This article is written by Ravi Karan, pursuing a Diploma in Companies Act, Corporate Governance and SEBI Regulations from LawSikho.com. Here he discusses “Five reasons why auditors resign before their term”.
USD 1.47 Billion – What is the significance of this number?
Unethical practices of corporate tycoons such as Nirav Modi, Mehul Choksi, Vijay Malya, Shivinder Singh, Malvinder Singh & Ramalinga Raju brought a bad name to the business ethics of India Inc. Central Government was forced to explain wrongdoings, however, when they were made to stand in the witness box, they blamed auditors for all these unprecedented lapses.
An auditor is solely responsible for vetting the financial statements of the company. “PERIOD”.
We should not pass the buck to auditors for every illegal activity in the company. It is perceived generally that an auditor is a watchdog of an entity, therefore they should be investigated for any or every fraud.
Having said that it cannot be concluded that the findings of the central government are inaccurate completely. But the situation demands a thorough examination of issues faced by auditors during the course of their client engagement.
Coming back to the question USD 1.47 Billion – What is the significance of this number?
India experienced its Enron moment during the twilight years of the first decade of the 21st century. That moment leads to the biggest showdown for Indian auditing industry.
Mr. Ramalinga Raju (founder and chairman of Satyam Computer Services Ltd) gave Enron Moment to India by admitting to manipulating accounts of the company by USD 1.47 Billion for several years. The sales revenue of the company was inflated by issuing more than 7000 fake invoices.
The auditor of the company Price-Waterhouse Coopers (PwC) was accused of negligence in their audit work that subsequently leads to SEBI issuing an order banning all the network firms of PwC in India. Recently the SEBI order was quashed by Securities Appellate Tribunal, however, such incidents make it difficult for auditors to perform their work diligently.
There is a sense of fear among auditors that any action performed in good faith by them may lead to investigation or suspension in future for crimes or frauds that they were unaware of in the first place.
With the formation of National Financial Reporting Authority (NFRA) by the Government of India along with supervision by Institute of Chartered Accountants of India (ICAI), there is a great degree of regulatory control on auditors now.
NFRA has the power to monitor and enforce compliance with accounting and auditing standards, oversee quality of service under sub-section 2 of sec 132 of the companies act 2013, and investigate under sub-section 4 of sec 132 of the companies act 2013 for all the listed companies (whose securities are listed on any stock exchange within India or abroad) ; Unlisted public companies with paid up capital >= INR 500 Cr or annual turnover <= INR 1000 Cr or total outstanding loans, debentures, deposits <= INR 500 Cr in preceding financial year; insurance companies, banking companies, electricity generation/supply companies, companies formed under special act; Any company referred by central government; Associate/Subsidiary company whose income/net-worth exceeds 20% of consolidated income/net-worth of a company which falls under the specified criteria.
NFRA has taken up the responsibility of:-
- Recommending auditing and accounting policies and standards to the central government.
- Ensuring compliance with regards to auditing and accounting standards.
- Overseeing quality of service of the professionals
- Power to investigate any corporates and individuals registered as members under Chartered Accountants Act 1949.
- Code of civil procedure, 1908 will apply in matters such as asking firm/individual to produce books of account, registers, any other documents; summoning of persons; issuing commissions for examination of witnesses/documents
Professional auditing firms are now pro-active in taking up auditing assignments and are calling it quits on their clients upon facing any suspicious activity during the course of their engagement.
There can be innumerable reasons for terminating the contract before the expiration of the term. In this article, we will discuss five instances when it becomes inevitable for auditors to resign before their term expires.
1. Hiding of information that can have a material impact on the accounts
Section 143 (1) of the companies act 2013 empowers the auditors to have access to the books of account and vouchers of the company at all times. An auditor is also entitled to inquire about any information or explanation from the officers of the company. At times the company may not disclose necessary information to the auditors fearing they might fail an audit. An auditor may approve the financial statements without being given access to information that could have resulted in disapproval of the same, subsequent to which the onus of accepting the fault if discovered will come on the auditing firm.
Failure to furnish requisite information by the company upon being asked by the auditor that can have a material impact on the accounts may trigger the auditors to resign from their assignment.
Case law/laws where auditors resigned from their assignment on account of hiding of information
- PWC resigned as the auditor of Vakrangee Ltd due to lack of information about its election books, bullion and jewellery business.
- PWC resigned as the auditor of Atlanta Ltd due to lack of disclosures about significant observations by tax authorities.
2. Reputational Impact
There is a lot of competition among big accounting firms and a mushroom of relatively small size firms/ independent professionals to acquire and retain niche clientele. Therefore a firm’s reputation in the market is of paramount importance. Often a fraud committed at board level of the company may escalate to such stage that it becomes a prestige issue for not only the company but also for their suppliers & consultants. In this modern era of internet connectivity where the news spreads across in no time, auditing firms tend to back off from such companies citing irreparable reputational impact that may happen to them due to their association with the accused company. A recent example of such event is fraud detected at IL&FS that became a topic of national importance. The news leads to a spate of auditors’ resignation from the company citing the reputational risk of staying put with IL&FS.
