Birth of Independent Audit Regulation in India: An Analysis with US Perspectives

Robust capital markets require highest levels of transparency in accounting. Therefore, several jurisdictions have established independent audit regulators. In India, three major audit scandals have recently led to the creation of the National Financial Reporting Authority (the “NFRA”) on the lines of the Public Companies Accounting Oversight Board (the “PCAOB”). The PCAOB was created as the independent audit regulator in the USA as a response to Enron and other infamous audit scandals. The Sarbanes-Oxley Act 2002 shifted the oversight of audit firms of public companies from the American Institute of Certified Public Accountants to the independent and external PCAOB. This post analyses the similar transition in India, from self-regulation of chartered accountants acting as auditors of listed companies and certain (yet to be specified) large public companies by their peers, who are all registered with and regulated by the Institute of Chartered Accountants of India, to their independent and external regulation. It also makes critical suggestions for the success of the new regulatory regime. 

The unholy trinity of accounting scandals and the birth of the NFRA

Three major audit scandals led to the creation of the NFRA. In 2009, a colossal fudging of accounts aimed to artificially inflate the stock price of Satyam Computer Services Limited, which was also listed on the NYSE, shockingly escaped the scrutiny of its auditors. The creation of an independent audit regulator was proposed as a result, but no concretemeasures were implemented. Earlier, soonafter the enactment of the Sarbanes-Oxley Act 2002, the proposal for independent audit regulation in India had already been examined and rejected by the Naresh Chandra Committee on Corporate Audit and Governance. In the aftermath of the Satyam scandal, the NFRA as an independent audit regulator resembling the PCAOB was proposed again, but it was not implemented.  

In February 2018, it was discovered that the failure of the auditors of publically traded Fortis Healthcare Services Limited, to report their suspicions of fraud, had facilitated the siphoning of billions of rupees. Shortly thereafter, the shocking negligence of the auditors of Punjab National Bank also came to light. Audit failures led to the unchecked issuance of fraudulent letters of undertaking by the bank, inappropriately guaranteeing buyers’ credit offered by certain overseas financial institutions to various firms, in sheer violation of banking standards. This finally prompted the Indian Government to establish the NFRA by implementing the statutory provisions relating to its establishment, which were already framed by the Indian Parliament when enacting the Companies Act 2013 (the “CA 2013”), unfortunately leaving the effective date of their implementation to the executive discretion of the Indian Government. The Indian Government has also framed rules for necessary appointments recently, in exercise of such discretionary power also delegated to it by the Indian Parliament. More rules are in the offing, including thresholds identifying public companies whose auditors will face independent regulation.

Under the new regime and in terms of Section 132 of the CA 2013, the NFRA is tasked with recommending auditing and accounting standards, monitoring audit quality, and overseeing compliance. Like the PCAOB, the NFRA is an independent and external regulator, similarly empowered to monitor performance of audit firms, with investigative powers as well as quasi-judicial disciplinary functions. 

Suggestions to strengthen the NFRA

Composition:The recently notified rules prescribe that the NFRA will include representatives of the Securities and Exchange Board of India, the Reserve Bank of India (the central bank), and the Institute of Chartered Accountants of India. Unfortunately, situations of conflict of interest might arise since such agencies are responsible for prosecution for violation of various statutes and also discharge regulatory functions, whereas their representatives in the NFRA will act in quasi-judicial capacity. Therefore, erstwhile members of such agencies should be appointed to the NFRA. Further, the Sarbanes-Oxley Act 2002 limits the membership of certified public accountants on the board of the PCAOB to two members. Likewise, the appointment of chartered accountants to the NFRA should be similarly restricted. It is critical that the NFRA’s composition ensures objectivity. 

Enforcement: The NFRA may conduct investigations suo motuor upon reference by the Indian Government in case of professional or other misconduct. Like the PCAOB, the NFRA may impose fines or suspend errant audit firms, which powers were never available to the Institute of Chartered Accountants of India. The NFRA’s powers should be expanded on the lines of the PCAOB, which has the power to even debar an individual’s association with registered audit firms. 

Audit inspections: When the NFRA recommends standards to the Indian Government, it should favour selection of audits for inspection and identification of their specific portions for deeper scrutiny based on risk-weighted factors rather than representative sampling, following the PCAOB’s practice. It will ensure effective identification of audit deficiencies and review of quality control systems. The NFRA should have complete discretion to select audits and their specific portions for inspection. It must review documents that support an audit firm’s opinion and emulate the PCAOB’s practice of questioning firms about potential issues identified in their audit work, while providing an opportunity to the firm to respond. In case of an unsatisfactory response, the audit deficiency should be included in the public parts of the NFRA’s inspection report. Like the PCAOB, the standards violated by the auditor should be specified in the report. This will ensure that audit deficiencies are effectively communicated to all stakeholders and auditors tread cautiously to safeguard their reputation.

Inspection approach: The auditors of Satyam did not detect several accounting irregularities, such as artificial inflation of profits and cash account, despite such practice continuing over several years. Although Satyam’s statutory auditor was registered with the PCAOB, the regulator also failed to detect any significant audit lapses despite an audit inspection in 2008. The NFRA should therefore closely scrutinise audits of the various individual components of financial statements (such as cash stated on the balance sheet), which components are often ignored by auditors as they are considered ‘low risk’ areas. 

Disclosures: The PCAOB makes certain parts of audit inspection reports public to expose negligent audit firms. The non-public parts of inspection reports, which contain quality control criticisms, are also made public if the firm fails to address such criticisms within 12 months. This can have a significant impact on audit quality, auditors’ reputation, and client retention. The PCAOB has also adopted a new standard (effective 2019), requiring auditors to report critical audit matters in which the auditors had to confront the management. Such practices must be adopted by the NFRA as well.

Saumya Bhargava is a lawyer (advocate) focusing on commercial litigation.