Enhanced Responsibilities of the Auditor: Key Changes in CARO 2020

Introduction and Background

The objective of this article is to highlight the increasing expectations of the regulators/stakeholders from the auditors, key changes in CARO 2020 and the consequential impact on companies in terms of additional disclosures and increased scrutiny in the current regulatory regime. The companies as well as the auditors can utilise the additional time given for implementing the newly added provisions in CARO.

The aim of CARO 2020 is to enhance the trust in financial reporting. India has witnessed multiple instances of corporate failures which have shaken the investor’s confidence. The regulators have increased their vigilance and oversight recently in the form of additional regulations, requirements and inspections. Issuance of CARO 2020 is another step in this direction. The regulators and investigation agencies noted that early warning signals through additional reporting requirements could have assisted in reducing some of the recent fraudulent activities in the business world.

Considering the prevailing lockdown in the economy, these relaxations/deferment in timelines will help reduce the immediate burden on companies and professionals. Companies will now have sufficient time to address their immediate business needs and then respond to the additional compliances by designing their systems and processes to meet the enhanced requirements that were envisaged under the new CARO provisions. It is expected that in the long run, new CARO will require the companies to set up systems and processes to streamline the new reporting requirements like internal audit system, whistle blower systems (even where there is no mandatory requirement).

The new reporting requirements in CARO 2020 will require additional efforts, both from the company as well as the auditors. The largest attention is on financing and investing activities of a company from both perspectives as a borrower and as a lender. There is a lot of attention to fraud and enhancing the responsibilities that auditors must investigate the themes around the same.

Applicability and Effective Date

There is no change in the applicability of CARO 2020 as compared to CARO 2016. CARO 2020 is applicable to every company including a foreign company except:

• (a) a banking company;
• (b) an insurance company;
• (c) a company licensed to operate under section 8 of the Companies Act, 2013 (Act);
• (d) a One Person Company as defined in section 2(62) of the Act and a small company as defined in section 2(85) of the Act; and
• (e) a private limited company, not being a subsidiary or holding company of a public company, having a paid up capital and reserves and surplus not more than one crore rupees as on the balance sheet date and which does not have total borrowings exceeding one crore rupees from any bank or financial institution at any point of time during the financial year and which does not have a total revenue as disclosed in Schedule III to the Companies Act (including revenue from discontinuing operations) exceeding ten crore rupees during the financial year as per the financial statements.

Enhanced and New Reporting Requirements

1. Default in Repayment of Loans

To tackle the liquidity issues being faced by corporates, the MCA has revamped disclosures relating to loans. Auditors will be required to report, in the prescribed format, the details of default in repayment of loans and interest thereon from any lender unlike only banks, financial institutions, Government or debenture holders in CARO 2016. It will even cover default in repayment of loans to companies (private/public), related parties and other than related parties.

The reporting on declaration of wilful defaulter by any bank or financial institution or other lender is another significant change. The introduction of this provision may help in early warning signals for the company as well as the regulators since the number of wilful defaulters in banks is on rise. RBI guidelines define wilful defaulter (e.g., the unit has defaulted in meetings its payment/repayment obligations to the lender even when it has the capacity to honor the said obligations). It will be practically challenging for both the management and auditor to identify wilful defaulters for financial institutions, Government or other lenders since there is no definition prescribed in the Companies Act 2013 and no such list is available in public domain.

Some of the requirements have been carried forward from CARO 2016 for instance, companies need to report whether term loans were used for the purpose for which they were obtained but with an additional reporting requirement to report on diverted funds and purpose for which funds were used. Also, the requirement of short-term funds utilized for long term purposes has been carried forward from CARO 2003 to assess liquidity position of the company.

Another new requirement added is to monitor the obligations of subsidiaries, associates or joint ventures taken over by the parent company. The auditor of the parent company will have to rely on the management to obtain such details wherein he/she is not the auditor of the components. Similarly, the auditor will be required to report if the company has raised loans during the year on the pledge of securities held in its subsidiaries, joint ventures or associate companies. The objective of these amendments is to avoid fund diversion and also to provide a holistic perspective of the group to the stakeholders and the regulators.

