Published Editorial

Companies` law and the auditor

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Live Mint and the Wall Street Journal

by

Dolphy D’souza
National Leader & Partner
EY

Under the new companies law, it was not clear whether the holding of office by an auditor prior to the commencement of the law needs to be considered or not for rotation. Also, it was not clear whether the new auditor can be from within a network firm of the auditor that will be rotated. The recently published rules provide the clarifications.

The five-year period for rotation in the case of an individual and the 10-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 law. 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 the rotation of the auditor happens in the right spirit.

Some aspects are still under consideration. For example, auditors are required to be rotated for listed entities and other prescribed class. The prescribed class in which auditors will need to be rotated is still under consideration.

Audit committees will now have a bigger say in the appointment of the auditor. As per the rules, the audit committee shall recommend the auditor to the board of directors in a company. If the board is not satisfied with such recommendation, and wants to proceed with its own nominee, it shall explain the reasons for not accepting the recommendation of the audit committee in the board’s report.

Interestingly, the audit committee or the board shall also consider the completed and pending proceedings against the auditor before the Institute of Chartered Accountants of India (ICAI)or the National Financial Reporting Authority (NFRA) or tribunal or any court of law.

The law requires auditors to report to the central government, whether a fraud has been or is being committed against the company by officers or employees of the company. There has been some breather here. 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.

However, the issue relating to fraud being committed remains nebulous. Many questions emerge. First, what is meant by fraud is being committed? At what stage could it be argued that a fraud is being committed? How will the auditor probably know that a fraud is being committed? Consider an example, where an employee manipulates the vendor master file by creating non-existent vendors. Even if the auditor does detect faults in the master file, how could he substantiate whether those were created with an intention to carry out frauds? Also, the requirements presuppose that the auditor is going to work round the clock using a whole battery of auditors. This is not practically feasible and the auditor is unlikely to be remunerated on that basis.

In addition to reporting on fraud, the new law requires auditors to report on two other critical matters. One is to report on financial transactions or matters which have any adverse effect on the functioning of the company. The other is to comment on whether the company has adequate internal financial controls system in place and the operating effectiveness of such controls.

These are highly onerous reporting requirements. The definition of internal financial controls includes controls with respect to efficient and effective conduct of business. If the auditors have to report on the same, then they will have to enter into the shoes of the management; which is actually what the auditors are supposed to avoid as per current auditing standards. This seems even more onerous than the Sarbanes-Oxley (a US law on company accounting reform and investor protection) requirement. Auditors should not be involved in reporting on propriety of transactions. Hopefully, this is not the intention and the matter should be clarified by the ICAI or the ministry of corporate affairs. One was expecting that the rules would provide clarification on these matters. But that has not happened, which makes the auditor’s role unclear.

The rules also prescribe the auditor’s report to include his views on certain additional matters. The auditor will report on whether the company has disclosed the effect, if any, of pending litigation on its financial position in its financial statements. The auditor will state if the company has made provision for foreseeable losses, if any, on long-term contracts, including derivative contracts. One can understand the term “foreseeable losses” in the case of long-term contracts. But how can one foresee losses in the case of derivative contracts? Only the future can tell whether those will be profitable or loss-making. Never mind, the Companies’ law and its rules expect the auditor to be a superhuman with extrasensory powers.