Accountants and auditors will have to grapple with a ton of new details and disclosures while preparing financial statements and audit reports, come financial year 2021-22. MCA brought, vide separate notifications dated 24th March, 2021 amendments in the Companies (Audit and Auditors) Rules,2014 (“Audit Rules”), the Companies (Accounts) Rules, 2014 (“Accounts Rules”) and Schedule III of the Companies Act.

While Schedule III changes will require wide ranging disclosures [to be covered by a separate write up], the amendments in Audit Report Rules  and Accounts Rules require the following new disclosures:

  • Camouflaged lending or investment, that is, where out-bound or inbound loans, advances and investments are intended to be routed through a conduit entity, masking the identity of the ultimate beneficiary
  • Compliance with respect to payment of dividend
  • The need for accounting software to maintain an audit trail, that is, edit log, of the primary entries, possibly with a view to enable the detection of any changes in primary entries
  • Gaps in valuations of securities, so as to reflect the valuations at the time of borrowing money, and at the time of OTS

We briefly discuss these.

Applicability – scope and date

  • The changes as will be discussed below will be applicable on the Auditor’s Report and Board’s Report from the financial year 2021-22 and onwards.
  • Since statutory audit is a mandatory requirement for all the companies, the changes in the Auditor’s Report shall be applicable on all companies.
  • From the language of the amendments, it is apparent that the changes are applicable only for the annual financial statements; neither are they applicable to interim financial statements, nor to special purpose financial statements.
  • An important question will remain whether the required management representation and the auditors’ check will pertain to transactions done during the financial year 2021-22 and thereafter, or does it pertain to opening balances of transactions as on 1st April, 2021. In absence of any suggestion as to retroactivity, it should be logical to assume that the required management representation and the auditors’ checking should pertain to the transactions done during the financial year.
  • The changes in relation to Board Report shall be applicable on all the companies, since the Board Report is a mandatory requirement for all.
  • The requirements of audit trail and edit log are applicable on companies maintaining their accounts in the electronic form. However, practically, all companies maintain accounts in electronic format, so the same can be said to be applicable on all companies.

Is it illegal to have investments via conduits?

Several laws refer to indirect lending or investment –

  • Sec 185 of the Act prohibits both direct and indirect loans, investments, guarantees or security to the directors and other specified entities.
  • Under the FEMA Regulations, the definition of “foreign equity holder” includes those equity holders having minimum 51% of indirect equity holding
  • Sec 186 (1) also refers to investment “through” one or more layers of subsidiaries, which is again a case of indirect investments.
  • In many commercial transactions, it is understood that the recipient is acting as a conduit – for example, lending through a fintech platform
  • Special purpose vehicles, which are well allowed to operate under various laws, are intended to be conduits only
  • Use of conduits is commonplace practice in many commercial transactions

Hence, while it is not illegal on the face of it, the use of a masquerading entity camouflages the real nature of the financial transaction. It acts as a subterfuge and hence, creates opacity. In the context of PMLA, these transactions may also be hiding the real identity of the real beneficiary.

Hence, it is important to ensure that the identity of the real beneficiary, if so targeted by the lender or investor, is disclosed.

What sort of transactions will be covered?

There are several elements in the camouflage rule that need to be understood:

There are 3 legs of the transaction: a source transaction, a conduit or intermediary transaction, and an ultimate beneficiary transaction.

The source transaction may be

  • Investments,
  • Advances, or
  • Loans

At the source stage, the money has come as a result of any borrowing, issue of shares or share premium or any other source or kind of funds. Since these expressions are wide enough, it does not matter what the source of the funds at the source level is.

The intermediary transaction may be by way of

  • Loan or advance
  • Investment
  • Provision of any guarantee or security

The ultimate beneficiary is the end beneficiary of the source transaction.

The following points may be noted about the scope of the Camouflage rule:

  1. Commercial transactions are not covered: Notably, the transactions covered by the rule are financial transactions, in the nature of loans, advances or investments. Real sector transactions such as sales, purchases, services, including payment and collection services, etc., are not covered by the rule.
  2. Non-discretionary transactions as regards the intermediary: In order to attract the offence of the camouflage rule,the source must have identified the ultimate beneficiary. This is clear from the words: “identified in any manner whatsoever by or on behalf of the company”. Thus, if the intermediary had the discretion in identifying the beneficiary, this rule is not attracted. Hence, the identification of the beneficiary is done by the source, and without any discretion on the part of the intermediary.
  3. Pre-contemplated transfer to the ultimate beneficiary: Next important element is the existence of an understanding with the intermediary that the funds passing through the intermediary are intended by the ultimate beneficiary. This is clear from the words “with the understanding, whether recorded in writing or otherwise”. The form of the understanding or the formal nature of the understanding also doesn’t matter, but the understanding must have been there.
  4. Direct nexus: This suggests that the flow of funds from the source of the intermediary, and from intermediary to the ultimate beneficiary must be part of the same transaction, showing a clear nexus.
  5. The intent of camouflaging the chain financial transaction is present: It is only when the real nature of the transaction is sought to be garbed, and the transaction purports to be a financial transaction with the intermediary, whereas the real intent is to provide funding to the ultimate beneficiary. For example, if a special purpose vehicle collects money from the investors, it is evident on the face of the transaction that the money is intended to go to another beneficiary. There is no garbing of the identity of the end beneficiary. These transactions are explicit and transparent transactions. The whole intent of the camouflage rule is to eliminate opacity. If the transaction was itself transparent, the rule has no relevance at all.

