechanism is mandated by law [SEBI LODR
and section 177(9) of the Companies Act]

 

If
the same is not mandated by law, the auditor may ask from the management all
the whistle-blower complaints received and action taken on the same

 

(Page
147 of GN)

21

3(xiv)(a)
– Reintroduced

Whether
the company has an internal audit system commensurate with the size and
nature of its business

The
auditor should evaluate the internal audit function / system like size of
internal audit team, the scope covered in the internal audit, internal audit
structure, professional compatibility of the team performing internal audits,
reporting responsibility, independence, etc., to comment on the above clause

 

(Page
161 of GN)

22

3(xiv)(b)
– New

Whether
the reports of the Internal Auditors for the period under audit were
considered by the statutory auditor

The
objective of reporting under this clause is just to obtain confirmation from
the statutory auditor that he has gone through the internal audit reports and
considered implications of its observations on the financial statements, if
any. Reporting under this clause will require the auditor to coordinate
closely with the Internal Auditor so that he considers the work done by the
Internal Auditor for his audit purposes, compliance with SA 610 (Revised);
‘Using the Work of Internal Auditors’, is mandatory for the statutory auditor

 

(Page
167 of GN)

23

3(xvi)(b)
– New

Whether
the company has conducted any non-banking finance or housing finance
activities without valid Certificate of Registration (CoR) from RBI

The
auditor is required to first identify whether the company is engaged in
non-banking financial or housing financial activities. If yes, the auditor
should discuss with management with regards to registration requirements of
RBI for such companies and report accordingly

 

(Page
181 of GN)

24

3(xvi)(c)
– New

Whether
the company is Core Investment Company (CIC) as defined by RBI regulations
and whether it continues to fulfil the criteria of CIC. If the company is
exempted or unregistered CIC, whether it continues to fulfil the exemption
criteria

The
auditor is required to identify whether the activities carried on by the
company, assets composition as at previous year-end, etc., satisfy the
conditions for it to be considered as CIC

 

He
should also go through RBI Master Direction – Core Investment Companies
(Reserve Bank) Directions, 2016 which are applicable to all CIC

 

(Page
183 of GN)

25

3(xvi)(d)
– New

Whether
the group has more than one CIC as part of the group, if yes, indicate number
of CIC’s which are part of the group

Companies
in the group are defined in Core Investment Companies (Reserve Bank)
Directions

 

(Page
187 of GN)

26

3(xvii)
– Reintroduced

Whether
the company has incurred cash losses in the financial year and in the
immediately preceding financial year, if so, state the amount of cash losses

The
term cash loss is not defined in the Act, accounting standards and Ind AS.
Thus, for accounting standards compliant companies it can be calculated by
making adjustments of transactions of non-cash nature like depreciation,
impairment, etc., to profit / loss after tax figure

 

Similarly,
for Ind AS companies, profit / loss (excluding OCI) can be adjusted for
non-cash transactions like depreciation, lease amortisation or impairment.
Further, cash profits / cash losses realised and recognised in OCI (not
reclassified to P&L) should be adjusted to above profit / loss to arrive
at cash profit / loss for the company

 

Adjustments
like deferred tax, foreign exchange gain / loss and fair value changes should
also be given effect to since they are non-cash in nature

 

(Page
189 of GN)

27

3(xviii)
– New

Whether
there has been any resignation of the statutory auditors during the year, if
so, whether the auditor has taken into consideration the issues, objections
or concerns raised by the outgoing auditors

The
reporting on this clause is applicable where a new auditor is appointed
during the year to fill a casual vacancy under 140(2) of the Act

 

The
incoming auditor who is required to report on this clause should take into
account the following before reporting on this clause,

•ICAI
code of ethics


Reasons stated by the outgoing auditor in Form ADT-3 filed with ROC in
compliance with 140(2) read with Rule 8


Implementation guide by ICAI on resignation / withdrawal from engagement to
perform audit of financial statements


Compliance with SEBI Circular applicable for auditors of listed companies

 

(Page
191 of GN)

28

3(xix)
– New

On
the basis of the financial ratios, ageing and expected dates of realisation
of financial assets and payments of financial liabilities, other information
accompanying the financial statements, the auditor’s knowledge of the board
of directors and management plans, whether the auditor is of the opinion that
no material uncertainty exists as on the date of audit report that company is
capable of meeting its liabilities existing as at balance sheet date as and
when they fall due within period of one year from balance sheet date


Prepare list of liabilities with due dates falling within next one year


Check payments subsequent to balance sheet date till the date of issuing
auditors report


Obtain plan from management indicating realisable value of assets and
payments of liabilities


Ratios to be considered are current ratio, acid-test ratio, cash ratio, asset
turnover ratio, inventory turnover ratios, accounts receivable ratio, etc.


