Cos Act Ep#9: NFRA & Auditor Liability
Has the Companies Act 2013 rung the death knell for ICAI’s regulatory powers? And can one fraudulent audit partner drown the firm? We’ve saved the best for last. Or should I say most contentious. Because in this 3rd and final episode of discussing Accounts & Audit we are going to focus on NFRA and auditor liabilities 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.
The Companies Act 2013 gives birth to the National Financial Reporting Authority or the NFRA. Its job will be to make recommendations to the government on accounting and auditing policies and standards, monitor and enforce compliance with these standards and oversee the quality of service of accountants and auditors. The NFRA will have the power to investigate, adjudicate, penalise and debar an accountant from practice and membership of the ICAI for up to 10 years.
Section 132 (2)
-Make recommendations to Government on accounting and auditing policies and standards -Monitor and enforce compliance with accounting/ auditing standards -Oversee quality of service
Section 132 (4)
Have power to investigate matters of professional or other misconduct committed by any member or firm of chartered accountants
Have same powers as are vested in a civil court for discovery, summons, inspection, examining witnesses & documents…
Where professional or other misconduct is proved, have the power to
- impose penalty of Rs 1 lakh to 10 times fees receieved
- debar member or firm for 6 months – 10 years
Doshi: Is this the death of the ICAI as a regulator?
Krishnan: No way. I will give you the background of NFRA. The Prime Minister and the whole country gave a commitment that the standard setting and regulation will be separated. NFRA was born out of that assurance that the standard setting and regulation will be separated and standard setting body will be the ICAI and regulatory & disciplinary mechanism will lie with NFRA. In between, we ended up removing both the standard setting approval- standard setting is still with ICAI- the approval of standard setting as well as auditing standards have gone to NFRA and disciplinary part of it has gone to NFRA. It is only the top 200 companies which will be subjected to the auditors of those 200 companies. I am saying, rough figure, would be subjected to disciplinary proceedings by the NFRA. Second is the Institute will still have all the roles that it used to play. If NFRA comes and decides to take a case, ICAI will have no role to play in that.
Doshi: That's how you read it?
Krishnan: No, that's the way it is. I am sure Ramesh will agree with me on this. Second issue is again my earlier statement. Very critical is that instead of strengthening institutions are we weakening institutions? There are two Acts of parliament- one is ICAI and one is Companies Act. You are creating NFRA. We have been working under the National Advisory Committee on Accounting Standards (NACAS) under the Companies Act. He has been a member of NACAS, we have never had any differences in standard setting- whatever Institute did the NACAS also approves or we changed it based on NACAS requirement. In my opinion there is too much of a layer which is coming up.
The second is would you discipline a doctors profession or a lawyers profession by an external agency? You are singling out the Charted Accountants alone because they are not the people who will come to streets and fight. Second, my opinion is the Institute could have done some errors, could have slipped on something but fundamental rights and the way the disciplinary mechanism proceeds public perception is delayed. I think once that perception is corrected, it will, but I don't see NFRA taking over ICAI rule because it will take five years for 200 companies auditors to be done, it will take five years and it will involve a huge amount of budget for them. I don’t think they would be able to do and they won't be able to complete an inspection. An inspection typically with four members will take 60 days.
Doshi: So you are saying it is a non starter?
Krishnan: In my opinion it will be very difficult for it to function in a manner in which it has been thought of. It will have to have a huge set up and the benefit that will arise out of it will not be commensurate with the money that you spend. Instead of that strengthening ICAI would be a lot of better way of doing it.
Doshi: To be fair and honest I did not intend to get into a very detailed debate on NFRA, simply because (a) we have so many other issues and time is always short and (b) NFRA deserves an entire episode of its own. Once we come closer to its sort of actioning, because it could change things in many good or bad ways as Krishnan has raised. I will still like to get quick comment reacting to what Krishnan has laid out as the potential non-starterness of NFRA - Ramesh would you agree because he said you will call for that.. (Interrupted).
