The enhanced regulations in relation to audit and auditors in the Companies Bill follow the dictum: ‘Accounting is too important to leave to accountants alone’. An important part of the reforms covers the role and responsibilities of auditors, who play a pivotal role in governance of companies.

Auditor rotation

The legislation prescribes mandatory rotation of auditors for listed companies (and such other companies as may be prescribed) where two terms of five years each have been completed by the audit firm.

The practice of rotation of auditors is in force for many years, in the insurance and banking sectors and in the public sector, and there are no indicators that this has resulted in any visible difference in audit quality. A major concern on rotation would be the availability of a sufficient number of audit firms to take up the audits of over eight lakh listed companies.

The implementing rules should perhaps consider phased rotation. Care should also be taken to ensure that audit fee undercutting does not take place when the existing auditor is replaced, as this would significantly undermine audit quality.

Internal financial control

The provisions of law extend the auditors’ reporting responsibilities and require the Auditors’ Report to state whether the company has adequate internal financial control systems in place and the operating effectiveness of such controls.

This appears to have been drawn from the experience of US legislation that requires the management and the external auditor to report on the adequacy of the company's internal financial controls. The processes leading up to certification by both management and the auditors are rigorous and costly for companies to implement.

The mandate would, however, ensure rapid skills development and employment opportunities for young chartered accountants. There could, however, be a substantial dilution in implementation, unless appropriate rules and standards are notified and made mandatory for both companies and auditors.

Restrictions on services

The law prohibits auditors from rendering certain specified non-audit services. These include accounting, design of financial information systems, investment advisory and management services.

Audit firms provide extensive skills training to their employees, to enable them to provide a range of services. These services, such as valuations, acquisition advisory, IT security and privacy, risk assessment, forensic and taxation, are complementary to audit skills, and assist the firms in performing their primary role as auditors. A blanket ban on provision of management services could therefore be counter-productive, as there are many areas in which an experienced specialist employed by the audit firm is best suited to evaluate complex transactions and advise the company on the implications.

As is the case in the US, the rules that are under formulation should prohibit specific services that impair independence, but allow discretion to the audit committee to decide on whether some of the other services are best provided by the auditor, who has in-depth knowledge of the company and can keep confidentiality.

The legislation provides that auditors have access to records of all subsidiaries, as it relates to consolidation requirements, which is a positive development. Moving in the same direction, the implementing rules should consider exclusion of subsidiaries in counting the limit of 20 companies per partner (regardless of size), as this would otherwise result in the audit partner only being able to audit a single group of companies.

The provisions envisage that the auditor would be a whistle-blower and report to the Central government in case a fraud is believed to have been or is being committed against the company by its employees or officers.

This needs more thought in implementation, as early reporting of an unsubstantiated fraud could have a significant impact on share prices, and damage, rather than protect, shareholder interest.

Finally, the Bill provides for a wide range of penalties on auditors. It provides that they may also be liable to refund remuneration received and pay damages to the company, statutory bodies, authorities or other persons.

All partners of the audit firm are to be jointly and severally liable. The concern here is that the law, arbitrarily applied, will cause hardship to the audit community, and drive away talent from the profession. The statutory auditor who exercises due diligence should be provided protection in his public service role so that he can perform the same without fear or favour.

It is expected that an independent National Financial Reporting Authority can play an important role.

(The author is Managing Partner – Audit, Deloitte Haskins and Sells)