The Ministry of Corporate Affairs introduced the Companies (Auditor’s Report) Order, 2020 (CARO 2020), to enhance transparency in audit reporting. Though CARO 2020 was originally meant to be effective from April 1, 2019, its implementation was postponed and made effective from April 1, 2021. Consequently, financial statements for the financial year 2021–22 were audited in compliance with CARO 2020. Alongside, Schedule III of the Companies Act, 2013 was amended and also made effective from April 1, 2021. These changes collectively brought significant alterations to how financial information is reported and disclosed.
The amended Schedule III has been structured to reflect better disclosure practices and transparency in corporate reporting. It aligns in several respects with the clauses of CARO 2020, thereby harmonizing the auditor’s reporting obligations with the presentation and disclosure responsibilities of the company. While CARO applies to auditors, Schedule III applies to the companies preparing their financial statements. Together, these reforms significantly alter the reporting landscape and are likely to have far-reaching implications, including for income tax assessments.
Applicability and Scope
CARO 2020 applies to all companies that were earlier subject to CARO 2016, with a few exemptions retained. These include banking companies, insurance companies, one-person companies, and small companies. The amendments in Schedule III, however, apply to all companies that prepare their financial statements as per the Companies Act, 2013. The revised disclosure requirements under Schedule III are mandatory and must be reflected in the financial statements starting from the financial year 2021–22.
The amendments made through CARO 2020 have introduced 21 clauses with over 50 sub-clauses, many of which impose new reporting requirements on the statutory auditors. In parallel, companies must now provide detailed disclosures in their financial statements under the revised Schedule III. These changes enhance the compliance burden but also improve financial transparency. For tax authorities, these additional data points offer better tools for scrutiny, analysis, and assessment.
Objective of Changes and Link to Tax Assessment
The central purpose behind these regulatory changes is to improve the quality of financial reporting and provide better information to stakeholders, including shareholders, creditors, and regulators. However, a consequential effect is the facilitation of income tax scrutiny, as several of the newly mandated disclosures are directly relevant to matters of tax compliance. These include disclosures regarding stock reconciliation, related party transactions, and funds advanced to promoters and directors, among others.
While Schedule III amendments were primarily intended to serve financial reporting purposes under company law, they indirectly provide the tax authorities with structured, standardised, and comparable data that can be used during assessments and audits. In practice, this means that income tax officers can now cross-reference financial statement disclosures with tax returns, enabling more effective scrutiny and identification of inconsistencies.
Impact of Enhanced Financial Disclosures
The new disclosure requirements compel companies to provide information that was either not previously disclosed or disclosed in an unstructured manner. For instance, reconciliation between quarterly statements submitted to banks and the audited financial statements is now mandatory. Any mismatch can raise questions about inventory valuation or revenue recognition, both of which have direct tax implications.
Similarly, the requirement to disclose ageing schedules for trade payables and receivables can uncover long-outstanding liabilities or uncollectible debts, which could have a bearing on provisions, write-offs, or tax deductions. Disclosures regarding transactions with struck-off companies and the nature and purpose of loans given to related parties expose the underlying substance of transactions that may otherwise remain obscured.
Structural Alignment Between CARO and Schedule III
The integration of similar reporting themes across CARO 2020 and Schedule III represents a shift towards unified corporate governance. Where the financial statements disclose a matter, the auditor is expected to report whether those disclosures are materially accurate and compliant. For example, if a company discloses loans to directors, CARO mandates the auditor to report whether such loans are prejudicial to the interests of the company. This dual-layer of reporting creates a cross-verification mechanism that strengthens reliability and can be exploited by tax authorities.
From an income tax assessment standpoint, this alignment means that auditors’ reports can act as supplementary material to assess the veracity of disclosures made in tax filings. If auditors raise qualifications or adverse comments in the CARO report, those can be triggers for deeper examination by income tax officials. In effect, Schedule III disclosures and CARO reports together act as a ready-made dossier for assessment purposes.
Strengthened Tax Intelligence Through Financial Statements
The revised formats and disclosures introduce a level of granularity that serves the objectives of both corporate law compliance and tax governance. For example, companies must now disclose whether they have advanced loans or provided guarantees to promoters or directors and whether the terms are at arm’s length. This becomes vital in examining issues of deemed dividends under income tax law or disallowance under section 40A(2)(b) for related party transactions.
