Cos Act Ep#8: Auditor Rotation & Disqualification
Hello and Welcome to Companies, Act!
This week we shift focus from Chapter IX to Chapter X Audit and Auditors with Seshagiri Rao, Joint MD & Group CFO, JSW Steel, Santhana Krishnan, Partner – PKF and an ICAI veteran, PR Ramesh, Chairman, Deloitte India and Jamil Khatri, Global Head of Accounting Advisory Services at KPMG.
One of the big new provisions in the Companies Act 2013 is Auditor Rotation. All listed companies, unlisted public companies with a paid up share capital of Rs 10 crore or more, private limited companies with a paid up share capital of Rs 20 crore or more and all companies with a public borrowings of Rs 50 crore or more must rotate their auditor or audit firm.
Section 139 & Rules
Unlisted Public Companies: Paid Up Share Capital >= Rs 10 cr
Private Limited Companies: Paid Up Share Capital >= Rs 20 cr
All Companies: Public Borrowings/Public Deposits >= Rs 50 cr
A company can appoint an audit firm for up to two consecutive 5 year terms. Any further re-appointment can happen only after a gap of 5 years. This tenure limit applies retroactively and companies have up to 3 years to comply. The law also applies several safeguards. An incoming audit firm cannot have any partners common with the outgoing audit firm, an incoming audit firm cannot belong to the same network as the outgoing audit firm and if the certifying partner joins another audit firm, then that audit firm becomes ineligible for a period of 5 years.
Auditor/Audit Firm to be appointed for 5 year term
Auditor Individual: 5 yrs
Audit Firm: 5yrs + 5 yrs
Cooling Off Period: 5 years
Companies to comply within 3years of 1st April, 2014
Audit period served prior to 1st April, 2014 will count towards maximum tenure
- Incoming Audit firm cannot have any partners common with Outgoing Audit firm
(as on date of appointment)
- Incoming firm cannot belong to same network as Outgoing Audit firm
- If Certifying partner joins another Audit firm, that firm is ineligible for 5 years
Doshi: Practical implication of audit rotations or practical issues?
Ramesh: If you look at that provision in isolation it is practical to deal with it but when you apply along side the provisions of scope of services, etc. the independence rules it becomes a challenge when you actually start rotating. As you rotate auditors mandatorily you need to be able to find auditors who are independent of their entities to be able to appoint. In this term of five years you are rendering services, other audit firms are rendering non-audit services and that could trigger the issue of independence. The second point in relation to the all these safeguards has been put there to deal with network firms.
Doshi: That is really not a company problem, that's an audit problem and that's in particular to a few audit firms, not all audit firms offer consulting etc. So, this is unique to a few group of audit firms?
Ramesh: The company problem is different. Just as we discussed for consolidation of accounts, we are talking of a joint venture abroad or a subsidiary abroad. Imagine a company which has 300 subsidiaries across the world. How will you rotate auditors? Will you do it all at the same time coupled with the auditing standard (SA)600 which requires you – India has carved out to some extent - but which in a way if you want auditor to take ownership for consolidated financial statements, he will insist that he has oversight on all the 300 subsidiaries which is being consolidated. So the rotation dimension is always a challenge for global entities. It is also a challenge for Indian subsidiaries of foreign multinationals entities- both ways Indian entities having a global footprint and global entities having Indian footprints. Whilst the principle is right for listed, in extending it one should have had some carve out.
Accounting Standard 600: Establishes standards to be applied in situations where an auditor uses the work of another auditor
Doshi: Do you see the problem the way Ramesh sees it or is he seeing it from a unique network firm point of view and are you saying that you don’t have an issue with 300 subsidiaries, audit rotation in all subsidiaries, parent company, intermediate level, that’s all fine?
Rao: Auditor has to understand the business. Now it has become a law that you have to rotate the auditor; so there is nothing else which we can do except change the auditor. So, when we have to change the auditor do we have any practical problems in changing the auditor? I don’t think so from the business point of view.
Khatri: You can’t wish away the fact that in a global setup, it is not easy to change auditors particularly when 10 years is not necessarily a long period in today’s environment. Even the EU that you referred to earlier as following our example is 20 years; it is 10 +10 years and if you do a joint audit it is 24. So, after a lot of discussion even they realized that you need a sufficient period of time for the auditor to be in there. However, having said that, companies will get used to it, auditors will get used to it, the one challenge which in practice that’s coming up is unlisted companies.
EU: Public-interest entities to change their statutory auditors after 10 years.
Member States can extend the term by 10 years if tenders are carried out
Doshi: I think that is one question that we have been asking could we have started just with listed and then overtime seen how it works and then moved on to unlisted and private companies.
