Audit & Auditors under the Companies Bill, 2012

Appointment of Auditors [Clause 139]

Key
Provisions The Bill provides that a company will appoint an individual
or a firm as an auditor at its first AGM. Such auditor shall hold the
office till the conclusion of its sixth AGM and thereafter till the
conclusion of every sixth Annual General Meeting. Though the appointment
is for five years, ratification of such appointment is necessary at
every AGM. [Clause 139(1)]

In case of listed companies and
certain other classes of companies to be prescribed compulsory rotation
of audit is provided for a) In case of Individual auditor, after one
term of five years; and b) In case of a firm, after two terms of five
years [Clause 139(2)].

The auditor, after completion of his
term/s, will not be eligible for reappointment for a period of five
years. Also, a firm, which has common partners with the outgoing audit
firm on the date of appointment, cannot be appointed as the auditor of
the company. [Clause 139(2)]

Every company will need to comply
with these requirements within three years from the date when these
provisions come into force. [Clause 139(2)]

Members of the
company may also decide that a) Audit Partner and audit team shall be
rotated after certain interval or b) Audit shall be carried out by joint
auditors. [Clause 139(3)]

RBI and IRDA have powers to regulate
the banking/ insurance companies respectively under the relevant Acts.
Being regulators, these institutions have issued guidelines for
appointment and rotation of auditors. The rotation and the joint audit
requirements enacted by IRDA and RBI, being stricter and by virtue of
special powers given to them in this regard, will prevail over the
provisions of the Bill. In such a case, the appointment criteria will
continue to be as per their respective norms.

An audit firm
(including an LLP) eligible to be appointed should have majority
partners practicing in India qualified for appointment. However, only a
qualified chartered accountant partner will be eligible to sign the
audit report. [Clause 141(2)] Eligibility of an LLP for being appointed
as an auditor is now a part of the Bill. [Clause 139(4)] Under the
Companies Act, 1956 (the Act) a notification was issued to the effect
that an LLP will not be considered as a body corporate for the purpose
of Section 226(3)(a) of the Act. However, doubts were expressed whether
that was sufficient for an LLP to be appointed as an auditor of a
company.

A company may remove the auditor before the expiry of
five year term by passing a special resolution and obtaining prior
approval of the Central Government. [Clause 140(1)]

An auditor
may resign. However, he has to file a statement with ROC and also with
the CAG in case of a company where the appointment of the auditor has
been made by CAG, giving facts and reasons for the resignation [Clause
140(2)].

Comments
Prior to the Bill, the Government
had published the Voluntary Corporate Governance Guidelines in December
2009. According to these Guidelines, rotation of audit firm after five
years was suggested and it provided for compulsory rotation of audit
partner after three years. This entire thought process was aimed towards
providing strict norms of corporate governance and enhancing investor
confidence. However, compulsory rotation of audit partner and
appointment of joint auditors have been left to the discretion of the
members of the company in the Bill. Also, the Bill mandates two terms of
5 years where auditor is a firm as against one term under the above
Guidelines. To that extent, there is dilution from the original
corporate governance norms.

A study of regulatory framework with
regard to appointment of auditors prevailing in various countries shows
that there exists a joint audit system in different forms in many
countries. Joint audit is common in countries like Denmark, Germany,
Switzerland and France. In France, joint audit became a legal
requirement in 1966. All publicly listed companies in France and Denmark
that prepare consolidated (group) financial statements are required to
be audited jointly by two independent auditors and a single audit report
is to be issued. Some mandatory provisions in the Bill in this regard
would have only given boost to the investor sentiments.

Further,
in case of listed companies which have long term audit relationships,
it would be a challenge to cope with a sudden rotation. The new auditor
will have no time for understanding the intricacies of business of the
company. This, in fact, enhances the need for joint audit system prior
to rotating out the existing audit firm and would have provided
continuity and at the same time helped more quality audit firms to
emerge in the country. Nevertheless, the corporate world and auditing
community can come together to take advantage of voluntary provision of
joint audit to overcome these challenges.

