The Concept of Propriety’— Dynamics & Challenges for Auditors

There is a saying that “we take propriety to encompass not only financial rectitude, but a sense of the appropriate values and behaviour”. Though the concept of propriety is generally associated with public sector activities, the time has now come to apply this concept even in the private sector due to the enhanced application of the ‘Agency Theory’ which requires an eloquent demonstration of the roles and responsibilities of the professional management running a company to all the stakeholders. With the changing environment, the expectations of the society have also changed and as a result, there is a greater emphasis on conformance with prescribed values, customs, procedures and practices, keeping in mind the public interest and greater application of prudence. This has resulted in an expectation of applying the concept of propriety in all the transactions carried out by the corporates and an endorsement of the same by an independent person. Consequently, the Statutory Auditors of the company, being independent, are expected to fill this vacuum. However, the Statutory Auditors focus more on the true and fair view of the financial statements and generally do not deal with the propriety aspects in depth due to various limitations and challenges. Whilst the auditors can certainly consider this emerging expectation as part of their audit process to the extent the same is significant and impacts the financial statements, there are certain practical challenges in dealing with the same. This article focusses on the concept of propriety along with its relevance for audits, propriety expectations from the auditors, responsibilities of the auditors in general, practical challenges in application of the concept of propriety in audits, audit defense to propriety concerns and the nuances of reporting propriety concerns by the auditors. This article is not intended to elucidate the responsibilities of the auditors regarding the frauds, if any, committed by the management.

What is Propriety?

In general, there is no fixed definition of the term ‘propriety’ which keeps changing, reflecting the changing expectations of society. The literal dictionary meaning of the term propriety encompasses ‘appropriateness’, ‘rightness’, ‘correctness in behaviour or morals’, ‘conformity with convention in conduct’, ‘the standards of behaviour considered correct by polite society’.

The core principles of the concept of propriety could be summarised as under:

• Integrity
• Openness
• Objectivity
• Honesty
• Selflessness

The concept of propriety can be related to various other concepts which are commonly known. To list a few:

• Accountability
• Legality
• Probity
• Value for money
• Fraud & Corruption
• Governance
• lInternal Control Environment

Practically, there is also a reasonable degree of overlap amongst application of these concepts and all the above can be analysed from the broad umbrella of propriety.

Propriety expectations from Auditors in India

Whenever the auditors carry out a Propriety Audit, they not only evaluate the underlying evidence, but also attempt to examine the regularity, reasonability, prudence and impact of various acts. In India, the audits performed by the Comptroller & Auditor General (C&AG) focus more on the propriety aspects and check the conformity with the established financial propriety standards.

Though the expectations of the statutory audit conducted under the provisions of the Companies Act, 1956 do not necessarily mandate a propriety focus on the part of the auditors, various amendments made to the Companies Act, 1956, specifically on the reporting requirements in the Auditors’ Report under the Companies (Auditor’s Report) Order, 2003 over a period of time indicate move in that direction. Certain illustrative instances of the same are given below:

• Auditors’ responsibility to inquire on the terms and conditions of the loans and advances to identify whether they are prejudicial to the interests of the company and its members.
• Reporting on transactions of the company which are represented merely by book entries and are prejudicial to the interests of the Company.
• Reporting on whether personal expenses have been charged to the revenue account.
• Reporting on reasonability of the pricing mechanism on transactions where directors are interested.
• Reporting on preferential allotment of shares to interested parties and the impact of the pricing on the interests of the entity.
• Reporting on the disqualification of the directors u/s.274(1)(g) of the Companies Act, 1956.
• Reporting on the frauds by or on the company.

In addition to the aforesaid reporting requirements, propriety expectations are also embedded in the Accounting Standards such as reporting requirements related to the Related Party Transactions in accordance with the AS-18. Needless to add, the Companies Act, 1956 contains several provisions relating to propriety elements such as greater level of monitoring/approval for transactions with directors/other interested parties, remuneration paid to directors, etc.