Other details which should be obtained from management post-balance sheet
date are MIS, cash flow projections, etc.

 

Adverse
reporting under this clause should have similar reporting in the main report
regarding going concern as specified in SA 570

 

(Page
196 of GN)

29

3(xx)(a)
– New

Whether
in respect of other than ongoing projects, the company has transferred
unspent amount to a fund specified in schedule VII of the Companies Act
within a period of six months of expiry of the F.Y. in compliance with 135(5)
of the Companies Ac.

The
auditor should ask the management to prepare a project-wise report on amounts
spent during the year and considered under CSR activities

 

(Page
204 of GN)

 

Clause
(a) requires unspent amount not relating to any ongoing project to be
transferred to specified fund as per schedule VII of the Act and Clause (b)
requires unspent amount relating to ongoing projects to be transferred to
special bank account opened for CSR activities

 

(Page
209 of GN)

30

3(xx)(b)
– New

Whether
any amount remaining unspent under 135(5) of the Companies Act, pursuant to
any ongoing project has been transferred to special account in compliance
with 135(6) of the Companies Act

 

 

CONCLUSION

The additional reporting
requirements would require additional details from the management and thus it
is very important that an auditor should have a dialogue with the management
immediately for the latter to gear up. It is also important for the auditor to
understand the process followed by the management for collection and processing
of the required information and its control environment which will give him
comfort while complying with the reporting requirements. Lastly, it is
important for the auditor to take suitable management representations wherever
accuracy and completeness of information provided by the management cannot be
confirmed by the auditor to safeguard his position. The auditor would have to
factor in additional time for reporting and the documentation will have to be
robust and fool-proof for future reference and as a safeguard against the
enhanced reporting responsibility. Lastly, reporting under CARO 2020 will no
longer remain a tick-in-the-box procedure or boilerplate reporting.
 

 

 

VALUE ADDITION IN INTERNAL AUDIT

BACKGROUND

If one looks for a common definition of ‘value add’, it is the
difference between the price of a product or service and the cost of producing
it. The price is determined by what customers are willing to pay based on their
perceived value. Value is added or created in different ways.

 

Historically, Internal Audit is treated as a ‘cost centre’ rather than a
‘value-added process’. That’s because the definition of ‘value add’ can vary
from one firm / audit department to another. Mostly, it means improving the
business rather than just looking at compliance with policies and procedures.
But what is ‘value add’ to one practitioner may be different to another practitioner
of internal audit. So how does one establish what is ‘value add’? This will be
different in every case and also for each organisation. It has become common
for most practitioners to claim that they deliver ‘value-added’ internal audit
services, and for most stakeholders to speak of availing of ‘value-added’
internal audit services. The question, therefore, is ‘how does an internal
auditor or internal audit team / department add value’ in a particular
assignment or to the organisation?

 

Broadly speaking, adding value would be based on the competencies and
personal qualities of the internal auditor and what is being delivered.

 

James Roth, who has done significant work in this area and published
papers and written books on the subject, in his paper How Do Internal
Auditors Add Value
identified four factors that can help internal
auditors determine what will add value to their organisation –

1. A deep knowledge of the
organisation, including its culture, key players and competitive environment.

2. The courage to innovate in ways
stakeholders don’t expect and may not think they want.

3. A broad knowledge of those
practices that the profession, in general, considers value added.

4. The creativity to adapt
innovations to the organisation in ways that yield surprising results and
exceed stakeholders’ expectations.

