The National Financial Reporting Authority (“NFRA”), India's audit regulator, earlier this year, published a circular relating to the appropriate discharge of statutory auditors' obligations for reporting fraud.
The circular referred to a recent Supreme Court ruling (“SC ruling”) that held that statutory auditors are not automatically absolved of their responsibility to report fraud, whether real or suspected, in a company by resigning from their engagement without having reported the same.
Noticing that several statutory auditors of the entities regulated by them had not been fulfilling their obligations to report fraud, the NFRA notified a change in practice standards in line with the Supreme Court ruling.
The following are key points raised in the circular –
- Statutory auditors would not be absolved of their statutory obligations by simply resigning from their engagements.
- Statutory auditors are required to operate with a level of professional scepticism and not be influenced by legal opinions provided by the Company or its Management while making their evaluations.
- Statutory auditors are required to report instances of real or suspected fraud even if they were not the first to identify it.
Current Auditing Practice
The Companies Act, 2013, widely defines fraud to be inclusive of abuse of position and concealment of facts with intent to deceive the company or its shareholders, regardless of actual wrongful gain or wrongful loss. Any instances in this regard are likely to trigger the reporting obligations of auditors. Auditors are required to report to the Central Government if they have reason to believe that an offence involving fraud amounting to INR 10 million (~USD 12,000) or more has been committed against the company or by its employees. Where the amount is lesser, auditors must report the same to the Audit Committee or the Board specifying the nature and amount of the suspected fraud. This information must subsequently be disclosed in the Board's Report.
The general practice has been to only report instances of fraud that auditors have themselves come across during the course of their duties. Further, the extent of their responsibilities and obligations was understood to be till their engagement by the company. However, this position has been reversed by the SC ruling and its expansive reiteration in the NFRA circular. In the SC ruling, it was held that litigation against an auditor for failing in their reporting obligations would not be automatically terminated just because he had resigned from his engagement. Simply put, the consequences of non-reporting cannot be avoided if the auditor had knowledge of the fraud prior to their resignation/termination.
Gaps and Consequences
The introduction of this circular will have several implications for both businesses and auditors operating in India.
Knowing that resignation will not absolve them of their duties, auditors will be hyper sensitive to the minutest hints of fraud or suspicious transactions in company operations and documentation. Their failure to report such incidents will influence and change their routine audit procedures. We have seen audit sign offs being held up due to these hyper-sensitive positions being taken by the auditors.
Further, due to these enlarged obligations on auditors, companies will have to rejig their existing accounting practices and ethical corporate conduct. Since auditors have been advised not to rely on the company's assessments and/or management representations, auditors will likely involve their own or external legal and risk analysis experts which could further delay completion. This may consequently require auditors to account for potentially extended timelines during audits and internal investigations to ensure accuracy and objectivity.
Materiality and judgement
Although the circular is a welcome move towards strengthening transparency and accountability for companies and shareholders, it has left several ambiguous gaps. For instance, the circular does not refer to any materiality thresholds for reporting fraud. This leaves open the question of whether even a petty incident that gives auditors a ‘reason to believe' that they could constitute fraud will require reporting. It is essential that auditors are able to exercise judgment based on materiality in good faith to enable businesses to function without undue latches and delays.
There is also no explanation of the types of fraud that are to be reported which can prove onerous when whistle-blower complaints involving frauds are reported, which typically take time to investigate and conclude.
The NFRA is likely to eventually bring more clarity to the circular to enable businesses to adjust to these new standards.
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