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Companies Act Diary: Part 3

Published on Wed, Jan 15,2014 | 16:19, Updated at Wed, Jan 15 at 21:32Source : 

By: Jamil Khatri, Deputy Head of Audit & Global Head of Accounting Advisory Services, KPMG

The Companies Act 2013: Higher Auditor Accountability

Continuing with the discussion on the six themes arising out of the Companies Act (the Act), this note discusses the second theme around the roles and responsibilities of the statutory auditor of a company.  The Act prescribes significant changes relating to appointment of auditors; mandatory audit firm rotation; restriction on specific non-audit services; and responsibilities and liabilities of auditors.  These key changes are discussed below:

Auditor appointment and removal

The Act mandates the appointment of an auditor for a term of five years with subsequent ratification at every Annual General Meeting (AGM), replacing the erstwhile provision of appointment until the conclusion of the following year’s AGM.  Further, the Act requires a special resolution and prior approval of the Central Government for removal of an auditor before the end of five years term.  In my view, the introduction of a longer tenure for auditor appointment with a more rigorous process for auditor removal is a welcome move.  Viewed in conjunction with other provisions of the Act, this could be supportive of greater auditor independence and objectivity.

Rotation of auditors

One of the most controversial and debated provision of the Act relates to mandatory audit firm rotation.  The Act restricts the appointment of audit firms to two consecutive terms of five years each.  The Act prohibits the reappointment of the retiring auditor or appointment of audit firms which are associated with the retiring auditor under the same network of firms or are operating under the same trademark or brand, for a period of five years.   Even though audit firm rotation has been a matter of great debate in the European Union (EU), and the EU has recently proposed rotation rules for member countries; support for audit firm rotation outside the EU has been very limited.  For example, regulators in the United States considered audit firm rotation post the Enron debacle and concluded that there was insufficient evidence that mandatory audit firm rotation would increase auditor independence.  Similarly, countries such as Spain and Korea have abandoned similar rules after an initial implementation period.   A few countries such as Italy have successfully followed the principle of audit firm rotation for the last several years.  In addition to the EU proposal discussed earlier, countries such as the Netherlands have also recently operationalized rules to mandate audit firm rotation.  In India, mandatory audit firm rotation has partly existed for entities such as banks and insurance companies driven by sector specific regulations.

The Act provides for the three year transition period to implement this requirement.  Thus, companies that have completed ten years with their current audit firm, would need to mandatorily rotate to another auditor within three years from the implementation of the Act. 

The Act prescribes that the auditor rotation requirement will apply to all companies, except small companies and one person companies.  In my view, this is an overreaction to auditor independence concerns.  Globally, even if audit firm rotation is mandated, it applies to listed entities and other entities where public interest is involved (example, banks and insurance companies).  Extending the requirement to closely-held unlisted companies would be cumbersome with little systemic benefits.  Implementing the rule as currently envisaged would require several thousand companies to change auditors in the coming years.

Another area that will throw up implementation challenges is to manage auditor rotation requirements in different countries.  For example, several EU domiciled multinationals have Indian subsidiaries that would be governed by separate audit firm rotation requirements in their home countries (at the group level) and in India (for their Indian subsidiaries). 

Lastly, unless sector regulators such as the RBI and the IRDA change their own regulations, banks and insurance companies would continue to be governed by the relatively more stringent rotation time lines (four years). 

Prohibition on rendering specific non-audit services

With a view to increase an emphasis on audit quality and independence from the audit client, the Act prohibits an auditor from rendering specified non-audit services including accounting and book keeping services, internal audit, design and implementation of any financial information system, investment advisory services, investment banking services and management services to the audit client, its holding company and subsidiary companies.  Further, the Act allows rendering of permitted services only if they are pre-approved by the Board or the Audit Committee.   These restrictions on non-audit services are generally based on the international practice that the auditor should not perform services that may result in the auditor auditing his own work; or where the auditor is stepping into the shoes of management.  The list of prohibited services is generally consistent with similar requirements in the Sarbanes-Oxley Act implemented in the US.  Several non-audit services such as tax services and due diligence services continue to be permitted. 

