First Things First

The recent notification of the Companies (Auditor’s Report) Order, 2020 (“CARO 2020”) by the corporate affairs ministry has set the WhatsApp groups of corporate finance managers and audit professionals on fire, and justifiably so. The notification coming just a month before the conclusion of the financial year has created a sense of urgency normally associated with a rain-shortened cricket match. (How can we not have a cricket analogy with the IPL around the corner!)

In this blog, we discuss the key practical implications of CARO 2020 primarily from the perspective of CFO Bridge’s key client constituents – SMEs and start-ups that form the backbone of our economy. We are keeping it conversational because we would like promoters and entrepreneurs to read this. You can find technical papers from other sources.

But before we go further, a contextual understanding is in order. CARO 2020 is best viewed as the latest link in the chain of reforms initiated over the past several years, the need for which were brought to the fore by a combination of systemic inefficiencies and high-profile scams. CARO 2020 will likely be remembered as a less flamboyant but impactful sibling of demonetization, bankruptcy regulations, and GST.

According to V. Srinivasan, founder of CFO Bridge, “CARO 2020 is wide and extensive in its coverage, certain aspects look like more of a forensic audit and certain aspects require an altogether separate audit exercise. Also, private companies could feel uncomfortable about certain public disclosure requirements mandated by this order that may affect their competitiveness. This is an orbit-changing notification with far-reaching consequences.”

About CARO 2020

What: CARO 2020 requires statutory auditors to perform additional verifications and reporting. Fundamentally, the government requires the auditor to shoulder more responsibilities and act more like a bloodhound for certain aspects. This is a significant shift with respect to the scope, skillsets, and effort required to discharge an audit successfully.

To Whom: These requirements apply to the audit of all companies, including foreign companies.

From When: Periods starting from April 1, 2019

The Requirements and Potential Impact

Note that we are only covering items that we believe are important to the majority of companies, and therefore the following section is not exhaustive.

Working Capital Facility. If the Company has a working capital facility exceeding Rs.5 Crores, the quarterly submissions to the lender should be consistent with the financial statements. Typically, borrowers are required to submit the value of receivables, inventory, and payables to the bank each month. This is a big deal. While larger corporates that have quarterly financial reporting requirements are unlikely to be impacted, other companies will now need to gear up to ensure reliable financial statements are prepared each quarter. Typically, many SMEs and start-ups do not have a robust quarterly book close process. Instead, they have a high-level MIS that focuses on sales and gross margin.

Further, the propensity of borrowers to take (and lenders to allow) liberties with the bank submissions will have to stop. Whether the already stressed lending environment in the country can handle the ramifications remains to be seen. Perhaps, this will encourage lenders and regulators to introspect if the lending norms can be relaxed.

Periodic Physical Inventory Verification

Whether the Company has conducted periodic physical verification of inventory at reasonable intervals and whether the exercise resulted in material discrepancies.

This is requirement will add to the cost of doing business. For many manufacturing entities, physical verification of inventory will require bringing the entire operations to a halt. The impact of this measure will depend upon what a ‘reasonable interval’ is and the cost of conducting the exercise.

Short-term Loans for Long-Term Purposes

Whether short-term loans have been utilized for long-term purposes. This requirement is problematic on many fronts. One, this is a subjective call. Further, reviewing the utilization of loan amounts throughout the year is practically impossible. This can turn out to be a complete audit of the following year in advance!

Evergreening of Loans and Loans to Promoters and Related Parties

Whether there has been evergreening of loans and advances and whether open-ended loans have been provided to promoters and related parties (not applicable to lenders)

The determination of whether a loan is evergreened is subjective, requiring the auditor to step into the shoes of the Company to determine the nature of the transaction.

Intangible Assets

Whether proper records are maintained with respect to intangible assets.

This requirement is relevant to Companies (typically start-ups) that invest in new product development, the costs of which are capitalized. If you don’t already, now is the time to run the project management and reporting system.

Investments, Loans, and Advances

The audit report should disclose investments in and loans and advances to a) subsidiaries, joint ventures, associates, and b) others. The disclosure should include amounts as at the Balance Sheet date and aggregate during the year (not applicable to lenders). The requirement to report aggregate amounts during the year will reduce the incentive of Companies to dress up their books on the balance sheet date.

Whistle-blower Complaints

Whether the auditor has considered whistle-blower complaints received during the year by the company, requiring auditors to determine the merits of a whistle-blower complaint before the Board has made the determination appears to be a demanding ask and furthermore, companies may not want this information in the public domain.

Others (Mostly Disclosure Requirements)

  1. Whether funds were raised to meet requirements of subsidiaries, joint ventures, and associates or by pledging shares in subsidiaries, joint ventures, and associates
  2. Whether proceedings have been initiated / or are pending against the Company under the Benami Transactions (Prohibition) Act, 1988
  3. In case of revaluation of a property, whether the revaluation is based on the valuation of a Registered Valuer and whether there is a change in the value of >10%
  4. Investments in and loans and advances to a) subsidiaries, joint ventures, and associates, and b) others, including the aggregate amounts during the year (not applicable to lenders)
  5. These will add to the procedures and effort but should not have a material impact on most Companies.

In Closing

The CARO 2020 requirements will require both Companies and auditors to strengthen the quantity and quality of their staff. Audit fees are likely to go up while auditors will see their professional liability risk increase as well.

In our opinion, CARO 2020 is also an admission that banks and rating agencies cannot identify borrower-specific risks in time. While the auditor is certainly better placed to identify red flags earlier, the question is whether the business realities allow the auditor to deliver on these expectations. While an auditor’s primary responsibility is towards the shareholders of the Company, there is a fine line that they tread by balancing their professional obligations and the Company’s business constraints. CARO 2020 will put a strain on that already challenging balancing act.

Lastly, there is the small matter of timing. With eleven months of the financial year behind them, Companies and auditors will have to scramble to meet these new requirements. We hope the regulators give a sympathetic ear and provide a longer glide path for stakeholders to meet these rules. To end with a cricket analogy, both the auditors and Companies find themselves in the plight of South Africa against England in the 1992 Cricket World Cup. From a challenging but gettable 22 runs of 13 balls, rain and Duckworth Lewis rule changed the equation to 21 runs from 1 ball. The question here is, will the third umpire intervene and give a reprieve.