 

Based on our experience in conducting internal audits in a number of
organisations in India and abroad and speaking to a number of Chief Audit
Executives, including 14 top CAEs in the country being interviewed and a book Best
Practices by Leading Chief Audit Executives – Making a Difference
published
with respect to best practices in their respective departments, we are giving
here a few key practices which would go a long way in providing ‘value add’ to
organisations. The internal auditor would then be welcomed and respected by the
top management and treated as a trusted business adviser.

 

IMPROVING CONTROLS OR IMPROVING PERFORMANCE FOR THE ORGANISATION

Normally, internal audit would include examination of financial and
operational information and evaluation of internal controls of significant
processes (ICFR / ICoFR). In terms of presentation to management and the Audit
Committee, the internal auditor would be presenting the risks and controls
evaluated for significant processes and non-conformance thereof with an action
plan to mitigate the non-conformance.

 

The question arises whether in practice the
stakeholders would be happy to get an assurance on controls alone or would they
value improving performance for the organisation. Improving performance would
mean measurable revenue growth or cost savings due to the work carried out by
the internal audit service provider. This is always a point of debate, whether
an internal audit work should be gauged by the cost savings and / or revenue
growth due to work directly carried out by them. From numerous interviews with
CAEs and our practical work in the field with organisations, it is clear that
improving performance is considered a ‘value add’ by stakeholders and is much
appreciated and valued. This does not mean that the internal audit would not be
evaluating internal controls but would mean focus on improving performance to
enhance the value of the internal audit service being delivered.

 

Consider the following cases:

Improving performance –
cost savings in procurement (a pharmaceutical company case)

A medium-sized pharmaceutical company with a yearly turnover of around
Rs. 1,200 crores is facing tough times due to the current pandemic as its
revenue has fallen by 35%. The outsourced partner of the internal audit firm is
approached by the management and helps constitute a team consisting of two
senior procurement officials, a cost accountant, one senior production official
and a senior internal auditor who has been working with the firm and deputed to
this client and having experience in the company processes; together, they go
through all major procurement items to identify areas for cost savings /
rationalisation.

 

A number of questions are raised with the aim of cost savings:

(i)         Are we buying from
authorised vendors, for example, bearings?

(ii)        What would be the
profit margins of vendors from whom we buy imported material – could we work
with them to reduce the cost of procurement of such material?

(iii) Could we substitute some materials being procured to reduce costs
without affecting quality?

(iv) Who are the vendors supplying to our competitors and what material
is being sourced by them? Are their procurement costs cheaper or is their
quality better?

(v)        Could we reduce our EOQ
without affecting costs and our production schedule – improve the working
capital and thereby reduce costs?

 

The team made a presentation on the progress to the top management every
fortnight. In an exercise over two and a half months, by analysing data,
raising the right questions and working on a number of parameters, the team was
able to effectively save Rs. 22 crores in procurement costs without compromising
on quality or service parameters. This was considered as a ‘value add’ for the
team, and especially for the partner of the outsourced chartered accountant
firm.

 

This may be considered as a special assignment but the point being made
is ‘what do the organisation / stakeholders require and is it being delivered
by the internal auditor / internal audit firm?’ In this particular case, the
internal audit was considered ‘value add’ and it would be welcomed and
respected by the stakeholders.

 

Improving performance –
mid-review of expansion project (an engineering company case)

In a new project expansion being executed by a large engineering
organisation, the internal auditor requested that the management allow his team
to carry out a mid-review of the project. Since the internal audit firm was
associated with the organisation for the last few years, the management liked
the idea of a mid-review as the costs for implementing the expansion were quite
high.

 

The internal audit team conducted the review – the estimates, project
plan including time and cost estimates, current time and cost incurred (all
purchase orders for materials and services, materials and services received to
date, consumption, all payments made, etc.), statutory compliances with respect
to procurement and site work, sanctions with respect to bank loans and current
utilisation (including all foreign loans and hedging).

 

The internal audit team highlighted a likely delay in procurement that
could lead to the overall project being delayed, higher costs in a few
procurement areas where similar work carried out in earlier years had been
executed at lower costs, and lapses in statutory compliances. This resulted in
the project being brought back on track in terms of time and cost. The
inspection schedule for outsourced fabricated items was increased, meetings
with vendors commissioning the project were handled at a higher level and some
re-negotiation on the procurement items was undertaken. Statutory compliances
were all competed.