Increase in auditor responsibilities and reporting requirements

The Act increases the responsibilities and reporting requirements of the auditor by requiring the audit to report on the following key additional matters:

• Whether the company has adequate internal financial controls in place and the operating effectiveness of such controls - Previously, an auditor had to report under the Companies Audit Report Order (CARO) on the adequacy of internal controls limited to purchase of inventory and fixed assets and sale of goods or services. The new provision extensively increases the reporting requirements and seems to require an auditor to comment on all internal controls over financial transactions, which include matters that impact ‘orderly and efficient conduct of business’.  Requiring the auditor to report on matters that are not directly related to the generation and production of the financial statements is debatable and may be cumbersome.  Even countries such as the US that require the auditor to certify internal controls, restrict the scope of the auditor reporting to ‘internal control over financial reporting’ and not ‘internal control over financial transactions’.  To ensure consistency, the regulators would need to prescribe the specific scope of the auditors’ responsibilities in this area.  Similarly, bodies such as the ICAI may need to provide guidance to auditors on the approach to be followed for such reporting.
• Observations or comments on financial transactions or matters which have any adverse effect on the functioning of the company - This is also an unclear and subjective provision that would require the auditor to evaluate financial transactions (as opposed to financial reporting) to determine if they would have an adverse impact on the company.
• Reporting on fraud - The Act mandates that if in the course of performance of his duties as an auditor, the auditor has reason to believe that an offence involving fraud is being committed against the company by officers or employees, the matter should be reported to the Central Government and to the Audit Committee or the Board.  To provide relief from reporting immaterial frauds to the Central Government, the Act provides that immaterial frauds (less than 5% of net profits or 2% of turnover) need not be reported, unless they occur frequently.  In my view, this approach for reporting frauds to the Central Government is cumbersome and unique.  Requiring reporting of immaterial but frequently occurring frauds provides limited systemic benefits.  Even for material frauds, the international practice is for the matters to be reported to the Audit Committee/Board.  Only if the auditor is not satisfied with the response of the Audit Committee/Board, would the auditor be required to report the matter to the regulators.  This may be a much more efficient process to deal with such frauds.

Oversight and liabilities of the auditor

The Act empowers the constitution of the National Financial Reporting Authority (NFRA), an independent authority which would replace the existing National Advisory Committee on Accounting Standards.  The NFRA would assist the government in formulation of accounting and auditing standards.  The NFRA would also act as a quasi-judicial body with power to conduct investigations or quality review of audit and impose penalty for professional misconduct by an auditor.   At present matters relating to professional or other misconduct are addressed by the ICAI.   While there is a need for clarity around any potential overlaps between the role of the NFRA and the ICAI, the formulation of the NFRA is consistent with bodies such as the Public Company Accounting Oversight Board (PCAOB) in the US, which independently monitor, review and investigate any deficiencies relating to performance of the auditor.

Further, in order to protect investor interest, the Act introduces the concept of class action suits empowering a specified number of shareholders and depositors to take legal action against inter alia the auditor in case of any fraudulent activity. Thus, a class of shareholders or depositors can now claim damages or compensation against the auditor, including the audit firm, by filing an application with the National Company Law Tribunal (NCLT).  Given that class action suits have not been previously prevalent in India, all stakeholders’ would need to closely monitor developments in this area.

On an overall basis, the Act increases the rigor on auditor appointment; enhances the focus on auditor independence; imposes additional responsibilities on the auditor and provides for a mechanism to ensure that audit quality and independence is not compromised.  Similar changes in the US (post Enron) through the Sarbanes-Oxley Act are seen to have improved audit quality and auditor independence.  However, the regulators should review the provisions relating to mandatory audit firm rotation for unlisted companies; the scope of internal control and fraud reporting, to ensure that provisions that impose significant costs without commensurate systemic benefits are avoided.



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