[By Ria Chaudhary & Aayush Akar]
Ria Chaudhary is a student at National Law University, Jodhpur and Aayush Akar is a student at National Law University, Odisha.
Introduction
In commonly accepted usage, auditing of books of accounts is taken to mean the verification and assessment of a company’s books and financial statements by an impartial, independent and qualified auditing professional. . It is undertaken with the primary objective of ensuring that the books of the company and transactions entered into, are in accordance with relevant regulatory frameworks as well as to form an opinion about the truth and fairness of the state of affairs reflected by these financial statements and accounts. This is done to appraise and enhance the trust of stakeholders of the organization.
Need for Regulation of Auditing – The Existing Legal Framework
Presentation of precise and true financial condition in the books of accounts is critical to the credence of the company and the soundness of investors’ investment decisions. As a result, it is but a necessity that preparation and audit of the financial statements maintained by the management of the company be governed by law, with legal consequences to follow for non-compliance. The Companies Act, 2013 (‘the Act’), Chapter X (S. 138 to 148) read with Companies (Audit and Auditors) Rules, 2014 (‘Audit Rules’) as well as Companies (Accounts) Rules, 2014 (‘Accounts Rules’) form part of the basic framework under which the process of auditing is regulated on aspects like appointment, remuneration, removal, powers and duties, qualifications, etc.
Recent Amendments & Their Implications – An Analysis
Through recent notifications in March 2021, the MCA has amended this regulatory framework, which has, at the most rudimentary level, significantly enhanced the ambit of statutory disclosure and reporting responsibilities to be complied by auditors. In furtherance of this, the following is an analysis of the Companies (Audit and Auditors) Amendment Rules, 2021 read with Companies (Accounts) Amendment Rules, 2021.
Rule 11 of the Audit Rules enlist certain circumstances other than those specifically provided, that are necessary to be included in the auditor’s report. While sub-rule 11(d), relating to the company’s disclosure of specific banknotes held by it during a specified period after demonetization in 2016, has been omitted, new sub-rules have been inserted:-
- Rule 11(e) – It requires the Auditor’s report to contain a statement regarding whether the management has made a representation that except for those transactions mentioned in the books – pertaining to transactions which the company has entered into for an ultimate beneficiary whose identity is sought to be kept hidden, by routing of the transaction through an intermediary – the company is neither acting as nor has employed, such an intermediary entity for channelization of funds to a beneficiary identified by the company.
Such lending or financing transactions, that is, where outgoing or incoming loans, advances, or investments are anticipated to be relayed through an intermediary acting on the company’s directives of channelizing financial resources are not prohibited under law. However, the MCA has enacted this amendment to maintain transparency through adequate disclosure of the ultimate real beneficiary in the books, so as to keep a check on the financing of illicit activities like terrorism, illegal trade, etc. which have a high incidence of occurring through this route.
It is also pertinent to note that this amendment not only places a duty of representation upon the management but also a double verification duty upon auditors to evaluate this representation through auditing procedures and substantiate whether no material misrepresentation has been made by the directors in relation to the abovementioned transactions. In the case of the contrary, auditors may be held liable/penalized.
- Rule 11(f) – It requires the Auditor’s report to contain comments regarding payment or declaration of dividend by the company as to whether compliance with S. 123 of the Act has been observed.
- Rule 11(g) – It implies that the Auditor’s report shall contain the auditor’s observation and opinion on whether the company has, with respect to, financial years beginning from 1st April 2022 maintained its books of accounts using such accounting software which has the facility of recording the audit trail (i.e. log of every change made in the books) and whether the same has been used for all transactions recorded in the software throughout the year. Secondly, it is also required to be taken into consideration that whether the audit trail has not been tampered with and finally that it has been preserved by the company in accordance with statutory requirements to retain such records.
In addition to this requirement under Rule 11(g), another pertinent change has been made by insertion of a proviso to Rule 3(1) of the Accounts Rules. It holds significance for companies that use accounting software to maintain electronic records of their books of accounts (which practically almost every company does), in as much as that such company, commencing from the financial year beginning April 1, 2021, ‘shall only’ use such accounting software that has the facility of recording audit trail and edit log of every transaction/change made in the books, along with the date of such change. It further states that it must be ensured that such edit trail facility cannot be disabled.
The compulsory requirement to have an audit trail has been introduced because it is a technique to prevent book falsification, fabrication or manipulation and subsequent overwriting in the same. Any individual inspecting the books of accounts may readily follow what modifications have been made to the accounts, by verifying with the audit trail and seek an explanation from the company for any discrepancies/reasons for such change.
Several additional and corresponding modifications have also been made in the entries under, Schedule III of the Act which establishes the framework for compiling of books of accounts (e.g., manner of maintaining income statements, cash flow statements, balance sheet, etc.), making it a crucial amendment for the auditors as well.
Examining the Conundrum Surrounding the Amendments vis-à-vis the Role of an Auditors in a Company
While these amendments may appear to be mere additions requiring a simple point of view to be added in the entire report by the auditor, it must be borne in mind that the auditor’s opinion plays a pivotal role in determining the company’s financial status and trustworthiness. The apex court has, in the case of Institute of Chartered Accountants of India v. P. K. Mukherjee while delineating the role of an auditor, stated that “an audit is performed with the intention of protecting the shareholders, and as such, the auditor is required to review the books retained and managed by the directors/key managerial persons, in order to inform the shareholders of necessary factors indicating the company’s real financial position.” The scope of discretion and powers that the auditor can exercise while reflecting their opinion regarding these financial statements is well-grounded under S. 143 of the Act, such that it is the duty of the auditor to maintain accuracy and transparency in every comment they record in the report. The section, by requiring the auditors to adhere to the professional code of conduct and ethics, actively participate by conducting inquiries when necessary regarding loans, advances, personal expenses, as well as forming of adverse opinion regarding the books than what is painted by the financial statements and express dissatisfaction/refrain from giving an opinion at all, enhances the degree of reliability that can be placed on the report.
Lord Denning best described the unique role that an auditor plays in examining a company’s books in the case of Fomento (Sterling Area) Limited v. Selsdon Fountain Pen Co. Ltd, noting that “[a]n auditor’s scope of work should not be limited to the mechanics of verifying vouchers and performing mathematical computations. Their primary responsibility is, with the application of reason and fair sense of logic, to guarantee that no errors are made, be it computation, omission or commission errors, or outright fabrications in the books.” This understanding of the actual role of an auditor has increased manifold today where auditors found guilty of gross negligence are suspended from practice, the judiciary’s objective is to bring about deterrence from engaging in such conduct.
Finding A Middle Path – The Road Ahead
Hence, the existing and real picture for auditors in the profession is not all rosy when it comes to balancing the magnitude and seriousness of responsibility as well as risk that the law makes them shoulder with the kind of rewards they receive. These recent amendments in the legal framework governing an audit and the role of auditors, when studied in light of this imbalance, leave the doors open for major incongruence between what the law is and how auditors choose to interpret and apply it when in hot water. At a time when the importance of corporate governance is steadily increasing due to the increase in number and complexity of the type of companies that can be established, their ever-widening ambit of activities, powers, as well as related disputes/litigation, the only viable path should be for the auditing professionals to align their profession with these changes, by ensuring quality and compliance with the law in the auditing process.