 

Again, this was a value addition because of an independent review by the
internal auditor. Had this been done at the end, it would only have been a
post-mortem and provided ‘learnings’ for the future. In this case, the review
actually resulted in improving performance by having the project being executed
in time with minimal time and little cost overrun.

 

STRATEGIC ALLIANCE WITH OTHER FUNCTIONS

It is important for the internal auditor to forge an alliance with other
functions in the organisation rather than work in isolation. There are other
functions like HSE – Health, Safety & Environment, Risk Management, Legal
& Compliance, Quality, IS or Information Security. All these are also
support functions providing much-needed assurance and governance support to line
functions.

 

Why does the internal audit function have to ‘reinvent’ the wheel? A
strategic alliance with other assurance functions would enable the internal
auditor to

i)   Benefit from work already
being carried out by other function/s and avoid repetition

ii) Have better understanding of
the risks and controls of the process under review

iii)        Make the internal audit
review comprehensive, building and learning from the work carried out by other
functions

iv)        Collaborate to jointly
carry out a review of the technical areas where the other assurance functions
would have better understanding of the process under review.

 

Consider the case where the internal auditor carrying out the review of
the production process first contacted the management representative for ISO
9000 Quality Standard and had a look at the number of non-conformities and
corrective action-taken reports of various issues highlighted by the ISO
auditor for the production process during the entire year.

 

THE INTERNAL AUDIT PROCESS – TRANSPARENCY AND
COMMUNICATION

The entire process from communicating objectives, field work – obtaining
data, analysing data, etc. and communicating final results should be a
transparent exercise. The internal auditor has to be working with auditees /
process owners throughout the life cycle of the internal audit project. There
is nothing to hide as the objectives for the auditee / process owner and the
internal auditor are the same.

 

To bring transparency in the process it will be necessary to communicate
continuously with the auditee team regarding

(a) what are the objectives

(b) what data is required

(c)        what will be achieved at
the end

(d) how can performance of the business be improved due to the internal
audit exercise being carried out for the process under review

(e) what deviations / bottlenecks are being found which can be improved
upon

(f)        what further data or
expert advice is required to form an opinion on the process under review.

 

These are just some aspects of the process but the idea is to
continuously communicate as if the internal auditor and the auditee / process
owner are working together on the project to improve the performance of the
business.

 

Except when the internal auditor suspects
that there are integrity issues which need to be separately reported and / or
investigated, there has to be complete transparency and the working of the
internal auditor needs to be integrated with that of the auditee / process team
under review.

 

An effective internal audit is the sum total
of a proactive auditor and a participative auditee.
This
will be possible only when the auditor is experienced in business process, and
is also competent, skilled, professional and transparent in his approach. This
would enable the internal auditor to have a participative auditee (it will also
depend on the maturity of the organisation and its culture) which, in turn,
would lead to an effective internal audit.

 

NEGOTIATING THE ROLE OF INTERNAL AUDIT

It is very important for an internal auditor to negotiate the role of
internal audit.
The idea is to work with management in the journey for business
improvement in terms of better technology for business, technological
upgradation, cost savings and other aspects of governance. For this, the internal
auditor has to negotiate his role and grab the opportunities which come his
way.

 

Let us consider the following cases:

(1) The internal auditor requests the management of a large
geographically-spread organisation to put up an exhibit at the annual event to
showcase the role and capabilities of the internal audit function. The
management was taken aback with this request but was pleasantly surprised with
the exhibit and it was much appreciated.

(2) A CAE feels the need to carry out an
energy audit throughout the organisation at its 22 plants in India. He inducts
an engineer with energy audit knowledge and helps with energy audit in many
plants, leading to tremendous savings in coal and improved efficiency in steam
generation.

(3) An internal audit function hires an
engineer with knowledge of transport trailers / trucks and ensures that a
technical audit is done for each trailer / truck in the organisation’s
transportation business segment where the organisation owned a fleet of trucks
/ trailers. This results in tremendous savings due to increase in the life of
tyres and less consumption of diesel and other consumables, etc.