Further, the details of funds routed through intermediaries or ultimate beneficiaries, now required under Schedule III, are instrumental in curbing tax avoidance practices involving round-tripping or layered transactions. Income tax authorities are likely to place substantial reliance on such disclosures to validate or challenge the treatment of such transactions in the tax returns.
Increased Risk of Tax Scrutiny and Assessment
While these reporting reforms are not tax provisions by themselves, their practical implication is the creation of new points of visibility for income tax officers. The completeness, accuracy, and clarity of disclosures will likely be evaluated in parallel with tax filings. Where discrepancies exist, they may lead to notices, reassessments, or penalties. Companies and their management must now be more diligent not only in preparing financial statements but also in aligning them with tax returns.
In this evolving framework, companies should anticipate more probing assessments, particularly in areas involving related parties, inventory valuation, classification of payables and receivables, and unexplained cash flows. Auditors also face increased responsibility in reporting, which further increases the probability of cross-examination during tax assessments.
Strategic Response for Companies and Tax Advisors
Given the interplay between CARO 2020, Schedule III, and the Income Tax Act, companies must adopt a holistic approach to compliance. Financial disclosures should not be viewed in isolation but aligned with the company’s tax positions and documentation. Coordination between accounting teams and tax advisors is now more critical than ever. For high-risk disclosures, companies should prepare detailed working papers and rationale to support the treatment adopted.
Companies are advised to review their financial statements not only from a corporate law perspective but also in light of how the disclosures could be interpreted by tax authorities. Any mismatch between disclosed positions and tax treatments must be reconciled or explained with appropriate documentation. In doing so, companies can better manage the risk of tax assessments arising from enhanced financial disclosures.
Reconciliation of Quarterly Returns with Financial Statements
One of the critical additions under the revised Schedule III is the requirement to disclose whether the quarterly returns or statements of current assets, particularly inventory, submitted to banks or financial institutions are in agreement with the books of accounts. If not, the company must explain the summary of reconciliation and the reasons for material discrepancies.
This reconciliation requirement gives tax authorities a clear opportunity to examine whether the valuations submitted to financial institutions align with those declared in the audited financials and tax filings. Discrepancies in inventory valuation can lead to disallowance of expenses or questioning of turnover recognition under income tax law. If a company overstates inventory in statements submitted to banks for enhanced credit limits but discloses lower figures in its financials, it may invite questions about misreporting, evasion, or concealment of income.
Tax officers are likely to compare the quarterly statements furnished to banks with tax audit reports, books of accounts, and income tax returns to verify consistency. Any mismatch, unless properly explained, can be treated as a red flag and may lead to the invocation of provisions like section 69 or 69C for unexplained investments or expenditures.
Trade Payables Ageing Schedule and Tax Implications
The amended Schedule III now requires companies to provide an ageing schedule of trade payables. This includes classification based on the due date of payment and categorisation by whether the payables relate to micro, small, and medium enterprises (MSMEs) or others. The ageing must be broken down into periods such as less than one year, one to two years, and so on.
This information is critical for income tax assessments for multiple reasons. Firstly, under section 43B of the Income Tax Act, certain payments, such as dues to statutory authorities and MSMEs, are allowable only on actual payment. If the trade payables ageing shows outstanding balances beyond the permissible payment period, tax officers can disallow the corresponding deduction in the computation of taxable income.
Further, where payables remain unpaid for long periods, it may indicate bogus liabilities or a window-dressing of financial statements to inflate expenses or reduce profits. Tax authorities can question whether such liabilities are genuine and subsisting or need to be written back and offered to tax under section 41(1). Companies must therefore ensure that ageing schedules are carefully prepared and supported by documentation to justify the outstanding nature of old payables.
Relationship with Struck Off Companies and Tax Consequences
Another key requirement introduced in Schedule III is the disclosure of transactions with companies that have been struck off under the Companies Act. This includes the nature and outstanding balance of any transactions, such as receivables, payables, loans, or investments, involving struck-off companies.
