Assessing the Responsibility of Auditors Under Indian Law

Since time immemorial, audits have served a foundational purpose in promoting confidence and reaffirming trust in financial information. The development of the audit finds its origins in the agency relationship, which comes into existence when a principal engages an individual as their agent to perform a service on their behalf and such performance is contingent upon the delegation of certain authority to such an agent. While such delegation of responsibility and the resultant division of labour translates in the promotion of an efficient management practice, such relationships are only successful if the principal trusts the agent enough to act in their best interest.

Now, a simple agency model would suggest that as a result of information asymmetries between the principal and agent and differing motives, principals lack reasons to trust that their agents are in fact, working in their best interest and in order to resolve such concerns, certain mechanisms would be put in place to align the interests of agents with that of the principal, thereby reducing the scope for information asymmetries and opportunistic behaviour.

In furtherance to this, the Companies Act, 2013 (hereinafter referred to as Act) by way of mechanisms provides for the need of Independent Directors and more importantly, External Auditors who in the performance of their duties act as a key monitoring agency on the management of an organisation, making them a vital constituent of the corporate governance mosaic.

With scandals of mind boggling proportions such as the infamous Satyam situation where the CBI found that Price Waterhouse, the auditors for Satyam had “deliberately” and “intentionally” failed to apply certain auditing standards, thereby enabling Ramalinga Raju and others to perpetrate India’s largest accounting fraud and more recently, the IL&FS fiasco which has had Deloitte and KPMG up in arms for violation of at least 22 auditing standards has time and again led to increased scrutiny of the role and responsibility of auditors and their inherently conflicting position within corporate structures.

Auditors and Indian Law

Who is an Auditor?

In simple language, an auditor is someone who inspects and verifies the accuracy of an organisation’s operational and financial records in accordance with recognised reporting mechanisms. This process enables an individual to ascertain the true financial position of an enterprise thereby allowing them to make an informed decision.

In India, the same has been expounded upon in Section 143(2) of the Act which has been provided below –

“The auditor shall make a report to the members of the company on the accounts examined by him and on every financial statements .... and to the best of his information and knowledge, the said accounts, financial statements give a true and fair view of the state of the company‘s affairs as at the end of its financial year and profit or loss and cash flow for the year and such other matters as may be prescribed”.

The Satyam scandal had the government and various subsidiaries scrambling to recommend and reform auditing and corporate governance practices in the country and the introduction of the 2013 Act was a big step forward from the 1956 Act through the introduction of numerous compliance measures aimed at making life easier for all stakeholders involved.

The Law on Auditors' Obligations and Regulation

Chapter X of the 2013 Act, specifically Section 139 to Section 148 of the Act deal with the various provisions and guidelines surrounding auditors including appointment, eligibility and qualifications, remuneration, powers, and duties, what they can and cannot do, removal and resignation and punishments for contravention of the provisions laid down.

The Act sets out clear obligations for reporting frauds on auditors, among others. Furthermore, the Act clearly stipulates the responsibilities and accountability of auditors and independent directors who are now expected to play a more active role in the company’s affairs in a bid to protect the interest of shareholders, creditors, investors, and other stakeholders in the company. In addition, the Act also provides for compulsory rotation of individual auditors after five years and audit firms after ten years to rule out any potential malpractices and financial oversight and also ensuring independence of auditors. It is also to be noted that auditors are also now obligated to report instances of fraud noticed by them during the performance of their duties.

In order to prevent potential conflict of interest situations and to ensure increased independence of external auditors, Section 144 of the Act provides a list of non-audit services (hereinafter referred to as NAS) that an auditor cannot provide to an audit client which includes book keeping, internal audits, investment advisory and investment banking services to name a few. This however only addresses the problem partially because firms are still free to offer tax and other such unspecified advisory services, subject to the approval of the board of directors or audit committee as applicable. A consultation paper however has been released by the Ministry of Corporate Affairs (hereinafter referred to as MCA) earlier this year which explores possible solutions to enhance audit independence and accountability, one of which is considering the expansion of the list of prohibited NAS and capping revenues from NAS.