There are several interconnected financial transactions that abound in the world of finance. Hence, it will remain a matter of intrigue as to what all transactions may be regarded as falling under the offence of the camouflage rule. There are several questions that arise in this respect:

Duty of the auditor

The provisions are not just casting a responsibility on the directors, but the auditors are also required to substantiate the statement of the directors by applying their audit procedures. While the auditors can have ways and means to identify the instances of “outward” surrogate lending well, how the auditors can assure there are no instances of “inward” surrogate lending will require some new auditing methods.

Reasons of such reporting requirement

The amendments can be looked upon as a way to ensure that the companies do not use masquerades for the purpose of distinguishing the identity of the ultimate beneficiary of the funds.  These might be to also check the instances of money laundering and terrorism financing.

Impact of the change

Though no specific punishments have been specified, on a conjoint reading of Sections 447 and 448 of the Act, it seems that the directors may be liable for fraud in cases of active concealment of material information or making mis-statements deliberately.

Since the Auditors are required to substantiate that there are no material mis-statements made by the directors as aforesaid, where the auditor fails to prove his innocence, he might also be penalised in cases of material misstatement.

Reason of the change

The change is to ensure that the company has not inflated the value of their books at the time of seeking loans from the banks and financial institutions, nor has it deflated the same at the time of proposing one-time settlement.

We understand that there may be various reasons for the differential valuation, like difference in time period and resultant depreciation, amortization etc, or due to varying market forces. Whatever be the reasons, the same needs to be adequately captured in the Board’s Report for the company.

 

Accountants and auditors will have to grapple with a ton of new details and disclosures while preparing financial statements and audit reports, come financial year 2021-22. MCA brought, vide separate notifications dated 24th March, 2021 amendments in the Companies (Audit and Auditors) Rules,2014 (“Audit Rules”), the Companies (Accounts) Rules, 2014 (“Accounts Rules”) and Schedule III of the Companies Act.

While Schedule III changes will require wide ranging disclosures [to be covered by a separate write up], the amendments in Audit Report Rules  and Accounts Rules require the following new disclosures:

  • Camouflaged lending or investment, that is, where out-bound or inbound loans, advances and investments are intended to be routed through a conduit entity, masking the identity of the ultimate beneficiary
  • Compliance with respect to payment of dividend
  • The need for accounting software to maintain an audit trail, that is, edit log, of the primary entries, possibly with a view to enable the detection of any changes in primary entries
  • Gaps in valuations of securities, so as to reflect the valuations at the time of borrowing money, and at the time of OTS

We briefly discuss these.

Applicability – scope and date

  • The changes as will be discussed below will be applicable on the Auditor’s Report and Board’s Report from the financial year 2021-22 and onwards.
  • Since statutory audit is a mandatory requirement for all the companies, the changes in the Auditor’s Report shall be applicable on all companies.
  • From the language of the amendments, it is apparent that the changes are applicable only for the annual financial statements; neither are they applicable to interim financial statements, nor to special purpose financial statements.
  • An important question will remain whether the required management representation and the auditors’ check will pertain to transactions done during the financial year 2021-22 and thereafter, or does it pertain to opening balances of transactions as on 1st April, 2021. In absence of any suggestion as to retroactivity, it should be logical to assume that the required management representation and the auditors’ checking should pertain to the transactions done during the financial year.
  • The changes in relation to Board Report shall be applicable on all the companies, since the Board Report is a mandatory requirement for all.
  • The requirements of audit trail and edit log are applicable on companies maintaining their accounts in the electronic form. However, practically, all companies maintain accounts in electronic format, so the same can be said to be applicable on all companies.

Is it illegal to have investments via conduits?