(4) A mid-sized organisation wants to implement a new ERP and the
internal auditor gives one senior team member who has been with the
organisation for many years and has deep knowledge of the processes as the
internal ‘Project Manager’ for the project. The project is successful with most
requirements built into the new ERP to ease availability of data and
decision-making for the process owners.

 

TECHNOLOGY UPGRADATION AND EDUCATION / AWARENESS TO
BUSINESS

One clear area for ‘value addition’ by internal audit is continuous
education and awareness to process owners whenever the internal auditor engages
with others in the organisation. There would be a number of ways this could
happen – promote benchmarking, make others aware of compliances, speak about
best practices in other parts of the organisation, bring good / best practices
from other non-competing organisations to the process under review.

 

Technology is a great enabler for making available data for
decision-making in the way business is carried out and the internal auditor can
help make changes by spreading awareness for adoption of technology by the
organisation.

(I) An internal auditor worked as
a consultant to bring awareness about technology to Legal and Compliance and to
make the entire process of compliance totally automated with alerts for action
to be taken by the process owners for various compliances and breaches being
brought up in real time.

(II) Similarly, in another instance
they worked with Corporate Communications and Investor Relations in a public
listed organisation to install a system to get a feed from social media about
the company’s reputation / news on a real-time basis.

(III)      Another example is an
internal auditor informing the management of a major hotel property and helping
install software which tracks information on day rates for guests with
competing properties and on popular hotel booking sites. Based on this runs an
algorithm to optimise the day rate for walk-in guests being offered. This
helped in increasing the revenue for the property.

 

CONCLUSION

Each and every practice given above for ‘value addition’ by internal
audit cannot be considered in a silo as a separate ‘to do’ but would overlap
with other practices.

 

It is now time to think afresh and work differently. The internal
auditor should be working with business, forging an alliance with other
processes / functions to improve performance, including productivity, for the
organisation and to bring new thought and innovation to every aspect of
business. There is need for the internal auditor to negotiate his role in the
organisation and be a part of the top management team.

 

Business disruption is leading to change which, in turn, is leading to
opportunity for the internal auditor as the process of internal audit is not
limited to any particular process or area unlike many other processes /
functions in the organisation.

 

INTEGRATED REPORTING – A PARADIGM SHIFT IN REPORTING

INTRODUCTION

Over the last few years there has been a paradigm shift in how the
performance of a company is viewed – it is no longer viewed only by how much
profits the company made, how much did it pay shareholders, or how much taxes
did it pay to the government. At business and investor forums, companies are
increasingly being asked questions like ‘Is the company following sustainable
practices?’ ‘Is it following the best ethical practices?’ ‘Is there gender
equality?’ ‘Is it employing child labour?’ ‘What is it doing about climate
change?’

 

At the UN Climate Action Summit in 2019 a
young activist 17 years of age, Greta Thunberg from Sweden (who on 20th September,
2019 led the largest climate strike in history), gave a devastating speech
questioning why world leaders are not considering climate change and are
‘stealing the future’ from the next generation. She said: ‘You have stolen
my dreams and my childhood with your empty words. And yet I’m one of the lucky
ones. People are suffering. People are dying. Entire ecosystems are collapsing.
We are in the beginning of a mass extinction, and all you can talk about is
money and fairy tales of eternal economic growth. How dare you!’

 

Welcome to the brand new world of Integrated
Reporting.

 

WHAT IS INTEGRATED
REPORTING?

Beyond the traditional financial reporting,
there is a growing interest in reporting other matters and this has drawn the
attention of not only activists and companies (mainly goaded by activists), but
also regulators and governments. Various stakeholders have started realising
the need to have a fundamental change in reporting wherein the focus is not
only the financial capital but also on demonstrating the value created by the
company while operating within its social, economic and environmental system.

 

The intended change requires in-depth
understanding of all the building blocks of the value creation process of
business, to enable corporates to develop a reporting model which gives an
insightful picture of its performance and is considered sufficient to assess
the quality and sustainability of their performance.

 

Integrated Reporting is the process founded
on integrated thinking that results in a periodic integrated report by an
organisation about value creation over time and related communication to
stakeholders regarding aspects of value creation.