As regards the
appointment/reappointment clause in the Bill, existing companies are
required to comply with the regulation within three years. However, the
wording of the clause providing for transition is not clear. Presently,
an auditor is appointed annually. After the enactment of the Bill, the
appointment will take place for 5 years. Hence, the audit firm may be
considered as eligible for appointment for two terms after the
provisions become applicable, since the audit firm will not have
completed the `term’ under clause 139(2)(b) of the Bill though the firm
may have been the auditor of the company for 10 years or more. However,
if we were to go by the spirit and the intent of the Bill, it seems that
the fact that companies are given transition period for three years,
indicates that the firm will not be eligible to be reappointed after
three years post the enactment of the Bill if it has already been the
auditor for 10 years or more.

A question remains whether an
audit firm, which has been the auditor of a company for more than 5
years when the provisions come into force, can be appointed as the
auditor of the company for 5 years at all after? Such appointment will
result in the firm being auditor of the company for more than 10 years
after the transition period. It may be noted that there is no provision
in the Bill to appoint auditor for a period shorter than 5 years. Can
the audit firm, in such a case, issue eligibility certificate under the
Bill?

Considering this, one is not clear how these provisions are going to be implemented in the initial years.

Eligibility, Qualification & Disqualifications of the Auditors [Clause 141]

A person or an audit firm
will be disqualified for appointment if he/it has direct or indirect
business relationships with all types of entities mentioned above.

A
person whose relative is a director or key managerial person by
whatever designation in the company is not eligible for appointment.

A person who is auditor in more than 20 companies will also not be eligible for being appointed as the auditor.

A
person who is convicted by a court of an offence involving fraud is not
eligible for the appointment as auditor for 10 years from the date of
such conviction.

Comments

It is significant to note
that the term used in this clause is “Person”. This term is not defined
in the Bill. In only case of “Business relationship” the term “firm” is
also used. However, in clause 139 the Bill uses the terms “Individual
auditor” and “firm”. Going by the spirit, in my opinion, term “person”
in the context means each individual partner of the firm.

Considering
this, going by the wording of the provisions, it is not clear whether
to attract disqualification to the firm should itself hold any security
or interest etc. in the company? Also, if a partner or his relative is
holding security, whether the firm will be disqualified? Clarification
may be needed on this. Also, where one partner is individually holding
appointment as auditor in more than 20 companies, whether his firm will
be disqualified? Going by the spirit of the clause, this does not seem
to be the case, though the drafting is susceptible to such
interpretation.

Keeping track of whether any relative is holding
any security above rupees one thousand (or the prescribed amount) or is
indebted to the auditee company is going to be extremely difficult. In
case of strained relationship with any of the relatives, a member will
find himself on helpless ground if any of the relatives decides to make
him ineligible for appointment or complains after the signing of audit
report that he was ineligible.

Surprisingly, a person or a
partner whose relative has a business relationship with the auditee
company or its subsidiary, associate etc. is not disqualified. Also, the
clause does not refer to `partner of the firm’ but only to the firm.
Does it mean a partner of a firm can have business relationship with the
company in his individual capacity without the firm attracting
disqualification?

The existing limit of undertaking audit of 20
companies per partner though continues under the Bill, this limit will
now apply while appointing auditors of private companies as well. Under
the Act, this limit is not applicable to private companies. The Bill has
also done away with the sub-limit 10 companies where the paid up share
capital of the company is Rs. 25 lakh or more. It is not clear from the
text of the Bill whether signing of consolidated financial statement in
addition to the stand alone financial statements of the company would be
construed as a separate audit assignment to be covered under the limit
of 20 companies.

The intent of the legislation seems good.
However the drafting of the Clause 141 is highly vulnerable to varied
interpretation (or misuse) . Overall, this clause will require great
amount of deliberations especially from the point of view of severity of
the punishments for violating any of the provisions.

Powers, Duties, Auditing Standards and Reporting Formalities [Clause 143,145,146]

Key Provisions

The
Bill provides that the auditor of a holding company will have right of
access to the records of all its subsidiaries so far as it relates to
consolidation of financial statements.

The Bill also requires the
auditor to report whether he has any reasons to believe that an offence
involving fraud is being or has been committed by any of its officers
or employees. The auditor will have the responsibility to report the
matter to Central Government within the time and manner as may be
prescribed.

At present, the auditor is required to report any
observation with any adverse effect on the functioning of the company in
bold/italics in the audit report. The Bill mandates that such
observation/comments should read at the AGM and can be inspected by any
member.

Currently auditor is required to comment on the internal
control matters and whether such system is commensurate with the size of
the company and nature of its business in respect of purchase of
inventory, fixed assets and for the sale of goods and services. The Bill
requires auditor to comment whether adequate internal financial control
is in place and whether it is operating effectively.