Additional Compliance Requirements

Formation of Audit Committees

Section 177 of Act read with Companies (Meetings of Board and its Powers) Rules, 2014 states public companies with either a paid up capital of ten crore rupees or a turnover of one hundred crore rupees or have in aggregate outstanding loans or borrowings or debentures or depots exceeding fifty crore rupees must constitute audit committees which will review and monitor the independence and performance of the auditors and the effectiveness of the audit process. This is an important step as it adds an additional layer of scrutiny in the corporate governance mechanism and considering that these companies are of such high value which translates to larger number of stakeholders, such mechanisms only increase market confidence in such companies. These audit committees which will majorly comprise of independent directors, and at least two-thirds in case of listed companies will only aid the objectivity of the committee’s findings.

Constitution of the National Financial Reporting Authority

It is also to be noted that the MCA has constituted the National Financial Reporting Authority (hereinafter referred to as NFRA), an independent regulator which will engage in monitoring and enforcing compliance with accounting and auditing standards and oversee the quality of service provided by auditors of listed and other specified companies. In addition, the NFRA also has the power to investigate any professional or other misconduct against any registered chartered accountant. The NFRA also has the authority to impose penalties upon individuals of up to five times, and for firms of up to ten times the fee received and to also debar them from practicing for a time period ranging from six months to ten years.

Extensive levy of Penalties

Furthermore, the 2013 Act lays down harsh penalties as well for failure to comply with the provisions so laid down. For instance, failure to comply with the requirement laid down in Section 144(12) will attract a fine of minimum one lakh rupees and may extend upwards to twenty-five lakh rupees. Furthermore, S147 of the Act lays down penalties upon the company and the auditor for failure to comply with the requirements laid down, none of which are cheap.

Conclusion

From the above mentioned framework, it is evident enough that the government and the industry has learnt from its mistakes and has made significant improvements in compliance standards so as to ensure that no malpractice takes place. The fact that more and more scandals and scams are coming to light is to be seen as a step forward, an indication that these fraudulent activities will no longer go unnoticed by the law and that due justice will be served upon those who dare to violate the system.

In order to be able to serve as effective ombudsmen and in light of this increased regulatory oversight, auditors will now have to introduce greater rigors into their audit exercises. They cannot simply approach the process with a tick-box compliance attitude as they have been for the longest time, but rather as the law stats, they must play a more active role in verifying and authenticating the information placed before them and must work hand in hand with the management so as to produce a credible financial report.

This post is written by Abhay Shetty, Editor at the LEC Blog and Law Student, Jindal Global Law School.

REFERENCES

Agency Theory and the Role of Audit, Audit Quality Forum (2005).
Jeffrey Cohen, Ganesh Krishnamoorthy & Arnold M. Wright, Corporate Governance, and the Audit Process, 19 Contemporary Accounting Research 573–594 (2002).
Consultation Paper to examine the existing provisions of law and make suitable amendments therein to enhance audit independence and accountability, Ministry of Corporate Affairs, Available at: http://www.mca.gov.in/Ministry/pdf/Comments_08022020.pdf.
Auditors in on Satyam fraud: CBI, Livemint (2009), https://www.livemint.com/Home-Page/jS33BnPzXSMnwbx9cFtplN/Auditors-in-on-Satyam-fraud-CBI.html.
Aiding 'organized crime': India alleges 22 audit violations by Deloitte, KPMG arm in fraud case, Reuters (2019), https://www.reuters.com/article/us-india-il-fs-deloitte-kpmg-idUSKCN1TE1X4 .
What is National Financial Reporting Authority?, The Hindu (2018), https://www.thehindu.com/business/Economy/what-is-national-financial-reporting-authority/article23280972.ece.