2. Investments, Guarantees, Loans and Advances

This clause contains extensive revisions to the existing reporting requirements. The auditor is required to report if the company has made investments in, provided guarantees or security in addition to loans or advances in nature of loans to companies, firms, Limited Liability Partnerships or any other parties (as against those parties covered under Section 189 of the Act in the erstwhile clause of CARO 2016). Both auditor and the management will now have to assess what constitutes advance in the nature of loan, basis the facts of each case, as the same has not been defined anywhere in the Act e.g., if a trade advance is 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 normal trade practice.

The auditor is required to exercise professional judgement to assess whether loans or advances in nature of loans granted, guarantees provided or security given to any other entity are prejudicial to the company’s interest. While an auditor was required to assess the loan’s basis terms and conditions on which it was given, determining whether investment made, guarantees/securities provided are prejudicial will be challenging for the auditor. The auditor will be required to consider factors connected with such an investment/guarantee/security, including company’s ability to make such investment or provide such guarantee/securities, nature of guarantee/security, covenants attached, etc. The auditor’s comment on whether investment, guarantees or security are not prejudicial to the interests of the company will help investors measure the end-use of funds and would contribute towards better corporate governance.

The auditor will be required to report on all such loans or advances in nature of loans which has fallen due during the year but has been renewed or extended or fresh loans granted to settle the overdues of existing loans to same parties. Some exemptions have been given to companies whose principal business is to give loans. Similarly, if company has granted any loans or advances in nature of loans either repayable on demand or without specifying any terms or period of repayment, specific reporting is required for such loans to promoters and related parties. This change is another step to deal with reporting related party transactions in addition to existing responsibilities of the auditor under SA 550, Related Parties.

3. Going Concern

The recent collapses of some of the large corporates despite no red flags on going concern raised by the auditors seems to have resulted in this new requirement wherein an auditor is now required to opine on company’s ability to discharge liabilities reflected in the balance sheet if they fall due within a period of 12 months from the balance sheet date. While opining on such matter, an auditor is required to consider factors like expected ageing of assets, financial ratios, plans of the board of directors and other information (i.e., Other information as defined in SA 720(Revised)) in the financial statements.

An auditor’s opinion as to whether there is no material uncertainty on company’s ability to meet its liabilities would indicate the ability of a company to sustain its business and remain stable in the next year. This reporting requirement is in addition to the auditor’s responsibilities under SA 570(Revised), Going Concern. Such opinion can help investors to make a better assessment of the company.

4. Working Capital Loans

Auditors will now be required to report whether during any point of time of the year, the company has been sanctioned working capital limits in excess of INR 5 crores, in aggregate, from banks or financial institutions on the basis of security of current assets (i.e., inventory, debtors, etc.) and whether the quarterly returns or statements filed by the company with such banks or financial institutions are in agreement with the books of account of the company.

If any discrepancy arises on comparison of such statement to the management certified books of account, the auditor is required to report the same along with the reasons. For unlisted companies, i.e., where there is no requirement to prepare financial statements on quarterly basis, the auditor will be required to check with the unaudited trial balance and books of account prepared and approved by the management.

5. Reporting on Fraud and Reporting on Whistle Blower Complaints

There is an increased focus on fraud reporting and auditor is required to report on any fraud by the company or any fraud on the company, i.e., reporting on fraud is not limited to frauds by the officers or employees of the company while reporting under this clause.

Further, the requirement to consider whistle blower complaints further expands auditor’s responsibilities. There have been several instances where companies have brushed aside whistleblower complaints and refrained from disclosing them to the shareholders. The auditor will be required to consider all such whistle blower complaints now while determining his audit procedures and issuing opinion on the financial statements.

Auditors will now report on filing of ADT 4 and report to the Central Government required to be filed by the auditor pursuant to requirements prescribed under Section 143(12) of the Companies Act 2013.

6. Cash Losses

This requirement has been reinstated from CARO 2003 and requires specific reporting whether company has incurred any cash losses in the current financial year and in the immediately preceding financial year and amount of such cash losses.

7. Internal Audit Reports

Auditors now have to specifically comment on the internal audit system of the companies considering the size and nature of the business of the company. This is unlike requirement of CARO 2003 wherein this clause was applicable to specified classes of companies. An auditor will also be required to consider reports of internal auditors of the companies which will require greater level of co-ordination between the statutory auditor and the internal auditor.