Khatri: The problem gets compounded for multinationals because think of a Dutch company which is got 100 percent subsidiary in India, they need to manage their own rotation requirements in the context of 12 years or whatever they are doing and then they look at India and try and deal with the rotation rules in India.
Doshi: Why, what is the big problem?
Khatri: It is a problem because they will change their auditor at the parent level after the 12 year period while they will have to change their auditor in India after a 10 year period.
Doshi: So, why is it an issue?
Khatri: Because prohibited non-audit services rules also come in, in relation to what you can and you cannot.
Doshi: Maybe people will move from doing consulting work with Deloitte, KPMG, EY, PwC to doing it with BCG and all the non audit firms, right?
Khatri: In practice we are seeing a lot of concerns. So, for example think of GE- if it has to rotate out - I am just giving an example- in India from its global auditor to another firm, now that same firm may be doing non-audit services which are prohibited across the world for GE and therefore many firms will be prohibited out just because of that relationship and these are practical issues which we are not dealing with, the GEs of the world will deal with this problem.
Krishnan: Surprisingly none of the industry associations took this as an issue. At the time of rule making while there were several representations which came, none of the industry associations took it up as an issue. Independent directors they said we wanted prospective. That is something which you should keep at the back of your mind. Second is rotation is nothing new to us. State Bank of India, all banks, all insurance companies, all government public sector navratnas have been undergoing it. I have never found issues in quality of audit.
Doshi: Mr. Rao has admitted saying that private sector companies don't see a big practical issue either as yet.
Krishnan: I am expressing my personal view and I am not here to represent the Institute on its view. I only said that rotation has been there. We should either take a consistent stand that rotation is needed. You can't say government companies will have rotation, banks will have rotation, insurance companies will have rotation but private sector - I won't take rotation- will not be the right argument. You have to take one consistent view.
Doshi: I am not even arguing in favor or against rotation, I am saying it is here, some of us welcome it others don't for practical reasons that pertain to their specific areas of profession. I am saying what is the impact of this?
Krishnan: In my view the overall requirement would be on about 100 companies. A country of our size if you cannot produce 100 chartered accountant firms who can do this - large or medium as long as they are capable it is enough because the company is not worried about the size, the company is worried about what quality of service I will receive. If you think, a country of our size cannot produce 100 chartered accountant firms; I am not able to agree.
Doshi: We don't have them now, do we?
Krishnan: No, I think we have.
Doshi: I have question - if you have been an auditor who has completed two terms of five years - which is the maximum term- with a holding company, can you then become the auditor of the subsidiary company in the third term or you are barred from that?
Khatri: I don't see any restriction.
Doshi: So, you are never going to run out of firms either Mr. Rao.
Rao: There is no restriction; there is no problem at all.
Khatri: Time will tell us whether it is an issue or not but we have to deal with it.
Ramesh: All I am saying is whoever is big let us say outside India and he has a subsidiary here it has to be audited by the same auditor if you want the parent company auditor to express an opinion on the consolidated financial statements; that is the auditing standard internationally. So, irrespective of whom you appoint in India it will still have to be audited by another firm. So, it means two auditors for the company, twice for the same period.
Khatri: That is exactly where the company's practical problem comes in. From a multinational perspective people will have to deal with two auditors and from our perspective it only doubles the market for us if that is the way you want to look at it because you will have two audits for the same company.
The new company law introduces new criteria for auditor disqualification; some vague other tough to comply with. For instance a person or firm who directly or indirectly has a business relationship with a company or its subsidiary, holding or associate company cannot be its auditor. Thankfully the rules clarify that permitted non audit services and commercial transactions in the ordinary course of business and at arm's length are not included within the definition of business relationship. So if an auditor buys airline tickets from an airline such a business relationship is not a disqualifier. But Section 141 also says that a relative of an auditor should not owe the company more than Rs 5 lakh and cannot hold securities of the company of more than Rs 1 lakh in face value.
Section 141 (3)
Not eligible for appointment as auditor of a company
(e) a person or a firm who, whether directly or indirectly, has business relationship with the company, or its subsidiary/holding/associate company…
‘Business Relationship’ excludes
- professional services permitted to be rendered by an auditor or audit firm
- commercial transactions in the ordinary course of business and at arm’s length price
Section 141 (3)
Not eligible for appointment as auditor of a company
(d) a person who, or his relative or partner
- is indebted to company or its subsidiary/holding/associate for > Rs 5 lakhs
- holds securities in the company of face value >= Rs 1 lakh
- has provided guarantee/security to company or its subsidiary/holding/associate > Rs 1 lakh
Ramesh: The real issue is on relative. Because an auditor's relative cannot hold securities beyond a certain limit, cannot be indebted, cannot provide a guarantee etc - the challenge is the principle of the dependents has been done away with. I can only control persons who are dependent on me otherwise it is impossible for me.
