Published Editorial

Act expects auditors to be skillful at crystal ball gazing

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The Financial Express

by

Dolphy D’souza
National Leader & Partner
EY

Under the new Companies Act/rules, audit committees will now have a bigger say in the appointment of the auditor. Though the appointment of the auditor is made at the AGM, the audit committee shall recommend the auditor to the Board.

Nonetheless, the Board may proceed with proposing its own nominee at the AGM. However, when it ignores the suggestion of the audit committee it shall explain the reasons for not accepting the recommendation of the audit committee in the Board’s Report.

This requirement may ensure that the suggestion of the audit committee is generally respected. One of the things that audit committees/Board are required to consider in the selection of the auditor are the completed and pending proceedings against the auditor before the ICAI or the NFRA or Tribunal or any Court of Law. This requirement may disqualify some auditors from seeking appointment as auditors.

Under the New Act, the requirement to rotate auditors applies to listed entities and other prescribed class of companies. The prescribed class has not yet been prescribed and is under consideration. Under the New Companies Act it was not clear whether the requirement to rotate auditors applies retrospectively or prospectively.

The recently published Rules provides clarifications. The five-year period for rotation in the case of an individual and the ten-year period in the case of an audit firm will be calculated retrospectively and will include holding office as auditor prior to the commencement of the Act. Thus if an audit firm has held office for more than 10 years in a company, then it will be rotated immediately subject to availability of a three year transition period.

Further, the rules also clarify that the new auditor cannot be a network firm. This will ensure that rotation of the auditor happens in the right spirit and is outside the common group of auditors.

The auditors reporting responsibilities under the New Act/Rules has been made very onerous. The Act requires auditors to report to the Centre whether a fraud has been or is being omitted against the company by officers or employees of the company. Fortunately, the rules clarify that reporting is required only with regards to material fraud.

Materiality shall mean frauds that are happening frequently or where the amount involved or likely to be involved is not less than 5% of net profit or 2% of turnover of the company for the preceding financial year.

This was one of the major concerns of the auditors and the companies, which has now been adequately addressed in the rules. However, the issue relating to “fraud is being committed” remains confusing.

It is practically impossible to know and detect if a fraud is being committed. Consider an example, where the company does not have a system of bank reconciliation on a regular basis. How will the auditor know if that was deliberately done to help commit a fraud that had incubated in the mind of the cashier?

Auditors also have to report on whether there were any financial transactions or matters that have any adverse effect on the functioning of the company, as well as whether the company has adequate internal financial controls system in place.

The definition of internal financial controls includes controls with respect to efficient and effective conduct of business. Both these requirements require reporting on the propriety aspect and are even more onerous than the Sarbanes Oxley requirement.

Auditors should not be involved in reporting on propriety of transactions as it requires them to step into the shoes of the management and second guess management action, which is against the requirement of auditing standards. One was expecting that the Rules would provide clarification on these matters; but that has not happened, which makes the auditor’s role unclear at this stage. Hopefully more guidance will follow.

The Rules also prescribe auditor’s to report on pending litigations of the company.

Interestingly, the auditor is also required to state if the company has made provision for foreseeable losses, if any, on derivative contracts.

This is a difficult concept to understand as foreseeable losses are not the same as mark to market losses. Only future can tell us whether long-term derivative contracts will be ultimately profitable or loss making. Never mind, the Companies Act/Rules expects the auditor to be skillful at crystal ball gazing and also outdo Sherlock Homes. Good luck Auditor!