The Bill specifically provides that it is the duty of the auditor to comply with the auditing Standards. [Clause 143(9)].

The
Bill provides for mandatory attendance of auditor’s authorised
representative who is qualified to be appointed as an auditor at the AGM
of the company.

Comments

The right of access to
the auditor to the records of all subsidiaries of the auditee company
for the purposes of consolidation may create certain issues among the
auditors in case the auditor of the subsidiary is different from the
auditor of the holding company.

Requirement of adherence to
auditing standards under the Bill (which was hitherto requirement of
ICAI alone) coupled with the penalties attached for non compliance has
substantially increased the auditors’ responsibility. The cost of audit
will increase and small audits may become unaffordable to both the
company and the auditor.

The scope of audit is materially
broadened with the reporting responsibility on the existence of a fraud.
As per SA240 that deals with the “Auditor’s responsibility relating to
frauds in an audit of financial statements”, the primary responsibility
of prevention and detection of fraud rests with management together with
those charged with governance of the entity. Fraud detections require
an attitude which is inherently different from the at-titude required
for the purpose of an audit. Further, in India in case of audit of
banks, the regulator has prescribed the fraud reporting responsibilities
on the statutory auditor. However, the regulator has given clear
directions with regard to the materiality and corresponding reporting
responsibility to various authorities. The Bill does not state any
materiality limits for the fraud reporting. All these indicate that
auditor has to inform all frauds detected/suspected during course of
audit to the Central Government.

Reporting on effectiveness of
internal control is highly subjective. Any comment thereon in the report
may impact the entity significantly. This will increase the
professional responsibility as well as the liability of the audit firm
very significantly.

Further in respect of reporting on fraud, in
the absence specific guidelines, there is a possibility of difference of
opinion whether any offence involving fraud has taken place. For
example, any strategic investment made by the company that is managed by
relatives of the top management or the Board, or divestment of
investment below market value but much above the cost of acquisition to a
company that is substantially influenced by the relatives of top
management or the board members may be construed to be a fraud. Such
interpretational issues may have to be dealt with very carefully
considering the penalties involved in non compliance of reporting
requirement.

Prohibition of undertaking certain services [Clause 144]

Key Provisions

The
Bill provides stringent norms for independence of the auditors. Under
the Bill, an audit firm will not be able to provide certain services
directly or indirectly to a company where it is appointed as the auditor
or to its holding company or subsidiary

companies. (Clause 144) The prohibited services are as under: –

1.    Accounting and book keeping services

2.    Internal Audit

3.    Management services

4.    Design and implementation of any financial sys-tems

5.    Actuarial services

6.    Rendering of outsourced financial services

7.    Investment banking or advisory services

It
is important to note that the restrictions of undertaking the above
mentioned prohibited services apply not only to the firm undertaking the
audit but to all other connected entities of the firm namely:

i)  All its partners;

i)    Its parent, subsidiary or associate entity; and

ii)   
Any other entity in which the firm or any of its partners has (or can
exercise) significant influence or control or whose name, trade-mark,
brand is used by the firm of any of its partners.

The auditor
will have to comply with the above restrictions before the end of the
first financial year after the enactment of the Bill.

Comments

The
Bill uses term “Management Services” for one of the prohibited
services. Under ICAI standard, the term “Management Consultancy
Services” is used for indicating prohibited service. The term
“Management Consultancy Services” used by ICAI at present specifically
excludes Tax services. In my opinion, though there is minor difference
in the terminology used in the Bill and by ICAI, an auditor will be able
to render services related to Direct Taxes and Indirect Taxes.

Punishment for contraventions [Clause 147]

In a case the auditor contravenes provisions of clauses
139 or 143 to 145 of the Bill, the auditor may become liable to a
minimum fine of Rs. 25,000, which may extend to Rs. 5 lakh. However, if
it is proved that the contraventions have taken place knowingly or
wilfully with the intent to deceive the company, its shareholders, its
creditors, or tax authorities, the auditor will be punishable with
imprisonment for a term up to one year and minimum fine of Rs. 1 lakh
which may go up to Rs. 25 lakh. [Clause 147(2)]

In the event the
auditor is convicted of intentionally deceiving the company,
shareholder, creditors or tax authorities he will be liable to refund
the remuneration received by him to the company and incur liability to
pay damages to all such persons/ authorities for loss arising out of
incorrect or misleading statements made in his audit report. [Clause
147(3)]