From a tax perspective, this is a major compliance vulnerability. If a company has receivables or payables with entities that no longer exist, tax authorities may raise questions about the genuineness of such balances. The existence of a debtor that has been struck off may imply that the receivable is uncollectible and should have been written off, thereby affecting income recognition. Conversely, a payable to a struck-off company may indicate a non-existent liability that could be added back to taxable income.
Moreover, transactions with struck-off entities could lead to the application of anti-abuse provisions under the Income Tax Act, especially if they appear to be accommodation entries or sham transactions. The tax department may examine the source, purpose, and flow of such funds in detail to determine if there has been tax evasion or concealment. Companies must therefore monitor their ledger accounts for transactions with deregistered entities and take appropriate corrective action where required.
Disclosure of Loans to Promoters and Related Parties
Under the amended Schedule III, companies must now disclose details of loans and advances,, like loans granted to promoters, directors, key managerial personnel, and related parties. These disclosures must include details of amounts outstanding, terms and conditions, and whether the loans are repayable on demand or without specified terms.
These disclosures have direct relevance for tax assessments. Section 2(22)(e) of the Income Tax Act treats loans given by a closely held company to its shareholders or concerns in which shareholders are substantially interested as deemed dividends, taxable in the hands of the recipient. Tax authorities can now use the Schedule III disclosures to identify such loans and evaluate their taxability under the deemed dividend provisions.
Additionally, section 40A(2)(b) disallows excessive or unreasonable payments to related parties. Loans on preferential terms, or advances without adequate security or repayment terms, may attract disallowance. The enhanced disclosure requirements under Schedule III provide tax officers with a ready reference to examine the arms-length nature of such transactions.
Companies must maintain strong documentation regarding the purpose, terms, and recoverability of such loans. Failure to do so may result in additions to taxable income or reclassification of advances into income in the hands of the recipient.
Funds Routed Through Intermediaries
The revised Schedule III requires disclosure of transactions where funds have been advanced or received with the understanding that they will be passed on to other persons or used for specific purposes. These disclosures are designed to identify instances where companies are used as conduits or pass-through entities in complex financial structures.
From a tax enforcement angle, these disclosures can reveal round-tripping of funds, diversion of income, or evasion of taxes through layered transactions. Tax authorities may seek explanations and source documentation to verify the genuineness of such transactions and examine whether the final recipient of the funds has duly accounted for them.
This area also has relevance for provisions dealing with unexplained credits under section 68 or unexplained investments under section 69. If the company cannot explain the source, purpose, or beneficiary of the funds routed through intermediaries, additions may be made during assessments. Companies must prepare trial documentation and keep their fund flow statements reconciled with their books and tax filings.
Comparative Transparency and Tax Risk
The cumulative impact of these Schedule III disclosures is a significant enhancement in the transparency of financial reporting. However, transparency also comes with increased visibility and exposure. Tax officers can now rely on statutory financial statements and CARO audit reports to detect patterns of non-compliance, anomalies, and inconsistencies.
The risk of tax scrutiny is no longer confined to direct evidence or information sought through notices. Disclosures in audited financial statements, if not properly aligned with tax positions, can become the basis for inquiry and assessment. With data analytics and artificial intelligence increasingly used by the tax department, structured financial data acts as input for profiling and risk scoring of taxpayers.
As a result, tax compliance must now be an integral part of financial reporting strategy. It is not sufficient to meet statutory disclosure requirements; companies must ensure that every disclosure is tax compliant, adequately explained, and supported by records that can withstand scrutiny during an assessment or investigation.
Reporting on Undisclosed Income
Under CARO 2020, auditors are required to report whether any transactions not recorded in the books of accounts have been surrendered or disclosed as income during the year in the income tax assessments. This includes undisclosed income that arises from surveys or search proceedings, or voluntary disclosures during scrutiny.
This clause is of critical interest to the income tax department. The requirement pushes companies to acknowledge and disclose income previously unrecorded, thereby creating a direct link between audit reporting and income tax transparency. If such income has been disclosed during the year but not properly accounted for in the financial statements, the auditor is obligated to report it.