‘Relative’ - Father (Step-Father), Mother (Step-Mother), Son (Step-Son), Son’s Wife, Daughter, Daughter’s Husband, Brother (Step-Brother), Sister (Step Sister)
Doshi: Does this only apply to the audit partner working on that particular audit; so it is only his relatives who are barred from holding anything more than Rs 1 lakh in face value of the share or does it apply to all the relatives of all the partners in that audit firm who is doing it?
Krishnan: All the relative of all the partners.
Ramesh: There are nine levels. Even if I had one in each level that would be nine. If you have more partners then you can see the dimension and you are seeking information almost on a daily basis. How would you operationally comply with it?
Doshi: It is just impossible to comply with it.
Khatri: It is a big issue and which is why globally once again you apply this to financially dependant relative.
Ramesh: Let us assume you had a stepfather and you wrote to him saying please give me what are the entities in which you have invested in, is he bound to reply to you. How would you comply?
Ramesh: And if you have not received a feedback from him, can I say with confidence that, yes I am completely independent.
Krishnan: In fact you have to keep your relatives in good humor. If he wants to remove you, he can go and buy 1,000 shares of this company and will not disclose it to you and write to the company saying I am a shareholder of this company and you will get disqualified.
Doshi: You won’t have a problem rotating auditors if only you could find an audit firm that does not own JSW Steel shares either through themselves or through their relatives. That is where you may run into a real practical issue!
Ramesh: Each time you have to look for a spouse for one of your children you will have to do an independence test, because on the day of the marriage, or on completion of the marriage you may be disqualified.
The powers and duties of auditors include commenting on financial transactions or matters that have an adverse effect on the functioning of the company. Then there is the internal financial control bogey that reappears and auditors must also report fraud that is being or has been committed against the company. A detailed process that has been laid out in the rules that requires the auditors to report any and all fraud not just to the board or audit committee but also to the central government.
Section 143 (3)
Audit Report shall also state
(f) observations/comments of auditors on financial transactions/matters which have any adverse effect on the functioning of the company
(i) whether the company has adequate internal financial controls system in place and the operating effectiveness of such controls
Section 143 (12)
‘if an auditor of a company, in the course of the performance of his duties as auditor, has reason to believe that an offence involving fraud is being or has been committed against the company by officers or employees of the company, he shall immediately report the matter to the Central Government within such time and in such manner as may be prescribed’
Forward report to Board/Audit Committee + Report matter to Government within 60 days of his knowledge
Khatri: A lot of the internal financial controls we discussed earlier is dependent upon on what framework is laid down by the Institute and hopefully we will move forward on that. There is some vagueness on financial transactions that have a material effect on the functioning of the company.
Doshi: Because there could be pretty much anything which is not necessarily in the scope of audits.
Khatri: That is correct. Let’s say if the company does a very large leverage Mergers and Acquisitions (M&A) transaction, is the auditor required to sit back and say this could have a material adverse impact on the functioning of the company. I don't think that is the intention and that is how we need to get to a resolution to say how does an auditor focus on those areas which are core to his responsibility. Fraud reporting is a challenge for a variety of reasons. Again the way this works internationally is that in the first call the auditor reports to those charged with governance which is the audit committee and only if the auditor is not satisfied with the response of the audit committee the auditor may report it to the regulator.
Doshi: That has been brought in the rules now?
Khatri: No, what the rule says is that they write to the Board. In the first instance you can write to the Board, but irrespective of the response of the Board- the Board may say, here is how we have investigated it and there is no fraud or there is a fraud and here is an action we have taken to which the auditor is satisfied but that still does not absolve the auditor of the responsibility to report to the Central government.
Doshi: Why is that a problem?
Khatri: The reason it is a problem because you will have lot of items being reported to the Central government including some which ultimately are not frauds at all.
Doshi: Is it such a big deal, you report to the government? Let the government take the decision,
Rao: Any fraud which has a material impact on the results which are shown or on the operations of the company they require to be reported to the Central government.
Krishnan: There is no distinction between fraud by the management and fraud on the management. If some fraud is happening today in a large company - you take every 5 star hotel, every hotel will have two or three frauds a day. It may be Rs 5 it may be revenue stamp stealing. Without making a distinction between frauds by the management, on the management; by the management you report to the government but on the management you directly go to the government and report because we have nothing else but we have an obligation to report - that is going to pose a serious problem.
Second, if you get probably 5,000 complaints a day, what will you do? You can't say I will not do anything about a fraud which comes to my notice, that’s an enforcement problem.
The third important issue would be that when the audit committee and the board are going to sit up and do investigation to take corrective measure, why would I go and report to the government?
Doshi: Because maybe they won't take corrective measures. I suppose it has come from a deep suspicious place.