Case law/laws where auditors resigned from their assignment citing reputational risk.
- KPMG (Germany) resigned as auditors of public company – ComRoad AG following their accounting scandal.
- BSR & Associates LLP (India) resigned as auditors of IL&FS financial services citing reputational risk after a financial fraud of massive scale was discovered at IL&FS.
3. Code of Ethics requirement as slated by ICAI
The Code of Ethics requires an auditor to consider resigning from an engagement when it is concluded that a requirement established by the Code of Ethics cannot be met and hence resignation is the only available alternative. Auditor compliance with the fundamental principles may be threatened by a broad range of circumstances.
Some of these are explained in detail below: –
3.1) Self – interest
If an auditor is concerned about losing a client or has any other business relationship with them, that may create self-interest threat for the auditor. This is against the ethical code requirement by ICAI, the auditor must resign from the engagement.
If the auditor has recently been a director or officer of the client or has been in a position where he or she could have significant control over the subject for which the auditor has been engaged for then it will create a self-review threat. In such cases, the auditor should avoid taking up such assignments or resign from existing ones.
Advocacy threat includes circumstances where the auditor is acting as a representative for a client in litigation or disputes. Therefore auditor should consider resigning from their auditing assignments as there is a genuine intention of defending their client in litigation or disputes that may lead to biased opinion.
There are cases when a member of the engaged auditing firm may be a relative of director or officer of the client. Such incidents will lead to familiarity threats that are against ethical practices.
If the auditor is threatened or pressurized to resign from the engagement by the client wherein a client may push auditor to reduce their fees or can ask for any uncalled demand, It may lead to intimidation threat which is against the code of ethics and calls for the resignation of the auditor from such assignments.
Case law/laws where auditors resigned from their assignment due to code of ethics
- PWC resignation as auditors of Reliance Capital and Reliance Home Limited due to unethical practices of the firms.
4. Investigation by regulatory bodies
The central government has tightened the noose on corporate governance so as to bring an enhanced level of transparency in the business environment of India. As the government is pushing for more FDI in the country, it is important for them to implement mechanisms for proactive fraud detection.
Recent amendments in companies act 2013 has introduced strict monetary penalties and imprisonment clauses for every fraud or contravention. Section 147 (2) of the companies act 2013 states an auditor shall be punishable with fine up to INR 5 lakhs and possible imprisonment for up to a one-year term in case of willful intent to deceive the company.
Section 447 of the companies act 2013 imposes fine of up to INR 50 lakhs and imprisonment of up to 10 years to any person who is found to be guilty of fraud.
Such actions by the central government have created ripples across India Inc, as a result of which companies are getting more compliant. Whenever a company comes under the scanner for violation of provisions of companies act, the auditors try to distance themselves by resigning from their engagement in fear of being cross-examined by the regulatory bodies.
Case law/laws where auditors resigned from their assignment due to investigation by regulatory bodies
- Grant Thornton resigned as auditors of Sports Direct (an FTSE 250 listed company) due to a financial reporting council investigation.
It is not always the case that auditors resign at their own will before the expiration of their term. Sometimes the client may terminate the contract in case of violation of terms by the auditor. Infibeam Avenues Limited terminated the contract of S.R.B.C & Co, LLB, an audit firm affiliated to Ernst & Young citing unauthorized distribution of company’s unpublished price sensitive information by the auditing firm. A significant data breach leads to the breakdown of trust by the company on its auditor.
Case law/laws where auditors resigned from their assignment due to termination by the client
- Infibeam avenues terminated services of SRBC & Co Auditors for sharing unpublished price sensitive information
Father of English literature Geoffrey Chaucer coined a term in THE KNIGHT’S TALE – “EACH MAN FOR HIMSELF”. While at the time of origin of this phrase it was meant “if you don’t look out for yourself, no one else will”; However, in today’s world, we can relate this to be a selfish act where every man wants to protect their own interests.
Nobody wants to end up in a legal soup or suffer from irreparable reputational or financial loss. Similarly, auditors may find any reason to retreat from their client engagement if there is substantial evidence of putting their self-interest at risk in the near future. Many times, the reason to call it quits been given is PRE-OCCUPATION. Ministry of corporate affairs has reprimanded the auditing firms for citing pre-occupation as the reason to dishonour their commitment with their client and demands a detailed explanation that can be considered as a solid reason for their resignation. Perhaps it is not always the client who is at fault.
If I have to summarize how the trend has changed for auditors over the decades, I can say
- In the decade of 2000 when auditors were in doubt, they use to disclose it in the notes to accounts.
- In the next decade, whenever they were in doubt, they use to qualify the audit report.
As this decade is coming to end when auditors are in doubt, they RESIGN.
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