This article has been authored by Nilika Sett, a third-year law student at Lloyd Law College, Greater Noida.
Introduction to CARO 2020 and its objectives:
Companies Auditor’s Report Order, 2020 (hereinafter referred to as “CARO 2020”) are reporting requirements which are signed by auditors along with the Statutory Audit Report for companies. The opinion expressed under CARO forms the basis of financial institutions extending capital to the company. A fateful spike of corporate frauds had questioned the efficiency of the earlier corporate reporting mechanism, CARO 2016. Such fraudulent activities include the diversion and misappropriation of inventories and evergreening of loans. This provided a way for the introduction of CARO 2020. It applicable to every company including a foreign company with the following exceptions: -
(a) Banking company
(b) Insurance company
(c) Section 8 companies
(d) A one-person company (OPC)
(e) A small company under Section 2 (85) of the Companies Act, 2013.
Comparative Analysis of CARO 2016 and 2020:
CARO 2020, applicable from April, 2020 is widely appreciated for diminishing the ambiguity of prior compliance of 2016. To understand the flaws addressed, it would be pertinent to analyze the provisions of the CARO 2020 in light of the provisions in the previous standards of CARO 2016.
Clause 3 (ii)(a) of CARO 2016 imposed an obligation on the auditor to provide for qualitative comments on the methodology of physical verification of classes of inventories conducted by the management of the company. The “class of inventory” referred in clause 3 (ii) (a) include raw materials, work-in-progress, finished goods and anticipatory inventory. Earlier, the auditors have to report only the material differences of inventories in the financial statements, detected during the audit. The materiality of the difference was subject to the discretion of the auditors. Whereas in CARO 2020, discrepancies of 10% or more in aggregate for each class of inventory, has to be reported, restricting the discretionary power of the auditors.
In CARO 2016, the auditor was not required to report on the quarterly disclosures by the company to the financial institution. The Clause 3 (ii) (b) of CARO 2020 mandates the reporting of the quarterly disclosures where sanctioned working capital exceeds Rs. 5 crores. The auditor needs to certify that the quarterly disclosures and statements filed by the company are in accordance with Financial Statements under Section 2(40) of the Companies Act,2013.
Under the 2016 order, the company in compliance to Section 189 of the Companies Act, has to maintain a register containing details of loan given to the interested directors under sub-section (2) of Section 184 and related parties under Section 188 of the Companies Act 2013 for the Related Party Transactions with related parties defined under Section 2(76) of the Companies Act. However, the CARO 2020 provides for a significant addition through Clause 3 (iii) (a) covering all types of loan and guarantees by the company and not limited to Section 189. This amendment would provide for greater transparency in inter-corporate loan and investment under Section 186 of the Companies Act in Subsidiary, Associates and Joint Ventures, which now has to be reported separately along with their respective balances due in their financial statements.
Clause 3 (iii) (e) is introduced in 2020 deals with the reporting of the steps taken by the company for the recovery of the loan fallen due during the year. The steps would include renewing of an existing loan or extending of fresh loans to settle the overdue of existing loans given to the same parties. The report should contain the aggregate amount of such dues renewed or extended or settled by new loans and the percentage of the aggregate to the total loans or advances in the nature of loans granted during the year. The report on the outstanding loan and advances would keep a check on the conversion of the loan into Non-Performing Assets (NPA). The disclosure of the extent of NPA of the company by CARO report will curb the practice of Evergreening loan by the banks. Evergreening is an activity of lending fresh loan to the borrower for the payment of interest on previous loan. This activity continues even when the loan becomes NPA.
The auditor under 2016 order, needed to report the deposits accepted by the companies. Nevertheless, newly introduced Clause 3 (v) of CARO 2020 also provides for the disclosure of the deemed deposits accepted by the companies. It further provides for the reporting on the compliance of RBI guidelines and Companies Act by such companies. Instances of deemed deposit would include financial arrangements having a structure of interest payment for a certain period or as the case may be. These arrangements may not possess the characteristics of deposit, rather they would be de facto deposits.
Earlier in CARO 2016, the report on the default in repayment of the loan was restrictive and limited to the financial institution, bank, Government or dues to debenture holders. The terms, period or alternative arrangements of repayment was not mandatory to be reported. However, Clause 3 (ix) of CARO, 2020 provides for the reporting on the default made by the company to any lenders. The auditor is also required to report the extension of the new loan to settle the outstanding loan or extension in the existing loan. If such is the case, then, the amount and percentage of such loan to total loan has to be reported. Moreover, any loan repayable on demand or without terms and condition has to be disclosed separately with an aggregate amount.
In CARO 2016, the auditor has to mention the status of the fraud reporting mechanism of the company. But in CARO 2020, the auditor is mandated to report the compliance of Section 143 (12) of the Companies Act for fraud reporting in addition to Whistle Blowing history of the company under Clause 3 (xi). Whistle Blowing mechanism is a confidential procedure used to report fraud, unethical behavior or other wrongdoings in the company and it is headed by the Chairman of the Audit Committee. Since, under CARO 2020, the auditor has to report every whistle blowing complaint, the frivolous complaints reported through the mechanism would negatively impact the interest of the company.
Provisions introduced under CARO 2020:
Apart from the amended portion of CARO 2016, the following provisions are the important new insertions brought by 2020 regulation. The additions include reporting of cash losses, working papers of outgoing auditors, financial health and fraud reporting mechanism of the company.
Clause 3 (xvii) requires to report if the company has incurred cash losses in the financial year and the immediately preceding financial year along with the amount of cash loss. Though the cash loss could be traced from the Cash Flow Statement, the reporting mechanism would have a positive impact on the credibility of the company.
Clause 3 (xviii) mandates to report on the resignation of any statutory auditors during the year as well as the issues, objections or concerns raised by the outgoing auditors. This is a welcoming move by CARO 2020 which would prevent the forced resignation of auditors leading to ignorance of the issues raised by such auditors who have been forced to resign.
Clause 3 (xix) emphasizes on qualitative remarks on the sustenance, survival, and the stability of the company based on financial ratios and probability of default on year by year basis. It would provide an eagle view to the creditors who may be considering taking steps for initiating the insolvency proceedings against the company.
Moreover, Clause 3 (xiv), deals with the reporting of internal audit by the companies. Nevertheless, it is to be observed that the statutory limit for internal audit is far higher compared to companies covered under the CARO provisions which apply to all companies except banking, investment, One Person Companies (OPC), Section 8 companies and certain private limited companies. Further, the CARO 2020 guidelines fail to recognize the circumstance where the statutory and the internal auditor belong to the same network.
CARO 2020 paves the way for the stringent implication of disclosures to be made on account of various crucial transactions entered by the company. It will not only provide strict reporting provisions for the Statutory Auditor but will also regulate the behavior and performance of the Key Managerial Personnel of the company. The creation of a robust reporting mechanism would prevent corporate fraud and will promote the solvency and transparency of the operation of the companies.