For tax purposes, this provision supports the department in tracing undisclosed or suppressed income. It offers a gateway for cross-verification of income surrendered during assessments with financial reporting. If companies attempt to keep such disclosures out of their books, they not only risk adverse audit remarks but also the possibility of penalty proceedings under the Income Tax Act for concealment of income.
Companies must ensure that any such surrendered income is duly recorded, offered to tax, and supported by adequate disclosures and documentation to avoid adverse inferences.
Details of Title Deeds Not Held in the Name of the Company
Another significant clause under CARO 2020 pertains to immovable properties. Auditors must report whether the title deeds of all immovable properties disclosed in the financial statements are held in the name of the company. If not, the auditor must provide details, including the reasons for the same.
From a tax perspective, this disclosure offers insight into the true ownership and legal title of properties. If title deeds are not in the name of the company, the asset’s ownership might be questioned. This could lead to the tax authorities treating the asset as belonging to another entity or individual, and the company may be asked to explain the basis of depreciation claims or capital gains treatment.
Discrepancies in property title documentation can also lead to scrutiny under the provisions related to benami property transactions, especially where beneficial ownership does not match the legal title. The risk of exposure to proceedings under the Prohibition of Benami Property Transactions Act is increased in such cases, and companies must reconcile property ownership records with disclosures in financial statements and tax filings.
Registration of Charges with Registrar of Companies
CARO 2020 requires auditors to report whether the company has registered all charges or satisfaction of charges with the Registrar of Companies within the statutory time limits. If not, the auditor must disclose the delay and the reasons.
Though this is a compliance issue under company law, it has taxation implications as well. Charges that remain unregistered or inaccurately reported can be questioned during tax assessments, particularly where interest on borrowings or financial liabilities is claimed as a deduction. The existence of a valid charge and the purpose of borrowings influence the allowability of interest and other finance costs.
If a charge is found to be invalid, unregistered, or fictitious, the tax department may treat related expense claims as inadmissible. Therefore, financial and tax reporting must be in sync, and registration of charges must be promptly updated to ensure the legitimacy of deductions claimed in the tax computation.
Utilisation of Borrowed Funds and Share Premium
One of the most discussed clauses in CARO 2020 relates to the end use of funds. Auditors must report whether the company has advanced or loaned funds to any other person or entity with the understanding that the recipient will directly or indirectly lend or invest those funds in the company or any other person as instructed by the company.
This disclosure is primarily aimed at identifying round-tripping or layered funding arrangements. From a tax assessment standpoint, such reporting is valuable in identifying artificial transactions used to inflate share capital, route funds through multiple entities, or avoid tax liabilities. In particular, transactions involving receipt of share premium over fair market value may attract tax under section 56(2)(viib).
Moreover, if borrowed funds are used for purposes other than stated, or rerouted to related parties, the tax department may deny interest deductions or raise questions about the commercial expediency of such arrangements under section 36(1)(iii). These disclosures enable tax officers to challenge such claims based on the auditor’s independent reporting.
Companies must maintain documentation of fund flows, board approvals, and the commercial rationale for loans or advances. Unexplained routing of funds can lead to the denial of tax benefits and exposure to penal consequences.
Compliance with Statutory Dues
CARO 2020 mandates auditors to report on whether the company is regular in depositing undisputed statutory dues, including income tax, GST, provident fund, employees’ state insurance, and others. Any outstanding statutory dues for more than six months must be disclosed separately. Furthermore, the auditor must report on disputed dues pending under litigation.
This clause has direct relevance to income tax assessments. Non-payment or delayed payment of tax liabilities, even when undisputed, may lead to interest, penalties, and disallowance of expenses under the Income Tax Act. Section 43B disallows certain expenses unless paid before the due date of filing the return. The CARO report helps tax officers identify such disallowed items.
In the case of disputed dues, the auditor’s reporting provides a list of ongoing litigations that tax authorities can follow up on. It also helps in reconciling the company’s contingent liabilities and tax provisions, thereby enabling a thorough assessment of tax positions taken by the company.
Fraud and Irregularity Reporting
CARO 2020 requires auditors to report any fraud by or on the company that has been noticed or reported during the year. They must also provide the nature and amount involved in the fraud. Additionally, auditors must report whether any whistle-blower complaints were received and how they were addressed.
