In a landmark decision in the Kingston Cotton Mills case of 1896, Lord Justice Lopes delivered a maxim which auditors have clung on to as an insurance policy ever since — auditors are watchdogs, not bloodhounds. Justice Lopes went on to rule that “it is the duty of an auditor to bring to bear on the work he has to perform that skill, care and caution which a reasonably careful, cautious auditor would use. He is justified in believing tried servants of the company in whom confidence is placed by the company. He is entitled to assume that they are honest and rely upon their representations, provided he takes reasonable care.”

The profession of auditing has changed to such an extent over the years that the words ‘watchdog’ and ‘bloodhound’ are long forgotten now and have been replaced by the words ‘gross negligence’ and ‘guilty’, whenever accounting accidents occur. In recent years, there has been no dearth of such accounting accidents — Enron, WorldCom, Satyam, IL&FS, Carillion, Luckin Coffee and Wirecard come to mind instantly.

NFRA decisions

In two landmark decisions in this month, the National Financial Reporting Authority (NFRA) held two auditors, who had worked on the audit of IL&FS entities, guilty of professional misconduct. In what can probably be a first for a regulator in India (though SEBI initiated some punitive action against the auditors of Satyam after a long time), it has banned these two individuals from auditing for five-seven years and also levied a monetary penalty (₹5-25 lakh).

The NFRA was empowered to pass these orders courtesy Section 132(4) of the Companies Act, 2013. Both the auditors in question have filed writ petitions before the Delhi High Court challenging the Section, and a decision is expected soon. However, the fact that the regulators are closely watching the work being done by auditors cannot be denied. Though establishing the NFRA took some time, the institution seems to be serious about its business.

IL&FS was its first case, but it has gone about recruiting chartered accountants and empanelling technical reviewers. It has also formed a Technical Advisory Committee and appears geared for action. Unlike the Serious Fraud Investigation Office (SFIO), whose work is shrouded in mystery, the NFRA appears be going about its business in a professional and business-like manner — much like the Insolvency and Bankruptcy Board of India (IBBI).

Auditing failures

IL&FS: In this case, there were quite a few charges against the auditors — actions/omissions leading to misconduct in independence requirements, misconduct in their role as an engagement partner, in communicating with those charged with governance, in evaluation of a risk of material misstatement, misconduct in relation to RBI inspection matters and in relation to evaluation of the going concern assumption. The NFRA concluded that the auditor compromised on his independence by rendering an eclectic variety of non-audit services to group companies of the same client at high fees. The NFRA did a deep dive into the auditors’ responses and ruled that the engagement partner did not involve himself fully in the audit and did not communicate with the management clearly.

The NFRA was surprised that despite the RBI raising concerns over the net owned funds and other mandatory criteria, the auditor chose to turn a blind eye towards it. What irked the NFRA further was that despite the fact that default on one instalment brought the whole complex edifice of IL&FS down, the auditors did not report any threats to the concept of going concern.

Café Coffee Day: The investigation report ordered by Café Coffee Day (CCD) after the promoter committed suicide reveals that there were large related party transactions that did not appear in CCD’s books, since they were ostensibly being used to buy back equity from PE (private equity) investors. While the synopsis of the report does not specifically blame the auditors, there can be no two thoughts on the fact that had the auditors gone a bit further than doing a routine audit, these transactions with related parties may have been a part of their audit report.

Unsurprisingly, the erstwhile auditors of CCD have resigned — which is becoming a sort of a routine phenomenon.

Wirecard: Wirecard was considered to be a fintech wizard across the world till it did an encore of Satyam and reported $1.9 billion in bank balances in Singapore that didn’t exist. Though this has been brewing for some time now, it was observed that even in the June quarter report, the auditors of Wirecard had planned to give a report as white as snow. They may not do so now, with the issue snowballing into a controversy.

Regulators all over the world have attempted to regulate the profession every now and then. Concepts such as rotation of auditors, mandating joint audits in some instances and publishing a list of non-audit services that audit firms cannot do were promulgated because of this. However, firms have been able to circumvent this by involving associate and network firms with whom there are “Chinese walls” built to ensure that there is no conflict of interest. As the Galwan River Valley shows, Chinese walls can no longer considered to be impregnable — this should be more like a “Mexico wall”, as thought of by US President Donald Trump.

Adverse opinions

All the work done by an audit firm culminates in the audit report. Over time, the audit report has become a complex document that runs into multiple pages, which are full of disclaimers. If an auditor really wants to make an adverse comment in his report, he has enough and more space to do so. Qualifying the audit report, disclaiming from forming an opinion, incorporating an ‘emphasis of matter’, detailing ‘other matters’ and reporting ‘key audit matters’ are also available apart from a separate clause to test the concept of going concern. If the auditor does want to report something, he is free to use the ‘other matters’ paragraph, if it is not an adverse opinion.

However, the harsh reality is that auditors would hesitate to write major adverse comments in their report since they are dependent on the client for their fees, apart from other assignments as well. If auditors are rid of this dependency, they could get more real in their audit reports. Regulators should think of a way for this — an audit fee fund with contributions from all companies can be parked in an SPV and fees distributed from there. The SPV can refuse to pay the fees if the auditor is found guilty of any misconduct, including doing non-audit services for clients.

The aggressiveness of the NFRA in these two decisions is bound to send some strong signals to the auditors of listed companies in India to buck up. Irrespective of the length of the audit report, the content is what the NFRA and all others would be analysing in great depth and detail.

The writer is a chartered accountant

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