 

The evolution of Integrated Reporting can be
depicted as under:

 

 

The accumulation of all the above reporting
aspects of an organisation would culminate in what is called an ‘Integrated
Report’.

 

An Integrated Report, besides the financial,
regulatory information and management commentary, also contains reports on
sustainability and the environment to give users and the society a 360-degree
view of the overall impact which a company can have on the society.

 

As can be seen from the above, Chartered
Accountants as well as other professionals in the finance and related fields
who till now considered ‘financial reporting’ as their main job, will now
understand and get involved in much more ‘reporting’, especially since many of
these ‘reports’ would, sooner than later, need independent assertion or
attestations.

 

GLOBAL FOOTPRINTS OF
INTEGRATED REPORTING

International Integrated Reporting Council

Founded in August, 2010, the International
Integrated Reporting Council (IIRC) is a global coalition of regulators,
investors, companies, standard setters, the accounting profession, academia and
NGOs. The coalition promotes communication about value creation as the next
step in the evolution of corporate reporting.

 

The purpose of IIRC is to promote prosperity
for all and to protect our planet. Its mission is to establish integrated
reporting and thinking within mainstream business practice as the norm in the
public and private sectors. The vision that IIRC has is of a world in which
capital allocation and corporate behaviour are aligned to the wider goals of
financial stability and sustainable development through the cycle of integrated
reporting and thinking.

 

IIRC has issued the International Integrated
Reporting Framework (referred to as the <IR> Framework) to accelerate the
adoption of integrated reporting across the world. The framework applies
principles and concepts that are focused on bringing greater cohesion and
efficiency to the reporting process and adopting ‘integrated thinking’ as a way
of breaking down internal silos and reducing duplication. It improves the quality
of information available to providers of financial capital to enable a more
efficient and productive allocation of capital. Its focus on value creation,
and the capital used by business to create value over time contributes towards
a more financially stable global economy. The <IR> Framework was released
following extensive consultation and testing by businesses and investors in all
regions of the world, including the 140 businesses and investors from 26
countries that participated in the IIRC Pilot Programme. The purpose of the
Framework is to establish Guiding Principles and Content Elements that govern
the overall content of an integrated report, and to explain the fundamental
concepts that underpin them.

 

GUIDING PRINCIPLES FOR
PREPARATION OF INTEGRATED REPORT <IR>

As per IIRC, the Integrated Report <IR>
should provide insight into the company’s strategy and how it relates to the
company’s ability to create value in the short, medium and long term and to its
use of and effects on capital. It should depict the combination,
inter-relatedness and dependencies between the factors that affect the
company’s ability to create value over time. Further, it should provide insight
into the nature and quality of the company’s relationships with its key
stakeholders, including how and to what extent the company understands, takes
into account and responds to their legitimate needs and interests. The report
also provides truthful information about the company, whether the same is
positive or negative. The information in the report should be presented:

(a)        On
a basis that is consistent over time;

(b)        In
a way that enables comparison with other organisations to the extent it is
material to the company’s own ability to create value over time.

 

SIX CAPITALS OF INTEGRATED
REPORTING <IR>

 

 

1. Financial Capital:

This describes the pool of funds that is
available to the organisation for use in the production of goods or provision
of services. It can be obtained through financing, such as debt, equity or
grants, or generated through operations or investments.

 

2. Manufactured Capital:

It is seen as human-created,
production-oriented with equipment and tools. It can be available to the
organisation for use in the production of goods or the provision of services,
including buildings, equipment and infrastructure (such as roads, ports,
bridges and waste and water treatment plants).

 

3. Natural Capital:

The company needs to present its activities
which had positive or negative impact on the natural resources. It is basically
an input to the production of goods or the provision of services. It can
include water, land, minerals, forests, biodiversity, ecosystems, etc.

 

4. Human Capital (carrier is the
individual):

This deals with people’s skills and
experience, their capacity and motivations to innovate, including their:

  •         Alignment with and support of the
    organisation’s governance framework and ethical values such as its recognition
    of human rights;
  •         Ability to understand and implement an
    organisation’s strategy;
  •         Loyalties and motivations for improving
    processes, goods and services, including their ability to lead and to
    collaborate.

