Qualification in an auditor’s report on the financial statements of listed companies is a matter of global concern. In certain jurisdictions, regulators do not accept qualified audit reports. For example, the US SEC does not accept a qualified audit report unless the qualification has been pre-approved by its staff.

In India, although the Institute of Chartered Accountants of India regulates members in the audit of financial statements, there was no regulatory oversight on companies until recently. Hence, some listed companies may have filed financial statements where the auditors’ report was qualified. To regulate such practices, SEBI issued a circular early this month.

According to the mechanism laid down, a listed company will submit its annual audited financial statements with the applicable form, namely Form A for an unqualified report (or report containing matter of emphasis), and Form B for a qualified report. The audit reports received in Form B will go through three levels of review — preliminary scrutiny by the stock exchange, review by the Qualified Audit Report Review Committee set up by SEBI, and review by the Financial Reporting Review Board of the CA Institute. If the explanations given are not satisfactory, SEBI may ask the company to restate its financial statements. The market regulator has prescribed an upper limit of approximately four months from the end of the half-year in which the exchange receives the qualified report, to complete reviews and communicate the decision to the company. This mechanism is applicable to annual results for periods ending on or after December 31, 2012.

However, the Companies Act restricts restatement of standalone financial statements after their adoption in the annual general meeting and filing with the Registrar of Companies. From the time limit set for the review of qualified reports, it appears it may not be completed before a company holds its AGM or files with the Registrar. This calls for an amendment in the law.

Nevertheless, significant benefits are expected from the SEBI circular:

Global experience shows that investors and analysts may view restatements negatively. To avoid this, many listed companies may amend their financial statements and avoid qualification. Hence, it may act as a significant self-regulation measure.

In accordance with the mechanism, the stock exchange, the QARC and the FRRB will evaluate all qualifications. They may also discuss with, or seek explanation from the management, audit committee and auditor. This will provide greater insight into the qualification and its potential impact. Based on the insight, SEBI may provide recommendations to the company for resolving the qualification. If the qualification is not justified, the CA Institute may take up the issue with the auditor.

Although SEBI may not require restatement of last year’s standalone financial statements due to legal restrictions, it may still require a company to correct the error in its next financial statement and disclose it as a prior period item.

There is no restriction on the restatement of consolidated financial statements in the Act. Hence, SEBI may require companies to restate consolidated financial statement, and thereby make accurate information available to investors.

SEBI’s decision to review qualified audit reports is expected to strengthen capital markets in the long run. Despite the legal challenges with regard to standalone financial statements, a significant improvement in financial reporting can be expected. Listed companies should be wary of audit qualification, as it potentially exposes them to restatement — and consequent loss of reputation.

Vishal Bansal is a senior professional in a member firm of Ernst & Young Global

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