Changes in Auditors’ Report and Financial Statements to reveal camouflaged financial transactions

In the financial year 2021-22, accountants and auditors will have to deal with a slew of new facts and disclosures while drafting financial statements and audit reports. MCA amended the Companies (Audit and Auditors) Rules, 2014 (“Audit Rules”), the Companies (Accounts) Rules, 2014 (“Accounts Rules”), and Schedule III of the Companies Act through separate notifications dated March 24, 2021.
While the Schedule III modifications will necessitate extensive disclosures [which will be the subject of a future article], the adjustments to the Audit Report Rules and Accounts Rules will necessitate the following new disclosures:

Outbound or inbound loans, advances, and investments that are intended to be routed through a conduit organization to conceal the identity of the final beneficiary are known as camouflaged lending or investment.
In terms of dividend payment, there is a high level of compliance.
The requirement for accounting software to keep an audit trail, or edit log, of primary entries, presumably in order to detect any changes in primary entries.
Gaps in security valuations, reflecting valuations at the time of borrowing money and at the time of OTS
These are briefly discussed.

Applicability – scope and date

From the financial year 2021-22 and onwards, the amendments outlined below will apply to the Auditor’s Report and the Board’s Report.
Because statutory auditing is a legal requirement for all businesses, the modifications to the Auditor’s Report will apply to all businesses.
The revisions are solely relevant to yearly financial statements, according to the language of the regulations; they are not applicable to interim financial statements or special purpose financial statements.

A key question will be whether the mandatory management representation and auditors’ check will apply to transactions completed during the financial year 2021-22 and later, or whether it would apply to transaction opening balances as of April 1, 2021. In the absence of any recommendation to the contrary, it seems reasonable to presume that the required management representation and auditing should apply to transactions completed throughout the fiscal year.
Because the Board Report is a necessary requirement for all organizations, the modifications in regard to the Board Report will apply to all of them.

Companies that keep their accounts in electronic form must comply with audit trail and edit log requirements. However, because virtually all businesses keep their books in electronic format, the same can be argued to apply to all businesses.

Is it illegal to have investments via conduits?

Several laws ban both direct and indirect loans, investments, guarantees, or security to directors and other specified entities. Sec. 185 of the Act prohibits both direct and indirect loans, investments, guarantees, or security to directors and other specified entities.
The term of “foreign equity holder” under the FEMA Regulations covers equity holders with a minimum 51 percent indirect equity holding.
Investment “through” one or more layers of subsidiaries is also referred to in Sec 186 (1), which is an example of indirect investments.

In many commercial transactions, the recipient is regarded to be serving as a conduit — for example, financing via a fintech platform.
Special purpose vehicles, which are permitted to function under a variety of rules, are only intended to serve as conduits.
Conduits are used in a wide range of commercial activities.
As a result, while the use of a fictitious business is not prohibited on the surface, it hides the true nature of the financial transaction. It works as a ruse and hence causes opacity. These transactions may also be concealing the true identity of the true beneficiary in the context of PMLA.
As a result, it’s critical to make sure the true beneficiary’s identity is revealed if the lender or investor is looking for one.

What sort of transactions will be covered?

The camouflage rule has numerous components that must be understood:
A source transaction, a conduit or intermediary transaction, and an eventual recipient transaction are the three legs of the transaction.
Investments, Advances, or Loans could be the source transaction.
The money arrived at the source stage as a consequence of a loan, a stock issue, or a share premium, or any other source or type of cash. It makes no difference what the source of the funds is at the source level because these expressions are broad enough.

The intermediate transaction could take the form of a loan or an advance investment, with or without the provision of any guarantee or security.
The source transaction’s end beneficiary is the ultimate beneficiary.
The following points about the Camouflage rule’s scope should be noted:
Transactions between businesses are not covered: Financial transactions, such as loans, advances, and investments, are among the transactions covered by the rule. The regulation does not apply to real-world transactions such as sales, purchases, and services, including payment and collection services.

Transactions involving the middleman that are not discretionary: The source must have identified the final recipient in order to be charged with breaking the camouflage rule. The phrases “identified in any manner whatsoever by or on behalf of the company” make this plain. This rule is not attracted if the intermediary had discretion in identifying the beneficiary. As a result, the source determines who the recipient is, with no choice on the part of the intermediary.

Pre-planned transfer to the ultimate beneficiary: The existence of an agreement with the intermediary that the monies traveling via the intermediary are intended for the ultimate beneficiary is the next key factor. The phrases “with the knowledge, whether recorded in writing or otherwise” make this apparent. It doesn’t matter what the understanding looked like or how formal it was, but it had to be there.

Direct nexus: This implies that funds must flow from the source of the intermediary to the eventual beneficiary as part of the same transaction, demonstrating a clear connection.
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 recipient, that the intent of camouflaging the chain financial transaction is present.

beneficiary. For example, if a special purpose vehicle gathers funds from investors, it is clear from the start that the funds are intended for a different beneficiary. The identity of the final beneficiary is not disguised. These are transactions that are both explicit and transparent. The camouflage rule’s entire purpose is to eliminate opacity. The regulation is irrelevant if the transaction was transparent in the first place.
In the world of finance, there are numerous interrelated financial transactions. As a result, it will remain a mystery as to what transactions will be considered to be in violation of the camouflage rule. In this regard, there are a number of issues to consider:

Duty of the auditor

The regulations not only place responsibility on the directors, but also on the auditors, who must use their audit procedures to substantiate the directors’ statements. While auditors may be able to recognize cases of “outward” surrogate lending, ensuring that there are no instances of “inward” surrogate lending will necessitate the use of novel auditing methodologies.

Reasons of such reporting requirement

The revisions can be viewed as a measure to ensure that firms do not employ masquerades to conceal the identity of the funds’ ultimate benefactor. These might also be used to check for money laundering and terrorism financing.

Impact of the change

Despite the lack of specific penalties, a combined reading of Sections 447 and 448 of the Act suggests that directors may be liable for fraud in circumstances of active concealment of material facts or purposeful misstatement.
Because auditors are obligated to substantiate that the directors have made no substantial misstatements as aforesaid, if the auditor fails to do so, he may be penalized in cases of material misrepresentation.

Reason of the change

The modification is intended to ensure that the company has neither exaggerated or deflated the value of its books when seeking loans from banks and financial institutions, or when offering one-time settlements.
We recognize that the disparity in valuation could be attributed to a variety of factors, such as a difference in time period and the resulting depreciation, amortization, or market pressures. Whatever the reasons, they must be adequately reflected in the company’s annual report by the board of directors.