Krishnan: Ideally what I would have preferred is report to the audit committee and Board and if you are not satisfied with the action taken, then go to the Central government. We are trying to centralize all controls. However very critical on these issues is the materiality - according to the draft rules which are exposed, materiality was there. I understand, I am not sure is that the law ministry said the Act says all frauds will have to be reported; therefore rule cannot make a deviation from the Act. So this is a fit case for the earlier amendments or for a removal of difficulties.
Ramesh: It is not as easy as that.
Doshi: Removal of difficulties has come up more frequently than independent directors, auditors; any of it.
Ramesh: The whole law has to be amended for removal of difficulties in a way. It is more deeper than just an issue of materiality. If you read the section 143(12), it talks of fraud is being or has been committed. So that means if a fraud has not yet been committed or is in the process of being committed you have to start the whole process.
The second is the definition of fraud. Whilst we are all discussing we seem to be very clear on what is fraud. But if you go to Section 447 and see the definition of fraud it talks of abuse of power, abuse of position, it talks of whether there is monetary gain or loss and does it mean mis-selling is a fraud, does it mean if I give you a defective product it is a fraud. There are whole host of definition, the concept seems to be that auditor should be a whistleblower. If you accept that concept and then look at the text of the law, it is operationally very difficult to comply with the text of the law. We are actually, as auditors, completely clueless.
WHAT IS FRAUD?
“fraud” in relation to affairs of a company or any body corporate, includes any act, omission, concealment of any fact or abuse of position committed by any person or any other person with the connivance in any manner, with intent to deceive, to gain undue advantage from, or to injure the interests of, the company or its shareholders or its creditors or any other person, whether or not there is any wrongful gain or wrongful loss’
Krishnan: It will be very difficult.
Rao: In addition to these frauds, there are also some more additional responsibilities on the auditor relating to litigations and also derivative losses, which are likely to come in future. They are also required to be commented and quantified.
Doshi: In the account, in the audit report?
Rao: In the audit report. For the future you have to take the view in a derivative transaction what could happen in the future and then comment about it.
The Companies Act 2013 goes one step further in mandating auditor independence. It lists a long list of Activities that an auditor cannot provide to the company. Also Section 144 explicitly bars network firms from providing these services.
Auditor cannot provide to company any of these services
- Accounting & Book-keeping
- Internal Audit
- Financial Information System
- Actuarial Services
- Investment Advisory Services
- Investment Banking Services
- Outsourced Financial Services
- Management Services
Ramesh: The principle of in the scope of services, restriction is that there are at least four threats in so far as independence but one of the things is self review threat. You should not be put in a position where you are reviewing your own work and that principle is well established in Section 144 in the list of services. The only challenging issue is the term 'management services'. If you go back to the Irani Committee report, Irani Committee report listed all of this- internal audit, valuation services- it used the term 'management functions'. It said an auditor should not undertake management functions- that means you should not be doing functions of the management which is outsourced to the audit firm. However, that wording somewhere down the line seems to have been changed from management functions to management services and therefore it is interpreted to mean any advisory services and there are interpretations floating in the marketplace. Then the second dimension is when you apply it into the group and through related entities and look at global entities, it becomes impossible to comply with that.
Krishnan: Subsidiaries, associates- so extending the definition to associate is the most difficult.
Doshi: Maybe we should go back to the age of standalone audit firms? Is that the message this Act is sending out saying let us have standalone audit firms, let us not have firms that also do consulting that also do other advisory work because we don't know where the conflict then creeps in.
Krishnan: That is what is going to happen. Can you bite the hand that feeds you, that is the question.
Doshi: That is the suspicion with which this Act has legislated all these provisions. I am saying maybe the message going out is standalone audit firms.
Khatri: I would prefer if that was the intention to just say it the way it is. It is always easier to deal with regulation straight. I think here what is happening is overall, non audit services, the restrictions are pretty fair. The challenge, as Ramesh rightly pointed out and again if we read it in the context of auditor rotation and all of that is once again I go back to the point because these restrictions apply to the parent company as well. So, if your member firm is providing prohibited services, let’s say valuation services anywhere in the world or to the parent company, you are precluded as being the auditor. Internationally there is something which is called the not subject to audit exemption which says that some of these services for example if I am doing the audit of subsidiary but somebody else is the auditor of the parent, I can provide valuation services to the parent entity; that is not a problem because that will never be subject to my audit. Now, that kind of benefit is not available.
Krishnan: My only point is already the Institute had a rule. These are more self regulation issues. Putting it in the Act has complicated the matter. The Institute has a rule saying you can't do the following services, you can't do more than 100 percent of the audit fee, you can't get into other services. They were running very effectively but I don't know why they have started putting everything in the Act.