Krishnan: I don't want to say potentially non starter but could be difficult for them to start unless there is a well thought out process how you will do it.
Doshi: Which doesn't exist right now is what you are saying?
Krishnan: No, it doesn't. The Ministry was aware of it. We wanted to do it later but today no, nobody has planned what is the infrastructure requirements for them.
Ramesh: Let me make some very quick points. One I agree with Krishnan that standard setting should be left to experts and therefore ICAI is the expert and should have been so. I know it is too late now to talk about accounting standards, which had already gone to NACAS, and now auditing standard are also coming into NFRA along with accounting standards.
The second part is there is this International Forum of Independent Audit Regulators (IFIAR). If you have to be a member of that it is important that your regulatory body, which oversees the auditing profession and audit is a very important public service function has to be independent of the profession it oversees. So it is in that context. Having said that, Krishnan is absolutely right if you want to get that oversight of the audit profession, you need to have substance; you need to have independent inspectors.
Doshi: And resources.
Ramesh: Absolutely, you need to have a budget and today it maybe all firms which audit more than 200 audits all of that but the principle seems to be cast in stone away that there will be an independent oversight. It is as substance.
Doshi: So in polite terms you are saying you don't think it is a non-starter or you don't think it is floor design?
Ramesh: I am saying it is a matter of time, I will never say it is a non-starter because we are heading towards a regime all over the world where there will be an independent audit.
Doshi: You don’t think that the better option would have been to strengthen the ICAI- you think this is where we should have moved?
Ramesh: ICAI is strong even today. We have the mechanisms.
Doshi: I am sure many people would dispute that. I don’t want to get into the SWOT analysis of ICAI at this point.
Ramesh: No, all I am saying is irrespective whether the ICAI is strong or weak, the principal of independent audit oversight is there across the world now and we will move towards that some day or the other.
Krishnan: I want to add one more thing. One is accounting standards and auditing standards even today are only with the Institute. Under the Act NFRA can only approve what has been done by the Institute; so it has not been taken away. So the answer to your question is no, because under the law it says accounting standards and auditing standards as set by ICAI will be approved by the NFRA. NFRA cannot on its own set any standard. It has to come only through ICAI.
The second is even today the disciplinary mechanism we have majority of members. Out of six members three are government nominees. You could have made six members as government nominees and only two from the ICAI. The same disciplinary mechanism which is there could have easily been strengthened rather than creating an institution ---(Interrupted)
Doshi: So you think honestly that the disciplinary mechanism under the ICAI has worked effectively?
Krishnan: It has not worked effectively not because ICAI did not do it. You take Satyam case. People will go to High Court or Supreme Court, get a stay and come back and you are not a policeman, you just cannot go and arrest a person and come back. You have to ask for the records, it takes time. I am not saying everything is great and there is no fault at all. There could have been some fault. Perceptions are there but as a disciplinary authority you cannot go and publicise what you have done but it did not warrant a complete change from the disciplinary mechanism.
Ramesh: No, but the issue is not of delay, because you could have the same issue with NFRA too. If there is a judicial process which has to be followed or a quasi judicial process, that has to be followed even by NFRA. That is not the issue. There are three elements here- setting of standards, oversight of the profession which is inspecting of audit firms and third is punishment which is the disciplinary proceedings. All three are today with NFRA. Even assuming that the disciplinary proceedings were to remains with ICAI, the inspection of audit firms would require an independent oversight audit regulator and that is how NFRA would come in. That is where the resources would be an issue. In terms of timeframe of disciplinary proceedings, I am not sure NFRA would be able to make it much faster than the Institute because of the process which he explained.
Doshi: It is not about being faster, it is about being more effective and going after people besides just the Satyam case but like I said I don’t want this to be a debate because that debate is a whole different debate on whether ICAI has delivered or not, therefore whether NFRA has space to grow and thrive or not- this is what it is now. We spent two years after Satyam asking why doesn’t India have a Public Company Accounting Oversight Board (PCAOB) kind of structure or a set up- is this you think is the answer for that?