8. Resignation of Statutory Auditors

In addition to the various requirements prescribed for resignation by auditor through filing of Form ADT 3 under Companies Act, 2013, compliance with SEBI LODR Regulations 2015 and SEBI circular dated October 18, 2019 on “Resignation of statutory auditors from listed entities and their material subsidiaries”, obtaining professional courtesy clearance from the outgoing auditor under Code of Ethics issued by the ICAI, this clause requires incoming statutory auditors to report on consideration of concerns/objections raised by outgoing statutory auditor of the company. The auditor is expected to understand the modifications in the audit report and address it as part of his audit engagement in accordance with the Standards on Auditing.

9. Inventory and Property, Plant & Equipment (PP&E)

The auditor is required to provide specified details of immovable properties disclosed in the financial statements whose title deeds are not held in the name of the company. There is new reporting requirement on maintenance of proper records showing full particulars of intangible assets.

Auditor is also required to report on revaluation of PP&E and intangible assets if change as a result of revaluation is 10% or more in aggregate net carrying value of each class of PP&E or intangible assets and whether such revaluation is based on valuation by a registered valuer. A clear picture on title deeds and ownership of assets may prevent mismanagement in companies having significant promoter control.

Auditor is also required to report on discrepancies of 10% or more in the aggregate for each class of inventory and whether such discrepancies were properly dealt in the books of account.

10. Unrecorded Income Subsequently Recorded

The auditors will be required to report on any transactions not recorded in the books of account but surrendered/disclosed as income during the year in the tax assessments under the Income Tax Act, 1961 and if such unrecorded income has been recorded in the books of account during the year.

11. Consolidated Financial Statements

Only one clause has been made applicable to auditor’s report on consolidated financial statements, i.e., auditor will need to give a CARO report on the consolidated financial statements with reporting on one Clause, i.e., Clause (xxi). Auditors are required to provide the details of the companies and the paragraph numbers of the respective CARO report containing the qualifications or adverse remarks. There may be situations wherein the component auditor has not issued his statutory audit report by the date of the principal auditor’s report and therefore will require co-ordination between the parent auditor and the component auditor.

12. Reporting Requirements Carried Forward and Dropped

Reporting Requirements Carried Forward: Some of the reporting requirements such as reporting under Section 185 and Section 186 of Companies Act 2013, maintenance of cost records, related party transactions, non-cash transactions, registration under Section 45-IA of RBI Act, public issue, etc. have been carried forward with no changes.

Reporting Requirement not Carried Forward: The requirement related to reporting on managerial remuneration has been deleted to avoid duplication of reporting requirements and will continue to be reported under the Section “Report on Other legal and regulatory requirements” in the audit report.

Concluding Remarks

CARO 2020 has made auditor’s reporting more onerous while mandating significant reporting and disclosures in the audit report. The extensive revisions to the reporting requirements are intended to bridge expectations gap which will provide useful information to users about the underlying financial statements and the findings by the auditor. Additional resources and time would be required to carry out audits while obtaining and gathering information which may not be available with the company. Auditors will be required to develop robust information gathering, data analysis and control procedures to meet the increasing expectations of stakeholders.

Considering applicability of CARO 2020 has been deferred by a year, both companies and auditors should co-ordinate and plan well in advance for the additional work and time involved. It is important to note that CARO 2020 not only enhances auditor’s responsibilities but also expands additional disclosures in financial statements, e.g., disclosures about proceedings initiated or pending against the company for holding any benami property; financial ratios, ageing and expected dates of realization of financial assets and payment of financial liabilities, other information accompanying the financial statements to enable auditor to opine on material uncertainty.

Further, to enable the auditor to report on the new and revised matters specified in CARO 2020, companies will not only be required to disclose additional information in the financial statements but also aggregate and compile information for the year commencing on April 1, 2020. Companies will need to recognise that the enhanced reporting requirements are intended to push for stricter compliance on the aforesaid matters by them. Failure with the disclosures would be regarded non-compliance and now need to be explicitly stated by the auditors in their audit reports.