 

5. Social
Capital:

This deals with institutions and
relationships established within and between each community, group of
stakeholders and other networks to enhance individual and collective
well-being. It would include common values and behaviours, key relationships,
the trust and loyalty that an organisation has developed and strives to build
and protect with customers, suppliers and business partners.

 

6. Intellectual
Capital:

This discusses a key element to a company’s
future earning potential, with a tight link and contingency between investment
in research and development, innovation, human resources and external
relationships. This can be a company’s competitive advantage.

 

RECENT GLOBAL INITIATIVES

In September, 2020 the following five
framework and standard-setting institutions came together to show a commitment
to work towards a Comprehensive Corporate Reporting System:

(i)         Global
Reporting Initiative (GRI)

(ii)        Sustainability
Accounting Standards Board (SASB)

(iii)       CDP
Global

(iv) Climate Disclosure Standard Board (CDSB)

(v)        International
Integrated Reporting Council (IIRC).

 

GRI, SASB, CDP and CDSB set the frameworks / standards for
sustainability disclosure, including climate-related reporting, along with the
Task Force on Climate-related Financial Disclosure (TCFD) recommendations. IIRC
provides the integrated reporting framework that connects sustainability
disclosure to reporting on financial and other capitals.

 

The intent of this collaboration is to
provide:

(a)        Joint
market guidance on how the frameworks and standards can be applied in a
complementary and additive way,

(b)        Joint
vision of how these elements could complement financial generally accepted
accounting principles (Financial GAAP) and serve as a natural starting point
for progress towards a more coherent, comprehensive corporate reporting system,

(c)        Joint
commitment to drive towards this goal, through an ongoing programme of deeper
collaboration between the five institutions and stated willingness to engage
closely with other interested stakeholders.

 

In September, 2020 the International
Financial Reporting Standards (IFRS) Foundation published a consultation paper
on sustainability reporting inviting comments by 31st December, 2020
on:

(I)        Assess
the current situation;

(II)       Examine
the options – i.e., maintain the status quo, facilitate existing
initiatives, create a Sustainable Standards Board and become a standard-setter
working with existing initiatives and building upon their work;

(III)      Reducing
the level of complexity and achieving greater consistency in sustainable
reporting.

 

In October, 2020 the International Auditing and Assurance Standards
Board (IAASB) highlighted areas of focus related to consideration of
climate-related risks when conducting an audit of financial statements in
accordance with the International Standards on Auditing (ISA) by issuing a
document, ‘Consideration of Climate-Related risks in an Audit of Financial
Statements’.

 

If climate change impacts the entity, auditors need to consider whether
the financial statements appropriately reflect this in accordance with the
applicable financial reporting framework (i.e., in the context of risks of
material misstatement related to amounts and disclosures that may be affected
depending on the facts and circumstances of the entity).

 

In November, 2020, IFRS issued a document on ‘Effects of climate-related
matters on financial statements’ – companies are now required to consider
climate-related matters in applying IFRS Standards when the effect of those
matters is material in the context of the financial statements taken as a
whole. The document also contains a tabulated summary of examples illustrating
when IFRS Standards may require companies to consider the effects of
climate-related matters in applying the principles in a number of Standards.

 

Auditors also need to understand how climate-related risks relate to
their responsibilities under the professional standards and the applicable laws
and regulations. (An illustrative audit report where a Key Audit Matter on
‘Potential impact of climate change’ is given in the feature ‘From Published
Accounts’ by the same author on page 75 of this issue.)

 

The importance of Integrated Reporting <IR> can be gauged by the
fact that HRH Prince Charles in 2004 founded the Accounting for Sustainability
Project (A4S). A4S is challenging accountants to save the world by helping
companies meet the United Nations’ Sustainable Development Goals. At present,
A4S has a presence across the Americas, Europe, Middle East, Africa and Asia
Pacific. Its Accounting Bodies Network includes 16 accounting bodies representing
2.4 million accountants in 181 countries, or nearly two-thirds of accountants
globally. Its goal is to inspire action in the global finance industry and
drive a fundamental shift towards resilient business models and a sustainable
economy.

