CARO 2020 – A regulatory measure to enhance trust in Indian Corporates – new challenges for auditors & auditees

Auditor’s reports are issued by the statutory auditor of the company as an end result of the audit to inter alia consolidate and  summarise at the outset the key points emerging therefrom as well as  to provide assurance and inspire confidence in the validity of the financial statements as it indicates compliance with applicable accounting standards. The format of auditor’s report is governed by Company (Auditor’s Report) Order. The Company (Auditor’s Report) Order, 2016 (CARO 2016) was notified on 29 March 2016.  

The past few years have witnessed significant negative impact on the financial services sector e.g. bank frauds, the collapse of IL&FS, the extreme stress suffered by housing finance and non-banking financial services sector. At the same time, the trust of the investors, regulators and auditors in India Inc has also eroded. The investigations in these matters and analysis by the Central Vigilance Commission of Top 100 Bank Frauds led to the identification of many disturbing patterns such as siphoning off, large scale diversion of funds, lack of diligence in lending transactions, round-tripping, ever-greening of loans and non-compliance of prudential accounting and provisioning norms, lack of scrutiny of whistle-blower complaints and poor quality of auditing in some cases, etc. Most of these lapses have necessitated systemic improvements. 

The notification of Companies (Auditor Report) Order, 2020 (CARO 2020) is a major initiative  taken by the Ministry of Corporate Affairs, Government of India in consultation with National Financial Regulatory Authority (NFRA), the ultimate watchdog for audit compliances with the objective of restoring the trust of the various stakeholders in the financial statements of India Inc.  Its scope of applicability remains the same as CARO 2016.[1] It shall be applicable for auditor’s reports issued in the financial year 2019-20 onwards.

CARO 2020 follows the same format of provisions like its predecessors, with additions to the list of reporting items and modifying disclosure expectations in a few cases increase the auditor’s responsibility and scope of work with respect to auditor’s report.

Summary and analysis of changes in reporting requirements:

The specific list of matters to be reported and addressed in the Auditor’s Report has increased from 16 items under CARO 2016 to 21 items under CARO 2020. There are also changes in the extent and manner of disclosure with respect to certain existing items.

New items:

a.       Unrecorded income: (carried forward from CARO 2016 but listed as a new item)

Disclosure has to be made with respect to transactions not recorded in the books of accounts, but otherwise surrendered or disclosed as income in income tax proceedings.

This seems to be an attempt to streamline the ascertainment of total income of the company. It may be an addendum to the tax amnesty Vivaad se Vishwas in the hope of reconciling income statements.

b.       Internal audit

Opinion of auditor whether the internal audit in place is commensurate with the size and nature of the business of the company and whether the internal audit reports were considered while preparing the financial statements.

This adds a layer to the existing responsibility of the statutory auditor, whose prerogative is auditing of financial statements. Additionally, to be able to reflect on the reports of the internal auditors may require the auditors to employ technical and specialised skills.  In the short term, only a limited number of audit firms may be able to demonstrate such capability.   The outcome of the ongoing discussion regarding clear segregation between audit and non-audit services may lead to new challenges, threats and opportunities for audit firms.

c.       Cash losses:

Cash losses, if any, incurred during the financial year and one immediately preceding it, with specific amount, need explicit reporting.

Cash loss is indicative of negative cash flow (i.e. when cash outflow exceeds cash inflow) in contradistinction to revenue loss. It is almost an indicator for detecting cash waste, fraud, embezzlement and other issues which may be affecting the financials of the company. Its addition in the formal audit report is likely to nudge the company to align its budget and put in place a budget control mechanism.

d.       Resignation of statutory auditor:

The Auditor’s Report should disclose details on resignation of statutory auditors during the financial year, and whether the auditor signing the Report has considered the issues, objections or concerns raised by the outgoing auditors.

The scope of confirmation and disclosure with respect to outgoing auditors is limited to instances of resignation of auditor and not termination or the auditor expressing unwillingness to be reappointed.

e.       Opinion on credit worthiness to satisfy short term liability:

The Auditor’s Report should contain the auditor’s opinion on material uncertainty as regards the capability of the company to meet its liabilities existing as at the date of the balance sheet, being due within a year therefrom, basis financial ratios, ageing and expected dates of realisation of financial assets and payment of financial liabilities due within a year, other information accompanying the financial statement, auditor’s knowledge of board and management plans.

This is an interesting addition, since it requires the auditor’s statement on the financial capacity of the company for short term liabilities. Such auditor’s statements are likely to draw caution to issues like going concern, bankruptcy, insolvency and classification as NPAs. This could assist in providing early warning for the banking distress. However, such opinions will largely depend on the amount of disclosure the auditor receives from the management.

f.        Unspent CSR fund:

Disclosure has to be made on the unspent CSR fund associated with an identified ongoing project and its transfer to special account under Section 135(6).  While CARO 2020 is already notified, the amendments brought about by the Companies (Amendment) Act, 2019 are yet to be notified.  This is a clear attempt to the strengthen the compliance regime for CSR. 

g.       Qualification / adverse remark in CFS:

CARO 2020 does not apply to consolidated financial statements, unless there is a qualification or adverse remark.  The CARO 2020 Report now requires all qualifications or adverse remarks with respect to companies included in the consolidated financial statement of the company. This would eliminate subjectivity in CFS reporting and bring much needed uniformity in reporting.

Changes in the existing items:

Remarks:

CARO 2020 will usher in  a new standard of transparency in reporting the health of an auditee company.  Some of the new items included in the Auditor’s Report will also facilitate identification of early warning signals and early reporting of frauds to the Reserve Bank of India.

The new CARO will also require better implementation of the whistle-blower policy in letter and spirit by auditee companies.  Auditors are now mandated to review the records of the whistle-blower complaints and the extent of fact finding conducted by the Audit Committees.  Companies will have to gear up to improve their procedures even to deal with anonymous complaints which in many cases were ignored by companies.

The new CARO Report will also be a single integrated document for all stakeholders and in particular, regulators for timely identification of misadventures, defaults and deficiencies in compliance expectations. 

From a global perspective, the changes, as a whole, can also be viewed as a nudge to streamline presentation of the financial affairs in a company to regain the confidence and trust of the investors and regulators.

CARO 2020 significantly increases the responsibilities and onus of the auditor and the auditee companies.   As of the date of notification of CARO 2020, auditors have already completed the review of the financial statements pertaining to 3 quarters of the financial year.  Since  CARO 2020 will be applicable to audits for the financial year 2019-2020 onwards, it is likely to pose some practical challenges for compliance concerning the new items. However, the benefits of the new reporting would outweigh the additional compliance burden. 

-          Sharad Abhyankar, Partner & Saranya Mishra, Associate