While this requirement primarily serves the purpose of corporate governance, its impact on tax assessments cannot be overlooked. Fraudulent transactions, misappropriation, or manipulation of accounts may lead to incorrect tax reporting, understatement of income, or inflation of expenses. Tax authorities can use the auditor’s observations to initiate further investigations or reassessments under section 147.
If a company is found to have concealed income or indulged in sham transactions, it may attract prosecution under sections 276C or 277 of the Income Tax Act. Furthermore, expenses incurred as part of fraudulent transactions are not allowable under section 37. The CARO disclosure thus becomes a vital document for tax officers during scrutiny.
Internal Audit Systems and Controls
CARO 2020 introduces a requirement for reporting on the internal audit system. Auditors must state whether internal audit is applicable and, if so, whether reports from the internal audit are considered by the statutory auditor. This clause enhances the focus on internal governance, risk management, and process integrity.
From a tax standpoint, the existence of an internal audit system adds weight to the accuracy of records maintained by the company. However, if the internal audit reports highlight weaknesses or irregularities that have not been addressed or disclosed, it creates an opportunity for tax authorities to probe deeper.
For example, an internal audit finding about misclassification of expenditure or revenue recognition could be grounds for revisiting income reported in tax filings. Tax authorities may also question whether audit findings were incorporated into the books and if corrective action was taken. Thus, internal audit reports may become a supplementary source of information during tax assessments.
Company’s Compliance with Deposits and Related Party Transactions
CARO 2020 also requires the auditor to report whether the company has accepted deposits in contravention of the provisions of the Companies Act or the RBI guidelines. In addition, the auditor must comment on transactions with related parties and whether they comply with the relevant sections of the Companies Act.
From a tax perspective, acceptance of public deposits in violation of legal provisions may affect the deductibility of interest paid on such deposits. Similarly, failure to comply with related party transaction requirements under company law may indicate a violation of arm’s length principles under tax law.
In particular, section 40A(2)(b) of the Income Tax Act allows tax authorities to disallow excessive payments to related parties. CARO disclosures help identify such transactions and evaluate whether the company’s tax position is defensible. Companies must therefore ensure that related party transactions are both compliant with the Companies Act and defensible under income tax scrutiny.
Reporting on Wilful Defaulters
CARO 2020 requires auditors to report whether the company has been declared a wilful defaulter by any bank, financial institution, or lender. Being declared a wilful defaulter indicates intentional default on loans despite having the capacity to repay, diversion of funds, or misrepresentation.
This disclosure has a direct bearing on tax assessments. Wilful defaulter status raises questions about the genuineness of borrowings, end use of funds, and potential suppression of income or overstatement of expenses. If the company has been involved in diversion or misapplication of borrowed funds, tax authorities may scrutinise related transactions for tax avoidance, misreporting, or bogus entries.
Further, companies with such a status are often subject to litigation, recovery proceedings, and closer scrutiny under the Income Tax Act. Tax officers may examine whether defaults have resulted in write-offs or restructuring, and whether any tax benefit has been claimed on such transactions. The disclosure under CARO serves as a starting point for such investigations.
Utilisation of Short-Term and Long-Term Funds
CARO 2020 requires auditors to examine whether funds raised on a short-term basis have been utilised for long-term purposes, and vice versa. It also mandates reporting on the utilisation of term loans and whether they were applied for their intended purpose.
These disclosures are relevant for income tax scrutiny in various ways. Misuse of funds, especially borrowings, can indicate financing of non-business activities, capital expenditure being wrongly treated as revenue expenditure, or personal expenses being routed through the business. Under the Income Tax Act, deductions under section 36(1)(iii) are available only if interest is paid for borrowings used wholly and exclusively for business purposes.
If term loans are diverted or misapplied, the deduction may be disallowed, and such diversion could be treated as deemed income in certain cases. Additionally, if short-term borrowings are used for long-term investments or for advancing loans to related parties, tax officers may question the commercial rationale and the legitimacy of interest and other related deductions.
Corporate Social Responsibility Expenditure
Schedule III requires companies to disclose amounts spent on Corporate Social Responsibility (CSR) and the reasons for any unspent amounts. CARO 2020 also requires auditors to report on compliance with CSR obligations under section 135 of the Companies Act.
