The Hindu Business Line : Promoters cannot afford to alienate accountants

ACCOUNTS and audit are mere ancillariesto commerce and industry. Nothing profound or original can be reasonably expected from accountants and auditors as professionals, but the fact that they lend essential support to all human activities which have financial implications is incontrovertible. Their contribution to the economy as a class is invaluable.

But that does not mean that the public should close its eyes to the temptations and risks to which they are exposed and avoid devising suitable counteractive measures to prevent anything being done that is adverse to its interests.

It is regrettable that obliviousness to this fact of life is one of the weak spots in the Irani Committee's report.

Accountants are `insiders'

There are two extreme views of a chartered accountant's equation with the company or group of companies for which he is the statutory auditor. One is that he eats out of the hands of the promoters of the companies. He is invariably their tax adviser entrusted with all their tax planning and paid by them handsomely. Their relationship is one of mutual trust and their ties are almost indissoluble.

The other is that an auditor knows all the skeletons in the cupboards of the companies and their promoters, as he is their conscience keeper, and his implicit duty is to cover up their track and safeguard their interests all the time. How he gets paid for his services is rarely disclosed in any detail.

The company law in India does not visualise severance of their relationship in ordinary circumstances.

How involved with his client's affairs an accountant can become will be evident from the fact that one of the four or five giant firms of accountants bestriding the US had to compound some of the offences that it had committed probably in the course of the service provided to their clients with hefty penalties or `consideration' to the state during the last few years.

How far trust in accountants can get them involved with large business groups/houses and the agonising experience they have to undergo as a result of such involvement should be manifest in India from the unfolding story of Lodha and the different branches of the House of Birlas. The relationship between accountants and promoters/controllers of companies seems to be one of love and hate. Accountants, whether they are employees or statutory auditors or `internal' auditors or special auditors, are necessarily and inherently insiders whom the promoters have to keep under continuous leash in their own interest.

Auditor, company connection

There is probably no country in the world where the auditor does not also deal with the tax matters of the company the accounts of which have been audited by him or by the firm of auditors of which he is a partner.

A company goes to a lawyer only when questions of law arise or where there is no alternative to the engagement of a counsel, say, in the High Court or the Supreme Court.

Wherever facts have to be unravelled or defended it is the accountant on whom the company and its promoters depend. Their connection continues throughout the financial year unlike the lawyer's engagement, which is casual and limited. It is true that the `verification' of a return of income can be made only by the taxpayer concerned unless the taxpayer is a non-resident. But it is the accountant who does all the spadework and computes the income even if the assessee may himself `verify' the declarations he makes in the return.

Whistle blowers have become heroes in India as in the US. But ordinarily, whistle blowing by any one in the accounts department or by the auditor, internal or statutory, would be more interesting and useful than `peaching' by the company secretary who is not more than a figurehead in most companies. If the statutory auditor does not know what is wrong and where exactly, who does?

The accountant who maintains the accounts in any unit of the company may be able to give precise and valuable information on the basis of what he has personally done, but he is like one of the seven blind men who took parts of the elephant's body for the whole. The statutory auditor is "the man who knows too much", the man who really matters, more dreaded than the others.

Though the country is reported to have over 1,30,000 chartered accountant in India, it is surprising that all the big companies are handled by a small number of chartered accountants, as in the US and the UK. It is clearly in public interest to ensure that a company should not be tied to the same firm of chartered accountants for years together.

The Madras High Court has held in the Institute of Chartered Accountants of India vs K Bhagavatheeswaran (AIR 2005 Madras 287) case that notifications specifying that a member of the Institute would be guilty of professional misconduct if he accepts in a financial year more than a specified number of audit assignments under Section 44AB of the Income-Tax Act, 1961 and if he accepts audit work involving receipt of audit fees in excess of the specified amount impose unreasonable restrictions under Articles 19(1)(g) and 14 of the Constitution of India.

The High Court has expressed the view that the choice of a lawyer or a chartered accountant and the fee payable for the service should be left to the option of the professional and his client. We respectfully differ from the approach. We submit that it may not be unconstitutional to insist on a rotation of auditors of a company at the end of every fixed term of, say, five years and that a company should not engage either the same chartered accountant or a near relative of his (or hers) or a partner of the firm in which he or a near relative of his (or hers) is a partner, for a specified period of years.

Such a stringent stipulation may be conducive to the objectivity, impartiality and probity that are indispensable not merely in the interest of the existing shareholders of the company but also in the interest of the potential investors in it. If the company is a listed one, the same condition should be included in the listing requirements of all the stock exchanges in which the company's shares may be traded.

Since a company is a creature of the law, the Companies Act, 1956 to which it owes its origin and identity can legitimately enforce compliance with the requirements that the independence of audit and the interests of the shareholders of a company should be protected by a system of rotation which can be made more rigid and fool-proof in the light of experience in due course.

Duty of care of a statutory auditor

A point on which there was a doubt 15 years ago was whether the statutory auditor of a company had a duty of care to the public at large or even the potential investors in a company.

In Caparo Industries PLC vs Dickman, the Court of Appeal in the UK held that while there was no relationship between an auditor and a potential investor sufficiently proximate to give rise to a duty of care at common law, there was such a relationship with individual shareholders so that an individual shareholder who suffered loss by acting in reliance on negligently prepared accounts whether by selling or retaining or purchasing shares, was entitled to recover compensation in tort.

The auditors filed an appeal to the House of Lords while Caparo also went up in cross appeal with reference to their claim that the auditor owed them a duty of care as potential investors. The House of Lords unanimously allowed the appeal and dismissed the cross appeal.

Much has happened since. Special provisions have been made in the Securities and Exchange Board of India Act, 1992 and the Securities Contracts Regulation Act, 1956 to protect the interests of the shareholders. Section 68 of the Companies Act provides for penalty for fraudulent inducement to invest money through a prospectus. The listing agreement which is to be signed by all companies which want to have trading done in their shares in the recognised stock exchanges, require proper corporate governance in addition to other stipulations. Sub-section (1) of section 211 of the Companies Act expects every balance sheet to give a true and fair view of the state of affairs of a company at the end of the financial year. Similarly, every profit and loss account of a company shall have also to give a true and fair view of the profit or loss of the company for the financial year.

The new sub-section (3A) inserted in Section 211 with effect from October 31, 1998, makes it clear that every profit and loss account and balance-sheet of a company, irrespective of whether it is private or public, shall have to comply with the prescribed accounting standards, disclosing all deviations from the accounting standards, the reasons for each deviation and the financial effect, if any, arising due to such deviation.

In such circumstances, can there be shadow of a doubt on the obligation of an auditor to see that the profit and loss account, balance-sheet and other statements that he certifies as providing a true and fair picture of the affairs of the company, do not mislead an innocent third party into investment in the company's shares, to his detriment? Such duty of care appears to be mandatory even in the case of a private company. The Companies Act should be amended to remove all doubts in the matter.

Since a company owes its very existence to the law, the law can leave no scope for such a legal entity being misused by any one in control of its management as well as any one who utilises it for carrying on any commercial activity.

Any device by which the profits and the intrinsic value of the securities of a company are manipulated to suit any individual's personal ends can only be construed as an unfair practice. Why should the law not make this explicit through a specific provision in the Companies Act?

(By arrangement with Corporate Law Adviser, New Delhi.)

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