Khatri: Anything that helps us move closer to international norms with the right safeguards is the right thing. It does as long as you create the infrastructure behind this because as we talked about when the PCAOB was formed, it hundreds of millions of dollars of funding to recruit the right people, to make sure this works efficiently. Our ability to put in that infrastructure is questionable and therefore it is a step in the right direction and all we need to do is make sure we create the infrastructure behind it.
Krishnan: The only thing is PCAOB had inspected Satyam. PCAOB came and inspected and they gave a clean report and then you got it.
Khatri: I deal with the PCAOB on a daily basis and I have clients who deal with them on a regular basis. Let me tell you how companies and auditors deal with the PCAOB is very different from the way they deal with the Institute and that is the point. The point is not that anybody will catch everything 100 percent but the level of rigour you put in into an international audit, because you know that the regulator who is an independent regulator -there is merit to that.
Krishnan: The delivery system in the United States is much faster than us. It is not the regulator who is threatening you. Legal delivery systems and enforcement systems are good there; therefore PCOB is effective. Here it is not good, therefore ICAI cannot be effective.
Doshi: This is an emotive topic. I would have the highest ratings if I spend the next one hour just discussing this because every accountant in the country would be watching. Unfortunately, it is not everything that we need to discuss in the Companies Act. So I will give the last word to you on this- do you think what we are getting in the form of NFRA, currently in the design stage, is the answer to the question does India have an independent audit regulator, does this fulfil those needs?
Rao: Yes, even today what is envisaged as far as the accounting standard setting is concerned - that is still with the ICAI as rightly pointed out. So only approval and making it effective that is only the role of NFRA. As Mr Ramesh has pointed out as long as oversight is with the regulator, it will be effective in my view. Oversight function should be independent. So that oversight function, as long as this new agency is going to fill up, it is a welcome step in my view.
Section 140(5) – the tribunal either suo moto or on an application made to it by the central government or by any person concerned, if it is satisfied that the auditor of a company has whether directly or indirectly acted in a fraudulent manner or abetted or colluded in any fraud, it may, by order direct the company to change its auditors. Such an order would bar that auditor from being appointed as auditor of any company for five years.
Section 140 (5)
‘the Tribunal…if it is satisfied that the auditor of a company has…acted in a fraudulent manner or abetted or colluded in any fraud…it may, by order, direct the company to change its auditors’
- Auditor barred for 5 years
- Liable to action under Section 447 (Fraud)
Section 140 goes on to explain that the liability shall be of all the partners that colluded in the fraud as well as that of the firm. Similarly, Section 147 also mentions liability whether civil or criminal shall be of the partner or partners concerned of the audit firm and of the firm jointly and severally.
The rules attempt to narrow that scope by saying, ‘in case of criminal liability of any audit firm; the liability other then fine shall devolve only on the concerned partner or partners.’
Section 140 (5)
Explanation - In the case of a firm, the liability shall be of the firm and that of every partner or partners who acted in a fraudulent manner or abetted or colluded in any fraud…
Section 147 (5)
In case of audit of a company being conducted by an audit firm, it is proved that the partner or partners of the audit firm has or have acted in a fraudulent manner…the liability, whether civil or criminal…shall be of the partner or partners concerned of the audit firm and of the firm jointly and severally.
In case of criminal liability of any audit firm, the liability other than fine, shall devolve only on the concerned partner or partners, who acted in a fraudulent manner or abetted…in any fraud.
Now on to penalties- while the Act levies similar penalties on defaulting companies and on auditors, an auditor can be punished with imprisonment only in the case of willful deception. If convicted, the auditor is liable to refund remuneration and pay damages.