Responsibility of the Auditors

The Statutory Auditors who conduct their audit in accordance with the Auditing Standards for reporting on the true and fair view of the financial statements may not necessarily be in a position to meet the propriety expectations of society in totality due to their role/legal boundaries. In this regard, it is worth noting that propriety challenges would invariably result in fraud on the company or by the company which needs to be reported and considered by the Auditors. As per the Generally Accepted Auditing Standards in India, the Auditors should always conduct the engagement with a mindset that recognises the possibility that a material misstatement due to fraud could be present, regardless of any past experiences with the entity and regardless of their belief about the management’s honesty and integrity.

• The relevant/specific Auditing Standards which need to be considered by the Auditors in responding to the propriety challenges are as under: SA 240 — The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements
•  SA 250 — Consideration of Laws and Regulations in an Audit of Financial Statements ? SA 260 — Communication with those in charge of Governance
• SA 265 — Communicating Deficiencies in internal control to those charged with Governance and Management
• SA 315 — Identifying and Assessing the Risk of Material Misstatement Through Understanding the Entity and its Environment
• SA 330 — The Auditor’s Responses to Assessed Risks.

The primary responsibility for prevention and detection of fraud and error rests with both those charged with governance and the management of an entity. The objective of an audit of financial statements prepared in accordance with the framework of recognised accounting policies and practices and relevant statutory requirements, if any, is to enable the auditors to express an opinion on them. An audit conducted in accordance with the Generally Accepted Auditing Standards in India is designed to provide reasonable assurance that the financial statements taken as a whole are free from material misstatements, whether caused by fraud or error. The fact that an audit is carried out may act as a deterrent, but the auditors are not and cannot be held responsible for prevention and detection of fraud and error.

A Financial Statement Audit conducted in accordance with the applicable auditing framework does not guarantee that all material misstatements will be detected because of such factors as the use of judgment, the use of testing, the inherent limitations of internal controls and the fact that much of the evidence available to the auditors is persuasive rather than conclusive in nature. For these reasons, the Auditors are able to obtain only a reasonable assurance that material misstatements in the financial statements will be detected.

In view of the above, the responsibility of the Statutory Auditors towards the propriety aspects would be more limited and focussed on specific aspects of reporting and need not necessarily extend to the entire gamut of the transactions carried out by a company. However, propriety concerns, if any, noticed by the Auditors during their audit process should be given adequate importance and should not be overlooked. They should consider the same as part of assessing the risk associated with the entity and the environment in which it functions, and should deal with the same appropriately, including reporting to those in charge of governance, wherever required.

Propriety challenges for Auditors
Propriety is concerned with compliance with expectations of conduct and behaviour, which although not written into legislation or regulations, are generally accepted as being central to the management of the affairs of an entity. Acts of impropriety will be concerned with specific misconduct, knowingly perpetrated for personal or political gain. Similar acts, undertaken with lack of knowledge and motivation, are on the other hand, omissions of propriety. The effects on an entity are often the same but the auditors may need to bear this distinction in mind. Whether an act constitutes improper behaviour within the generally accepted standards of conduct expected in business is often a matter of interpretation and professional judgment. Invariably, the question of proving the propriety element would depend on facts and circumstances of the case. The availability of the proof and its adequacy is a matter of personal judgment of the Auditor.

Root cause for propriety issues
Propriety issues arise in entities due to the following:

•     Corporate culture

•     Poorly designed or operated internal controls

•     Ignorance of the rules or expectations of proper behaviour, especially in small and medium-sized entities

•     Urge to achieve targets/results in the short-term

•     Greed

Symptoms for propriety issues
The propriety challenges for the auditors could take different dimensions depending on the nature of the entity and the activities carried out by it. The symptoms of propriety concerns could arise from various matters such as:

•     Absence of business rationale for significant transactions

•     Lack of transparency in awarding contracts

•     Liberal/flexible arrangements with contractors

•     Transactions without written contracts

•     Entering into side agreements/arrangements with contracting parties

•     Avoidance of proper tendering procedures

•     Excessive involvement of agencies/ third parties

•     Having an overriding authority with few individuals for allowing exceptions

•     Situations where there is a conflict of interest

•    Large infructuous expenses triggering propriety concerns

•     Abnormally high hospitality expenses

•     Lack of conclusive evidence regarding the ultimate usage of funds

•     Weak Audit Committee/Board Members who are silent spectators

•     Absence of appropriate disclosures in the financial statements

•     Lack of sanctity for the Internal Audit/other audit observations.

