The Hindu Business Line : CARO with due care

THE draft statement issued by the Auditing and Assurance Standards Board of the ICAI provides guidelines to the members about how to go about complying with the Companies (Auditors' Report) Order 2003 (CARO) requirements. Paragraph 4(XI) of CARO: This is on whether the company has defaulted in repayment of dues to a financial institution or bank or debenture-holder. If yes, the period and amount of default to be reported. The draft guidelines specifies what should fall under `dues' and requires the auditors to obtain a schedule of repayment with timing and amount of dues to banks, financial institutions and debenture-holders. Dues will include not only the principal sum but also interest.

The auditor will have to examine the agreements, terms and conditions of the borrowings and other related documents and verify whether the dues were paid in accordance with the agreement/sanction terms. Repayment of principal amounts normally falls due on fixed dates as specified in the agreements and if payments were not made on or before the specified dates, a `default' had taken place.

Dates of interest payments are also normally set out in the agreements. The agreements would also normally specify under what circumstances an `event of default' would take place. For example, an agreement may provide that if an instalment of loan repayment is not received by the lender within seven days from the date specified in the agreement, it would amount to an `event of default'. In such a case, the auditor will have to mention the definition of default in his report in the event a default had taken place.

In case the borrower had submitted to the lender a proposal for rescheduling of loan agreement or if there is any dispute on any issue between the lender and the borrower, the auditor needs to report the same.

For example, if a loan repayment is due on February 1, 2004, and the borrower has submitted a proposal for deferment of the repayment to August 1, 2004, which, at the time of finalising the audit report was under consideration of the lender (but not formally approved), it will be necessary for the auditor to disclose the matter in his report.

In the event of a situation of unresolved disputes between the borrower and lender, the auditor should report about his inability to determine whether or not a default has taken place.

The draft guidelines suggests that the auditor, in the event of a default, should specify in his report, the period and amount of default, the lender's name and a description of the loan.

The requirement of CARO under this clause is limited to borrowings from banks, financial institutions and debenture-holders. The term `financial institutions' used in CARO has not been defined. Section 4A of the Companies Act, 1956, provides a list of institutions which are to be construed as `public financial institutions' and sub-section 2 of Section 4A empowers the Central Government to notify through the Official Gazette, other institutions which may be considered as public financial institutions. The draft guidelines lists out the names of public financial institutions which have so far been notified by the Central Government. This would mean that the draft guidelines suggest that for the purpose of CARO, `financial institution' and `public financial institution' are synonymous.

It may be noted that only loans from banks (including foreign banks), financial institutions and debenture-holders are covered by CARO. If there is any default in payment of dues to other lenders, such as borrowing from other companies, international organisations such as ADB/CDC, and so on, CARO does not appear to require the auditor to report the same. This may not be the intention or the spirit of the Order and the draft guidelines state that the auditor should comply with CARO both in letter and spirit.

Paragraph 4(xv): "Whether the company has given any guarantee for loans taken by others from banks or financial institutions, the terms and conditions whereof are prejudicial to the interests of the company."

This requirement of CARO imposes considerable additional responsibility on the auditor in the sense that to make a comment on whether the terms and conditions of any guarantee given by the auditee to others are prejudicial to the interest of the auditee, it will be necessary for the auditors to examine the financial health of the borrower, terms and conditions of the borrowing, circumstances under which the auditee agreed to give the guarantee, and so on. Such instances which are shown as contingent liability in the books of the auditee were hitherto not required to be verified/examined by the auditor from the point of view of reasonableness of the terms and conditions of the guarantee.

Question of giving guarantee by a company for borrowings of others arise normally in the case of borrowings by subsidiaries, associates or other group companies. Guarantees are insisted by the lenders as an additional security when either the value of tangible assets offered as security are insufficient or the lender anticipates a fall in the realisable value of the assets offered as security.

The terms of guarantees issued would provide that if the borrower fails to repay the loan, the lenders will have recourse to the guarantor. Thus, the liability of the guarantor crystallises only on failure/default of the borrower to repay and till then, it remains as a contingent liability. The draft guidelines require the auditors to, among others, verify: a) whether the guarantee was issued with proper sanctions; b) the terms and conditions including the security for the loans; c) reasonableness of the terms and conditions of the guarantee; d) tangible/intangible benefits accruing from giving the guarantee alternative source of finance to the borrower; and e) urgency or need for borrowing.

If the auditor feels that the company could have issued the guarantee on better terms, he should obtain written representation from the management as to why it considers that the terms and conditions of the guarantee are not prejudicial to the interest of the company.

If the auditor comes to the conclusion that no reasonable person would have issued the guarantee on the terms and conditions in which it has been issued, he should conclude that the terms and conditions are prejudicial to the interest of the company.

The auditor should, therefore, obtain in writing from the management: a) a list of all obligations in respect of guarantee issued; b) the contingent liabilities do not include any contingencies which are likely to result in a loss to the company

Considerable judgment needs to be exercised by the auditor in reporting on this aspect of CARO. Such instances arise only in cases of loss making or not-so-well-to-do borrowers when the lenders insist on a collateral by way of guarantee.

There is, therefore, prima facie a possibility of actual liability attached to giving such a guarantee. It will often be difficult to specify any tangible/intangible benefit arising to the auditee by giving the guarantee. Corporates should, therefore, in their interest, record in writing through the correspondences exchanged on issuance of guarantee about the benefits accruing to the company by giving the guarantee.

Further, in the case of guarantees continuing for several years, it could happen that the terms and conditions of the guarantee which the auditor had earlier reported to be not prejudicial to the interest of the company have become subsequently prejudicial to the interest of the company in view of adverse performance of the borrower or default committed by the borrower to repay the loan. Reporting on this clause of CARO will require the auditor to go beyond verification of the books and records of the auditee. He will need to examine the financial health of the borrower for whom the guarantee has been given even though he may not be the auditor of the borrower. This will considerably increase the work of the auditor.

There may be occasions when the auditor may not be able to come to the conclusion whether the lenders will exercise its option to invoke the guarantee should the borrower default in repayment. In such cases, it would be advisable for the auditors to disclose the uncertainty or inability to come to a definite conclusion in his report.