Several laws refer to indirect lending or investment –

  • Sec 185 of the Act prohibits both direct and indirect loans, investments, guarantees or security to the directors and other specified entities.
  • Under the FEMA Regulations, the definition of “foreign equity holder” includes those equity holders having minimum 51% of indirect equity holding
  • Sec 186 (1) also refers to investment “through” one or more layers of subsidiaries, which is again a case of indirect investments.
  • In many commercial transactions, it is understood that the recipient is acting as a conduit – for example, lending through a fintech platform
  • Special purpose vehicles, which are well allowed to operate under various laws, are intended to be conduits only
  • Use of conduits is commonplace practice in many commercial transactions

Hence, while it is not illegal on the face of it, the use of a masquerading entity camouflages the real nature of the financial transaction. It acts as a subterfuge and hence, creates opacity. In the context of PMLA, these transactions may also be hiding the real identity of the real beneficiary.

Hence, it is important to ensure that the identity of the real beneficiary, if so targeted by the lender or investor, is disclosed.

What sort of transactions will be covered?

There are several elements in the camouflage rule that need to be understood:

There are 3 legs of the transaction: a source transaction, a conduit or intermediary transaction, and an ultimate beneficiary transaction.

The source transaction may be

  • Investments,
  • Advances, or
  • Loans

At the source stage, the money has come as a result of any borrowing, issue of shares or share premium or any other source or kind of funds. Since these expressions are wide enough, it does not matter what the source of the funds at the source level is.

The intermediary transaction may be by way of

  • Loan or advance
  • Investment
  • Provision of any guarantee or security

The ultimate beneficiary is the end beneficiary of the source transaction.

The following points may be noted about the scope of the Camouflage rule:

  1. Commercial transactions are not covered: Notably, the transactions covered by the rule are financial transactions, in the nature of loans, advances or investments. Real sector transactions such as sales, purchases, services, including payment and collection services, etc., are not covered by the rule.
  2. Non-discretionary transactions as regards the intermediary: In order to attract the offence of the camouflage rule,the source must have identified the ultimate beneficiary. This is clear from the words: “identified in any manner whatsoever by or on behalf of the company”. Thus, if the intermediary had the discretion in identifying the beneficiary, this rule is not attracted. Hence, the identification of the beneficiary is done by the source, and without any discretion on the part of the intermediary.
  3. Pre-contemplated transfer to the ultimate beneficiary: Next important element is the existence of an understanding with the intermediary that the funds passing through the intermediary are intended by the ultimate beneficiary. This is clear from the words “with the understanding, whether recorded in writing or otherwise”. The form of the understanding or the formal nature of the understanding also doesn’t matter, but the understanding must have been there.
  4. Direct nexus: This suggests that the flow of funds from the source of the intermediary, and from intermediary to the ultimate beneficiary must be part of the same transaction, showing a clear nexus.
  5. The intent of camouflaging the chain financial transaction is present: It is only when the real nature of the transaction is sought to be garbed, and the transaction purports to be a financial transaction with the intermediary, whereas the real intent is to provide funding to the ultimate beneficiary. For example, if a special purpose vehicle collects money from the investors, it is evident on the face of the transaction that the money is intended to go to another beneficiary. There is no garbing of the identity of the end beneficiary. These transactions are explicit and transparent transactions. The whole intent of the camouflage rule is to eliminate opacity. If the transaction was itself transparent, the rule has no relevance at all.

There are several interconnected financial transactions that abound in the world of finance. Hence, it will remain a matter of intrigue as to what all transactions may be regarded as falling under the offence of the camouflage rule. There are several questions that arise in this respect:

Duty of the auditor

The provisions are not just casting a responsibility on the directors, but the auditors are also required to substantiate the statement of the directors by applying their audit procedures. While the auditors can have ways and means to identify the instances of “outward” surrogate lending well, how the auditors can assure there are no instances of “inward” surrogate lending will require some new auditing methods.

Reasons of such reporting requirement

The amendments can be looked upon as a way to ensure that the companies do not use masquerades for the purpose of distinguishing the identity of the ultimate beneficiary of the funds.  These might be to also check the instances of money laundering and terrorism financing.

Impact of the change

Though no specific punishments have been specified, on a conjoint reading of Sections 447 and 448 of the Act, it seems that the directors may be liable for fraud in cases of active concealment of material information or making mis-statements deliberately.

Since the Auditors are required to substantiate that there are no material mis-statements made by the directors as aforesaid, where the auditor fails to prove his innocence, he might also be penalised in cases of material misstatement.

Reason of the change

The change is to ensure that the company has not inflated the value of their books at the time of seeking loans from the banks and financial institutions, nor has it deflated the same at the time of proposing one-time settlement.

We understand that there may be various reasons for the differential valuation, like difference in time period and resultant depreciation, amortization etc, or due to varying market forces. Whatever be the reasons, the same needs to be adequately captured in the Board’s Report for the company.