Acts of impropriety
By studying the symptoms carefully, the Auditor may identify transactions where there are propriety concerns for the entity. Though the acts of propriety may vary from entity to entity depending on the nature, environment, etc., instances of the acts of impropriety could take any of the following dimensions:

•     Facilitation payments, bribes, speed money paid for expediting clearances, getting things done fast which are coloured differently.

•     Awarding contracts at a price lower than the expected value.

•    Exorbitant service charges which are not commensurate with the services rendered.

•     Excessive remuneration to promoters/directors which does not commensurate with the services rendered.

•     Preferential treatment in making appointments either of contractors or of staff.

•     Misuse of office for personal purposes.

•     Foreign travel by senior management and board members without proper justification or clear benefit to the entity.

•     Inflating the payments to vendors for services rendered/goods delivered where the vendors make certain improper payments on behalf of the entity which triggers propriety issues.

•     Disposal of scrap at a value much lower than its realisable value.

•     Selling shares held by a company to another company at a consideration above cost but substantially below the market value.

•     Structuring the transactions with group companies which are de facto related parties in a manner that does not apparently fit into the definition of related party.

•     Recruitment of employees based on recommendations of authorities as a quid pro quo for consideration received.

Though the propriety concerns could be factored in by the Auditors as part of their audit process, there are a number of factors that significantly limit the extent to which an audit of financial statements can be expected to identify impropriety, including:

•     Multiple versions of the concept of propriety and its meaning

•     Absence of adequate evidence of conducting the business

•     Concealment and collusion

•     Difficulties in identification of impropriety elements by an outsider

•     Application of the concept of materiality by the auditors

•     Actual/Perceived scope limitation on the part of the audit process

•     Skills required on the part of the auditors for identifying transactions involving impropriety

•     Lack of clarity in the statutory provisions dealing with the roles and responsibilities of the auditors.

In view of the various challenges listed above, it may not be possible for the Statutory Auditors to confirm propriety aspects of all the transactions entered into by the entity as part of his audit. Hence, subsequent discovery of acts of impropriety by the entity audited may not imply inadequate/ improper audit.

Audit Defense for Propriety Concerns
Whilst external Auditors of companies are not required to perform specific procedures for the purpose of identifying improprieties as part of their audit of the financial statements, they should remain alert to instances of significant possible or actual non-compliance with general standards of public conduct. In particular, the Auditors may develop a general appreciation of the framework of governance and standards of conduct within which the company conducts its activities during the course of their audit to gain an understanding of the overall internal control environment. This can be an important potential source of information on any impropriety.

As part of the Auditor’s responsibility to assess the overall internal control environment, the Auditor is required to assess inherent risk, taking account of factors relevant to the entity as a whole. In this regard, the Statutory Auditors could:

•     Familiarise themselves with the general regulations, rules and other guidance relating to the conduct of the company’s business.

•     A thorough understanding of the company and its business and a review of its financial control environment.

•     Enquire of the management about the company’s policies and procedures regarding the implementation of code of conduct and instructions, while having regard to whether the policies and procedures are comprehensive and up to date.

•     Discuss with the management and internal auditors the policies or procedures adopted for promulgating and monitoring compliance with relevant codes and instructions.

•     Read minutes of the board and management meetings to pick up matters of propriety concern.

•     Read the newspaper articles related to the company.

•     Review the arrangements for whistle-blowing.

•     Discuss with client staff in various departments including operations.

•     Focus on areas, if any, which have not been reviewed by them for a number of years.

•     Introduce surprise elements in the audit process.

The Auditors may also discuss their plan to perform the stipulated audit procedures to identify any propriety concerns with the Audit Committee/ those in charge of governance. This by itself could create moral pressure on the environment as well as on the management. In the process of identifying the propriety concerns, the Auditors should not go overboard and over audit the entity which may not be warranted.

The Auditors may also closely assess the following to form their opinion regarding the entity’s response towards propriety challenges:

•     Tone at the top in dealing with the matters of impropriety.