From a tax perspective, CSR expenses are not allowable as a deduction under section 37(1) of the Income Tax Act, following the Finance Act, 2014. However, if companies structure CSR-related expenditures to resemble regular business expenses orr record them under promotional or welfare activities, tax officers may disallow the deduction and impose penalties for misreporting.
Disclosures under Schedule III and CARO help tax authorities identify and segregate CSR spending from other business expenses. Companies must ensure proper classification and documentation to avoid adjustments in tax assessments. Misclassification of CSR expenses may also invite audit objections and increased tax liability.
Registration of Loans with ROC under Section 77
CARO 2020 requires reporting on the registration of charges with the Registrar of Companies. If charges are not registered, it affects the validity of security interests created on company assets.
This has implications under the Income Tax Act when companies claim deductions for interest or related financial costs. If the borrowing is unregistered and not legally enforceable, it may raise doubts about the legitimacy of the transaction. Tax authorities may suspect that the borrowings are fictitious or accommodation entries.
Moreover, unregistered loans or advances from related parties may be treated as unexplained cash credits under section 68, especially if there is insufficient documentary evidence regarding the source and purpose. The CARO clause helps tax officers detect such gaps and use them to question deductions or to make additions during scrutiny.
Disclosure of Contingent Liabilities
Under Schedule III, companies are required to provide detailed disclosure of contingent liabilities. These may include pending litigation, income tax demands under appeal, or other potential outflows dependent on future events.
For income tax assessment purposes, contingent liabilities serve as indicators of ongoing disputes, past tax positions taken by the company, and potential future obligations. If a company has disclosed a significant contingent liability related to income tax, it suggests that earlier tax filings may involve aggressive or interpretational claims.
The tax department can use this disclosure to examine the related assessments, reopen concluded cases under section 147 if there is evidence of income escaping assessment, or reject the treatment adopted in subsequent years. Additionally, non-disclosure of material contingent liabilities may lead to penal consequences under both the Companies Act and the Income Tax Act.
Unspent CSR Amount and Fund Transfers
Companies failing to spend the required CSR amount must either transfer it to a specified fund or an unspent CSR account. Schedule III and CARO require disclosure of these actions, including the amount and date of such transfers.
Failure to transfer the unspent CSR amount can result in a violation of company law provisions and may also be used as evidence in tax proceedings. If the amount remains in company books and is not properly accounted for, it may be viewed as unutilised liability or misappropriation of funds.
From a tax standpoint, treatment of the unspent amount must be consistent across financial statements and tax returns. Any mismatch may lead to scrutiny of the CSR policy, actual spending, and related financial flows. This is particularly relevant where CSR projects are executed through trusts or implementing agencies.
Reporting on Consolidated Financial Statements
CARO 2020 has specific provisions applicable to consolidated financial statements. Auditors must report whether there are any qualifications or adverse remarks in the reports of component auditors and how they affect the overall financial statements.
For income tax assessments, this clause becomes significant in group cases or where assessments involve associated enterprisesholdingssng,, or subsidiary companies. The auditor’s observations on components’ financials can alert tax authorities to risks arising from related entities. This could lead to transfer pricing audits, clubbing of income, or assessments under provisions dealing with connected transactions.
Moreover, inconsistencies between standalone and consolidated statements may indicate manipulation, suppression, or misstatement of inter-company transactions. Tax officers can use these gaps to probe into group structures, inter-company loans, and cross-border transactions for possible tax implications.
Conclusion
The enhanced disclosure regime under CARO 2020 and the amended Schedule III has introduced a new level of transparency and accountability in financial reporting. While these reforms were designed primarily to improve corporate governance, their spillover effect on income tax assessments is profound.
Disclosures on loans, related party transactions, receivables, payables, asset ownership, CSR, and fund usage provide the income tax department with structured data that can be directly used for scrutiny. The auditor’s independent verification through CARO further strengthens the ability of tax authorities to identify non-compliance, misreporting, and tax avoidance.
Companies must recognise that financial statements and tax returns are no longer independent documents. They are integrated sources of information that will be jointly examined by regulators. Therefore, alignment between books of account, statutory disclosures, and tax filings is critical for risk mitigation.