Section 147 (2)
‘…if an auditor has contravened such provisions knowingly or wilfully with the intention to deceive the company or its shareholders or creditors or tax authorities, he shall be punishable with imprisonment for a term which may extend to one year and with fine which shall not be less than one lakh rupees but which may extend to twenty-five lakh rupees
ALSO LIABLE TO
- Refund remuneration received by him to the company
- Pay for damages to company, statutory bodies/authorities or to any persons for loss arising out of incorrect or misleading statements made in his audit report
Ramesh: Fundamentally, under the earlier law, there was nothing wrong with it. The liability was on the person who signs the financial statements. You don’t penalize the firm and bring down the whole firm merely because of the fault of one partner. That in the rules and so far as the deals with criminal liability has been brought out. The principle should be that if the firm on a recurring basis has these issues, then you need to take an action at a firm level in terms of the firm not instituting processes in place.
Doshi: I get it but you are suggesting what it should be. I am saying what does it amount to? Criminal liability has being circumscribed just to the concerned partners.
Doshi: But civil liability now applies to the partner, the partners and firms.
Ramesh: We will have to wait and see as to how it is actually applied in practice.
Krishnan: The principle that if one patient dies you don’t close the hospital- that has not been applied here. If one partner does a mistake the whole partnership will take a liability is wrong.
Doshi: But at least the whole hospital won’t go to jail but the entire hospital might get penalized.
Krishnan: Impact of it is going to be severe because it is impossible for you to control all the partners unless you proved connivance in partners working together. I will also give you the background of why it happened. When it came to the rule making committee, the partner who was responsible for it said that I had a review partner. The review partner said that there was a quality partner who did that. Each person trying to escape by saying I did it but there was also a quality partner and quality partner says I didn’t sign it, so you can’t hold me responsible but I had a review partner. So each one was trying to shift the blame to the other and they were trying to escape. So, for an exception in that case government said put a rule on all the partners as responsible.
In my view this is too harsh a provision. We should aim at making a change to Act to that partner being both civilly and criminally responsible. If the whole partnership acted as connivance; they all derived the benefit out of it, knowing fully well he has done something wrong then you can take penal action on the firm.
Doshi: So you are saying just like the criminal liability has been circumscribed, the civil liability should also be circumscribed.
Krishnan: Unless proved that there is connivance.
Doshi: So the concerned auditors, I am using the word if its concerned auditors in the sense that you have been proven to be party to the fraud, then the liability whether criminal or civil should apply to you as well?
Krishnan: It has to go through the amendment to the Act but unfortunately, for the auditors they have levied heavy penal provisions. While you have restricted the audit provisions from rotation and non-audit services etc. you also ended up with that severe penal provision.
Khatri: Ultimately this will show up in the pricing of audit services because nobody is doing this for charity and the risk will have to be priced in whether it is in terms of the increased efforts or whether it is in terms of how you conduct an audit.
Doshi: That was the most important impact. Two hours of discussion that we have had, basically what they are telling you is that they are going to send you bigger bill starting FY15.
Krishnan: There are not many women who want to come and join the practice at all. They say we won’t sign the balance sheet.
Krishnan: Because you may have to go inside if something else went wrong in the company - I may have to have civil and criminal liability.
Doshi: That’s unfortunate collateral damage. The auditors look fatigued, tired, beaten down. Should I give you the last word on what these two chapters really mean because at the end of the day this is an Act that regulates companies. It is not an Act that’s meant to regulate accountants. So, from the company point of view, at the end of the day what do you think the ultimate impact is? Is business become too difficult to do because of these two chapters?
Rao: Particularly the consolidation of accounts and the related party transactions where it has to be disclosed in the director’s report and the subsidiary is the related disclosure. So, these are the issues which will delay the entire process of doing business. It has to be relooked as far as these particular areas are concerned.
Similarly, the penalties which are there today not only to the auditors, even if we take from the company point of view- so every Section talks about imprisonment and fine. So, it is not that it is severe on auditors; it is severe on companies, severe on professionals, executives and everybody. It is very severe. So cost of compliance is very high. Therefore, the industry has to be very vigilant in ensuring that the compliances are done properly. So, one way it is good that the governance system will improve as far as India is concerned but it will take long time to adjust to the new Act.