In this third article, we take a closer look at some of the clauses that help to provide more information to lenders/investors as they analyze the utilization of the money raised and the governance in the entity that is raising the funds.
Some of these clauses will also help credit and risk teams to better understand the financial position and performance of borrowers.
Working capital financing
It is estimated that a significant portion of financing requirements in India is towards financing working capital, i.e. trade credit, and short-term bank credit. Overstatement of inventory is a risk that lenders are wary of in such products. CARO 2020 requires auditors to highlight if there is a discrepancy noted in the physical verification of inventory if the observed inventory differs from that in the books by 10 percent or more. CARO 2020 mandates that the auditor must reconcile the levels of inventory reported to banks at quarter ends to that in the books of account and highlight if discrepancies are noted.
Borrowing and end-use of funds raised monitoring
CARO 2020 makes the responsibility of an auditor more onerous- from commenting upon whether the funds were used for the purposes for which they were raised to whether short term funds were used for long term purposes. This will now require auditors to focus more on the audit of liquidity risk, consider the maturity profile of assets and liabilities rather than merely look at a traditional fund flow statement. One unique challenge companies and auditors will face is that money is fungible and hence fundraising for short term purposes being used for long term purposes will be a real test!
Additionally, a specific comment is required that no material uncertainty exists as on the date of the audit report that the company is capable of meeting its liabilities existing at the date of the balance sheet as and when they fall due within a period of one year from the balance sheet date.
CARO 2020 also requires reporting on funds raised by the pledge of shares of a group entity as well as whether a company has taken funds to meet the obligations of a group entity.
"CARO 2020 sharpens the reporting requirements with respect to utilization and end-use of funds, including bringing back certain requirements around the use of short term funds for long term purposes"
Greater scrutiny on loans given by companies
The erstwhile CARO largely required reporting on whether loans to parties covered under section 189 were prejudicial to the interests of the company and reporting of irregularity in payments as well as steps taken to recover amounts overdue for more than 90 days. CARO 2020 has significantly enhanced the work to be performed by the auditors by covering all loans, guarantees, and investments made by a company.
Following interesting points emerge for auditors of NBFCs, HFCs, etc and this is the right time to engage with auditors to agree on the approach before the year-end:
- Lending and experiencing delinquencies are business as usual for NBFCs, however, auditors of NBFCs still need to mention the amount of loans that are overdue for more than 90 days
- The amount reported above would not corroborate with assets that are classified as Stage 3 since other qualitative criteria also factored in the staging analysis
- The ICAI Guidance note also suggests that the audit should report the number of cases that were overdue/irregular, i.e. even if the account is 1 DPD!
Auditing evergreening of loans is now not just restricted to auditors of NBFCs and banks, every auditor will require to assess whether loans that were due for collection by the company were refinanced by that company to avoid the account from being classified as irregular.
More on the additional onerous responsibilities of an auditor in the next article, where we capture the requirements related to fraud reporting, auditing of whistle-blower complaints, and commenting on the internal audit function.
In summary, while loans to related parties were a focus area in the erstwhile CARO, this time around, CARO 2020 significantly enlarges the scope of reporting- both in cases where the company is a borrower as well as when the company is an investor/lender. Certain clauses would require extraction of a large amount of data and hence is important to start work and discussions with the auditors now and make 2021 a better year!
The author is a Chartered Accountant, an alumnus of IIM Bangalore, and Co-founder of World of Financial Reporting, a firm founded after over a decade of experience in audit and financial reporting advisory with a leading accounting firm. He can also be reached at firstname.lastname@example.org