The annual inspections of major audit firms planned by the National Financial Reporting Authority (NFRA) will help bolster compliance with auditing standards and protect the interests of investors and shareholders, said its chairman Ajay Bhushan Pandey. In an interview to ET’s Banikinkar Pattanayak, he said the regulator is also planning to hold talks with the audit committees and independent directors of listed firms. He said the regulator has found that in some cases, the entire meeting between the auditors and the audit committee of listed companies has been reduced to a formality, which must be avoided. Edited excerpts:
Why did the NFRA decide to conduct annual inspections of major audit firms? Is it a regulatory crackdown?
Let me first make it very clear that it is not a regulatory crackdown. As per section 132 of the Companies Act, the NFRA has the responsibility of monitoring and enforcing the compliance of accounting and auditing standards. These inspections should be seen as an exercise to fulfil that mandate. Also, inspection is a regular feature of major audit regulators across the world, including in the US, the UK, Canada and Australia. So, this is a standard monitoring mechanism across jurisdictions.What we are trying to do is to protect shareholders’ interest, which is important when India is poised to become a $10-trillion economy in the next few years. Moreover, thanks to the massive growth in digital public infrastructure in recent years, millions of small and retail investors, in addition to the big domestic and foreign ones, are putting their money in the capital market. It is very essential to protect the interest of such a large number of investors, including the retail ones. And that is why, it is very necessary to ensure accurate financial reporting, good corporate governance and also good audit quality in listed companies. This is our fiduciary responsibility.What would be the focus of your annual inspections?
The purpose of such inspections is to monitor the audit firms and look at their practices, particularly the quality control, among others. We will see to what extent the auditors follow those standards or maintain their independence or exercise any oversight over the engagement team which does the actual audit. If we ensure the quality of the auditors at the source (audit firm) itself, it will have a salutary effect on the listed companies they audit.
Similarly, if the audit documentations have been maintained properly, it gives confidence to the regulator and to the entire ecosystem.
Importantly, since the inspection is not a disciplinary proceeding, auditors are given ample opportunities to explain things and also improve. So, these inspections are an integral part of the monitoring process to get to the root of audit problems, if any, and then try to address them so that they don’t explode into a crisis.
The NFRA has objected to non-audit services extended by certain audit firms to companies of which they are statutory auditors. Is there a regulatory grey zone with regard to what services can be taken up by the auditors and what not?
There is no grey zone. Non-audit services are very intricately linked to the issue of auditor independence. The conduct of the auditor should be such that it must inspire confidence among the shareholders. The auditors are appointed by a company’s shareholders, and not by the management. They are expected to provide a true and fair view of the company and not just toe the management line. But if you are not independent, then you cannot exercise professional scepticism. And if an auditor or its related party is involved in non-audit activity relating to the same client of which it’s the statutory auditor, this can create a conflict of interest or lead to what is called the “familiarity threat”, “self-review threat”, “advocacy threat” or “financial interest threat”.
So, all these things should be avoided. Often people read only section 144 of the Companies Act (which deals with prohibited non-audit services) and not the Code of Ethics. Once they read both, there should be no confusion.
How would you ensure the audit committee of companies, comprising mostly independent directors, play their part in improving audit quality?
Auditing standards require that there should be an effective two-way communication between the auditor and those charged with governance of a company, which is usually the audit committee and the board. We have seen that in many cases of corporate failures the auditors didn’t clearly point out signs of stress in their audit reports to the shareholders. Then we found that there was no effective two-way communication. Had the independent directors or the audit committee asked relevant questions to the auditor, the auditor would have been forced to address those questions. Similarly, if the auditor had raised certain issues with the audit committee, the independent directors and the board, they would have probably taken remedial measures on time. This could then have prevented a corporate collapse or fraud. In some cases, we find that this entire meeting between the auditors and the audit committee is reduced to a formality—that is, before the board meeting to approve the financial statement, the audit committee meeting is held for 15-20 minutes. This should be avoided and there must be effective two-way communication throughout.
Is there any plan to address this issue?
We are planning to soon have dialogues with the audit committees of the listed companies where we find initial signs of trouble which, unless checked or addressed early, could flare up. In such cases, we will have a dialogue with those charged with governance, particularly the audit committee, so that we can make them aware of their responsibilities. This will enhance the overall quality of the financial statement as well as audit, which in turn, will improve shareholder confidence.
In recent months, Byju’s has gotten into trouble, with its former auditor resigning in the wake of a delay in the announcement of its financial results. Does the NFRA have a role in regulating audits of large private firms?
The NFRA’s mandate is to recommend accounting and auditing standards and also monitor the enforcement of these standards. It was set up under Section 132 of the Companies Act, 2013, which gives it powers to take action against auditors of all listed and large unlisted public limited companies for professional lapses. Private companies are not within the inherent jurisdiction of the NFRA. However, the government has the powers under the Companies Act to refer any such cases to the NFRA, considering the larger public interests involved.
What new initiatives are you taking to further bolster the overall audit ecosystem?
First, we have started the inspection of audit firms in sync with the global best practices; it will be an annual affair. During the inspection this year, we will also verify the steps that the audit firms have taken with respect to the issues which we identified earlier. We will conduct the inspection of a larger number of audit firms this time. We will deploy data analytics and artificial intelligence to select the companies for inspection so that we can use our resources optimally.
Second, we will have dialogues with the audit committees and independent directors of listed companies so that they can improve the quality and accuracy of the financial statements.
Third, we are undertaking many outreach activities such as seminars, workshops, etc. We have become a member of the International Forum of Independent Audit Regulators. And we are organising, for the first time, an international conference on March 5-6, which eminent experts from across the globe and our counterparts from the US, Austria and other countries will attend. The idea is to facilitate the exchange of inputs and share experiences on how best to improve the quality of auditing. The topic of the conference is “Transparent Financial Reporting and Audit Quality: The Pillars of Corporate Governance”. Today, financial reporting and audit quality is the heart of corporate governance.