 

‘The risks from environmental, social and economic crises are clear to
see – not just for our planet and society, but also the future resilience of
the global economy,’
said A4S executive Chairman Jessica Fries who led a session titled ‘Can
Accountants Save the World?’ at the 20th World Congress of Accountants, Sydney,
in 2018. She added, ‘Finance leadership and innovation are essential to the
changes needed to tackle these risks and to create the businesses of tomorrow.
The accountancy and finance profession are uniquely placed to create both
sustainable and commercially viable business models’.

 

INTEGRATED REPORTING
<IR> IN INDIA

In 2017, the Securities Exchange Board of
India (SEBI) had issued a circular encouraging the Top 500 companies of India
to consider the use of the Integrated Reporting <IR> framework for annual
reporting. The circular was delivered on the International Organization of
Securities Commissions (IOSCO) principle 16 which states that ‘there should be
full, accurate and timely disclosure of information that is material to
investors’ decisions’.

 

Since then, the companies have started their
integrated reporting journey. In 2019, it was noticed that approximately 100 of
the top 500 companies have reported on Integrated Reporting in their Annual
Reports. Further, SEBI also issued a ‘Consultation Paper on the Format for
Business Responsibility & Sustainability Reporting’ to invite the views of
various stakeholders.

 

In India, several companies included
information on emissions management, water conservation, energy reduction,
human rights and similar topics in the annual report or published / hosted the
same in a separate sustainability report. The transition from corporate social
responsibility to sustainability reporting focused on moving from philanthropic
social impact to stating the impact on natural and human capital. Moving to
Integrated Reporting <IR> would further broaden the report to be
inclusive of all material capitals, connecting them to business risks, its
related decisions and outcomes in the short, medium and long term.

 

Several leading companies in India have
already started issuing Integrated Reports and reporting on the six capitals of
Integrated Reporting listed above. These additional aspects of reporting can
result in an extra 15 to 20 pages of reporting, depending on the use of
graphics, etc. Some of the leading companies that have started issuing
Integrated Reporting are Reliance Industries Ltd., Mahindra & Mahindra
Ltd., HDFC Ltd., ITC Ltd., Tata Steel Ltd., Bharti Airtel Ltd., WIPRO Ltd.,
Larsen & Toubro Ltd., Bharat Petroleum Corporation Ltd., Indian Oil
Corporation Ltd. and so on. Though some disclosures in these reports are of the
‘boilerplate’ type, these would evolve in course of time to carry more
meaningful information.

 

INTEGRATED REPORTING AND
THE ICAI

In February, 2015 the ICAI constituted a
group on Integrated Reporting and in February, 2020 it constituted the
Sustainability Reporting Standards Board (SRSB), respectively. The mission of
SRSB is to take appropriate measures to increase awareness and implement
measures towards responsible business conduct; its terms of reference, inter
alia,
include developing audit guidance for Integrated Reporting and to
benchmark global best practices in Sustainability Reporting.

 

ICAI has, to encourage SEBI, also introduced
India’s first award to celebrate the business practice of Integrated Reporting,
internationally acknowledged as the emerging best practice in corporate
reporting.

 

IN CONCLUSION

A recent trend in investing is
‘Environmental, Social and Governance or ESG Investing’. ESG investing refers
to a class of investing that is also known as ‘sustainable investing’. This is
an umbrella term for investments that seek positive returns and long-term
impact on society, environment and the performance of the business. Many
investors are now not only interested in the financial outcomes of investments,
they are also interested in the impact of their investments and the role their
assets can have in promoting global issues such as climate action. Although big
in global investments, ESG funds, which imbibe environment, social
responsibility and corporate governance in their investing process, are
witnessing growing interest in the Indian mutual fund industry, too. As per
reports, there are currently three ESG schemes managing around Rs. 5,000
crores.

 

Trust in a company is achievable through transparent behaviour and is a
key success factor for the business to operate, innovate and grow. Integrated
Reporting <IR> is promoting the need to answer important questions around
long-term value creation and in a world where economic instability and
long-term sustainability threaten the welfare of society. Integrated Reporting
<IR> is not the ultimate goal. It is only the beginning to take the world
towards more sustainability, to make it a better place for the future
generations.