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Corporate Litigations & Auditors’ Responsibilities

Published on Mon, Nov 18,2013 | 18:40, Updated at Mon, Nov 18 at 18:40Source : 

By: Sunil S Kothari & Nikhil Kenjale, Deloitte Haskins & Sells

Recently a leading Indian IT company agreed to pay US $34 million to end the investigation relating certain visa related irregularities. The cost of litigation has been significantly increasing in the recent years, where the litigation expenses by corporates have been estimated over Rs. 5,500 crores according to a recent news article. How do these things go beyond the management’s control and what are the auditors’ responsibilities in such cases? Let us analyze.

Global Economic environment and Company’s risk management - The global economic environment has not only created operational challenges for the Indian companies but also has created legal exposures. Every opportunity of expanding globally will have these associated risks. The distinguishing factor for success is the ability to address and manage such risks in a timely manner. This largely depends on the maturity of risk management procedures a company has and the quality of people it deploys to take care of the legal exposures. A company may be adhoc in addressing the legal issues which do not come to surface quickly at the time of entering into a cross border transaction and may choose to handle the legal issues as and when and if they come up. This would be a reactive approach. On the other hand the vigilant company may do scenario planning while evaluating the proposed transaction, get legal advisors’ input in time and then take the calculated decision to enter into the transaction. This is a proactive approach.

How Companies monitor the legal exposures? - Very few companies in India have the Chief Legal Officers appointed to specifically look after the legal issues and usually the responsibilities lie with the Company Secretarial function posing inherent limitations to address all the legal issues. Such companies do largely depend on the external legal advisors.

Which laws and regulations to comply? In India we have many Central, State and local laws to keep the legal departments busy throughout the year. Identifying all the laws which are applicable to a particular company itself is a tough task. A priority has to be set keeping in view the criticality of compliance considering the possible penal actions and possible damage to the company’s reputation. Usually, the operational functions are asked to prepare the list of laws applicable to their operations, for example human resources function is vested with the responsibility to identify regulatory requirements relating to the employment, labour, minimum wages, provident fund, ESI, gratuity, etc., prepare a comprehensive list at the entity level and report the compliance status to the board / audit committee on a quarterly basis. Similarly the finance function is responsible for commercial laws, exchange regulations, tax matters etc., and the factory \\ plant is responsible for work environment, pollution control, waste management etc., and so on and so forth. Clause 49 of the listing agreement as well as the new Companies Act, 2013 have vested the responsibility with the Directors to ensure compliance with all laws applicable to the company and the above process assists them in doing so. Care has to be taken by conducting the independent cross verification of the status reported by various functions to ensure that the above reporting is current and objectively completed.

Auditors’ responsibilities and challenges in auditing litigations – While the primary responsibility to design, implement and maintain an effective internal control system including on financial reporting is on the company and the auditors responsibility is to review and express their opinion on the reasonableness of such system, however the perceived expectation from the stakeholders and public at large is not so. When anything goes wrong the first question asked is what was the auditor doing? 
Accounting Standard 29 (AS 29) “Provisions, Contingent Liabilities and Contingent Assets” deals with the accounting and disclosure requirements of contingencies. A liability which can be measured on an estimate basis is recorded in the books of accounts and is an ‘on balance sheet’ item. A liability which would depend only by the occurrence or nonoccurrence of one or more uncertain future events not wholly within the control of the company and a reliable estimate of the obligation cannot be made is contingent liability and an ‘off balance sheet’ item.

On balance sheet items or recorded transactions would undergo review in the course of the audit, for example scrutiny of payment towards penal interests / penalties / fines may indicate breach of some law by the company and auditor may undertake further procedures like understanding the legislation, its compliance requirements, understand possibility of further penal actions, consult legal advisors, get management view of their best estimate of the possible outflow etc. Significant challenge for auditors is to audit ‘off balance sheet items’ or matters not recorded in the books of account. The procedures auditors generally undertake include review of the pending/ongoing litigations under various statutes as compiled by the management and identify potential legal issues through discussions with the management about new ventures, transactions, media reports involving the company, management or investors etc. Discussion with the legal counsels whom the company consults also provides information and insights to the auditor on such matters and potential exposures

It is also critical for auditors to understand industry in which the entity operates, understand the current state of economy, its impact on the business and also technology used by the entity. The areas of litigations are also widening from complex customer/supplier arrangements/contracts entered by the companies, various laws being enforced by government, business being carried by various geographies etc. Further, there are specific industry related matters to be dealt with, for example radiation norms in telecom industry, new drug trials and hygiene requirement norms with periodic independent audit requirements in pharmaceutical industry, environmental clearances by mining industry etc., to name a few.  These matters are operational issues and auditors are generally not required to perform audit procedures to assess compliance with these requirements. However, Indian companies have faced significant penalties for non- compliances, many prolonged litigations and may have going concern issues. This confronts an auditor to a separate set of audit risks and they are required to assess impact of these risks on their audit conclusion. Such litigations are increasing very fast and companies are likely to face heightened scrutiny from various regulators in future which will only increase number of litigations.

In the west, where auditor is sued for any reporting errors and faces continuous scrutiny of the regulators, has resulted in very high cost of audit. In India too number of corporate litigations are increasing over the years and are likely to increase further due to ammunition made available in the hands of various stakeholders by the new Companies Act. The new Companies Act provides for class action suits against the Company, its management, directors and also auditors. The Act also provides for imprisonment and imposition of fine/compensations.

The practice management guidelines issued by the Institute of Chartered Accountants of England and Wales (ICAEW) makes it compulsory for all ICAEW members who have a practicing certificate and are engaged in public practice to have professional indemnity insurance.

Given complex business environment and laws, the auditors’ responsibilities has significantly increased much beyond what it seems or perceived to be.



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