•     Extent of evangelism of the principles of propriety amongst the employees by the management through code of conduct/ ethical training, etc.

•     Process of obtaining compliance declarations from the management to confirm the propriety elements for all the contracts/transactions entered into by the company.

•     Extent of interference by the promoters with the professional management personnel.

•     Sanctity given to various processes and procedures.

Reporting by the Auditors
If there are impropriety symptoms identified in the course of enquiry/discussion or verification by the Auditors, it is appropriate for them to report the same to the management or even to those in charge of governance and to consider their impact on audit risk. When the Auditors become aware of any failure of propriety, they should aim to understand its nature and the circumstances under which it has occurred and sufficient additional information should be obtained to evaluate the possible impropriety. If the Auditors consider that the impropriety could be significant, they may perform appropriate additional procedures and document the results.

The extent of additional procedures the auditors decide to perform in response to impropriety is a matter of professional judgment and depends on:

•     Its impact on the financial statements

•     Nature of the impropriety

•     Persons involved

•    Likelihood that the impropriety may have led to loss of funds

•     Likelihood that the suspected impropriety involves fraud

•     Extent to which further procedures can be expected to clarify the situation

•     Extent to which the impropriety indicates that other impropriety or mismanagement may be present

•     Likelihood of the need to report.

Where there is suspicion of impropriety but an absence of evidence, the Auditors may consider drawing the management’s attention to the possibility of introducing procedures that would generate evidence were the suspicion to be well founded.

To explain this concept further with an example, if the management has entered into a contract for disposing of the scrap for a value which is less than its actual realisable value for benefiting somebody, the amount received and recorded as per the books and pursuant to the contract, duly approved by an appropriate authority, need not necessarily pose an accounting challenge; however, the real value of the transaction has not been reflected in the books of account due to an act of impropriety which would definitely trigger an audit concern. This has to be investigated further and the same has to be appropriately dealt with.

Significant matters of impropriety would require appropriate reporting by the Auditors not only in their Audit Report but also communication to those in charge of governance. At the earliest suitable opportunity, the Auditors should discuss their findings at an appropriate level of management whom they do not suspect of involvement with the impropriety. Wherever there is an Audit Committee, the auditors should also discuss their findings with them.
    
If the auditors consider that impropriety may have or has occurred, they may need to reconsider their assessments of audit risk and the validity of the management’s representations. For example, a series of suspected or actual instances of impropriety that are not significant financially may be symptomatic of the management’s general disregard for proper conduct and hence may cast doubt on the general integrity of the management.

The method of reporting on audit work relating to propriety will vary depending on the nature of the work undertaken and its results. The auditors may also consider communicating the propriety concerns, if any, primarily due to internal control lapses to the management through a management letter. The auditors should also request the managements to place the management letters along with the management’s responses before the Audit Committee.

Conclusion
Impropriety is considered as one of the serious evils in all the countries and in particular in the developing countries. Governments in various countries are attempting to enact/strengthen various laws to combat impropriety. They are aware of the fact that the first stage in the dynamics of the rule of law is the framing of effective rules and laws, which are equipped to hinder the ever-rising escalation of the impropriety graph. There is nothing in this world which can guarantee high standards of propriety but appropriate safeguards can be put in place to minimise the risk of impropriety occurring or remaining undetected. These safeguards include:

•     Clear expectations of standards of individual behavior.

•     Appropriate internal controls to provide checks and balances against individual misconduct.

•     External supervision to hold the organisation accountable.

Above all, such safeguards help to create a climate and culture in which high standards of propriety is valued.

In India, the proposed Companies Bill, 2011 contains various provisions relating to propriety aspects, including a provision of direct reporting of frauds by the Auditors to the appropriate authority which would enhance the role and the responsibilities of the Auditors considerably and is in the direction of thrusting propriety principles as part of the audit expectation. The Auditors should be cognizant of propriety concerns and the expectations of society in discharging their professional duties within the legal framework which would go a long way in setting the standards for audit excellence.

Reference material

•     Indian Auditing Standards

•     Report of the Public Audit Forum, UK

•     Nolan Committee Report, UK

•     Various Research Reports on Audit process available for General public.