Further, if proved that partner or partners of the audit
firm have acted in a fraudulent manner or abetted or colluded in fraud
then the liability for such act will be that of the firm and the
concerned partners jointly and severally. [Clause 147(s) and Explanation
to Clause 140(5)]

Members or depositors or any class of them are
entitled to claim damages, compensation or demand any suitable action
from/or against audit firm for any improper or misleading statement made
in the audit report. [Clause 245(1)(g)(ii)]

Comments

The
Bill rests a heavy responsibility on the audit profession and the
provisions are open to abuse. Eventually, even if the auditor is able to
prove that his actions were not fraudulent or that he had sufficient
evidence to support his comment in the report he has submitted, the
audit firm carries the risk of damage to reputation on account of
accusations. It is necessary to provide sufficient defense measure for
the auditing community at large.

National Financial Reporting Authority [Clause 132]

The
discussion in regard to audit and auditors cannot be complete without
mentioning the immergence of the new authority National Financial
Reporting Authority (NFRA). The existing advisory committee under the
Act known as NACAS will be replaced by NFRA with much wider powers. It
will a) Make recommendation on formulation and laying down accounting
and auditing standards; b) Monitor and enforce the compliance of
accounting and auditing standards; c) Oversee the quality of service of
the professions associated with ensuring compliances with standards and
suggest measures required for improvement in the quality of service; and
d) Perform such other functions as may be prescribed.

NFRA has
been also entrusted with wide powers such as to investigate suo moto or
on reference made by the Central Government into matters of professional
or other misconduct committed by a chartered accountant or a firm of
chartered accountants. Once NFRA commences investigation, ICAI or any
other body cannot initiate or continue proceedings in such matters. NFRA
will have the same powers as vested in a civil court under Code of
Civil Procedures.

For proven misconduct, NFRA will have power to
levy penalty amounting to not less than Rs. 1 lakh but which may extend
to five times the fees received in a case of an individual and not less
than Rs. 10 lakh but which may extend to ten times in case of a firm.

NFRA
will also have the authority to debar a firm or a member from engaging
in practice as a member of ICAI for a minimum period of six months or
such higher period not exceeding 10 years as may be decided by NFRA.

Comments

NFRA
is authorised to act as a regulator for members registered under the CA
Act. This means it may also take action against the company officials
if they are chartered accountants. With constitution of NFRA, powers of
ICAI in regulating members’ conduct will be diminished.

Excessive Powers to Make Rules

In
spite of having in the Bill stringent regulations relating to the audit
and auditors, the Bill has given powers to the Central Government to
prescribe rules at as many as 19 places in Chapter X alone (in the
entire Bill at 346 places). A summary of provisions where powers to
prescribe rules have been given is as under:

Procedure for selection of auditors [Clause 139(1)]

Eligibility conditions for appointment as auditor [Clause 139(1)]

Classes of companies that require rotation of auditor [Clause 139(2)]

Approval from Central Government for removal of auditor [Clause 140(1)]

Statement by the auditor to be filed with ROC in case of resignation [Clause 140(2)]

The value of security that my be held in auditee company [Clause 141(3)(d)(i)]

Amount up to which auditor may be indebted to auditee company [Clause 141(3)(d)(ii)]

Amount of guarantee that may be given to the company in respect of any third person [Clause 141(3)(d)(iii)]

Nature of business relationship with the company [Clause 141(3)(e)]

Information to be included in the “financial Statements” [Clause 143(2)]

Matters that an audit report should include [Clause 143(3)(j)]

Duties and powers of auditors in respect of branches outside India [Clause 143(8)]

Time limit and manner of reporting of fraud to the Central Government [Clause 143(12)]

Prohibited services by an auditor [Clause 145]

Class of companies that need to maintain Cost re-cords [Clause 148(1)]

Items of cost that should be included in books of account [Clause 148(1)]

Net worth or turnover of the companies that require Cost audit [Clause 148(2)]

Manner of calculating remuneration of a Cost Audi-tor [Clause 148(3)]

Conclusion

It
is necessary for all of us to take serious cognizance of all these
provisions in the Bill. We need to understand the entire direction in
which the legislation is moving and be ready to build necessary
professional expertise as well as safeguards in the interest of the
profession.