Deficient Financial Statements: Are auditors alone to be blamed? The other side of the coin!

1. Background and Current Scenario

Orders issued by the NFRA imposing financial penalties and debarring auditors have become frequent. Since releasing its first Audit Quality Review Report in December 2019, NFRA has debarred individual Chartered Accountants and firms for periods ranging from 1 to 10 years, alongside fines ranging from ₹1 Lakh to ₹3 Crore.

Crucially, most entities where audit deficiencies were identified are listed companies. This raises significant questions regarding the efficacy of corporate governance mechanisms within these organizations.

2. Significance of Corporate Governance in Financial Reporting

The Companies Act, 2013 and SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 ("LODR") reshaped corporate governance in India. The Audit Committee acts as an indispensable intermediary between the board of directors, management, internal auditors, and external auditors. Its independent oversight directly impacts the accuracy, reliability, and transparency of corporate financial disclosures.

3. Applicable Legal Provisions

• Section 177 of Companies Act, 2013: Mandates every listed public company (and prescribed classes of companies) to constitute an Audit Committee.
• Regulation 18 of SEBI (LODR) Regulations, 2015: Requires a qualified and independent Audit Committee where all members are "financially literate" and at least one member possesses accounting or related financial management expertise.
  • Financially Literate: Ability to read and understand basic financial statements (Balance Sheet, Profit & Loss Account, and Cash Flow Statement).
  • Financial Expertise: Experience in finance/accounting, professional certification, or financial sophistication from senior executive roles (e.g., CEO, CFO).

• Standard on Auditing (SA) 260 (Revised): Regulates communication between statutory auditors and "Those Charged with Governance" (TCWG). Paragraph A51 explicitly underscores the supervisory role Audit Committees must perform.

4. Did Audit Committees Function Effectively?

Analyses of NFRA orders indicate key structural gaps in how Audit Committees exercised oversight across multiple failure areas:

Oversight of Financial Reporting

Audit Committees are obligated to review financial statements and disclosures (including Schedule III to Companies Act, 2013 and Ind AS compliance) prior to board submission. NFRA inspection reports revealed widespread non-compliances and inadequate disclosures. In one instance, a company reported a 1,026% sharp rise in revenue (from ₹159.07 crores in Year 1 to ₹1,791.01 crores in Year 2) without the Audit Committee questioning potential aggressive or improper revenue recognition practices.

Oversight of External Audit Process

Audit Committees must select external auditors, evaluate independence, review audit scope, and assess competency. NFRA reports revealed instances where:

• Auditors lacked understanding of Standards on Auditing (SAs) and Ind AS.
• Sole-proprietorship auditors with limited resources were appointed for complex listed entities without Engagement Quality Control Reviews (EQCR) or adherence to SQC-1.
• Severe conflicts of interest existed under Section 144 of the Companies Act, 2013, including an instance where an auditor owned shares of the auditee through a family-owned company.
• Abysmally low auditor remuneration suggested that cost considerations outweighed competency requirements.

Review of Related Party Transactions (RPTs)

Under Section 177 and SEBI LODR Schedule II Part C, Audit Committees must scrutinize inter-corporate loans, investments, and approve RPTs at arm's length. In the Coffee Day Enterprises Limited case, NFRA highlighted massive fund diversions, understatement of loans, and evergreening through related party networks that went undetected or unscrutinized by the Audit Committee.

Financial Literacy Gaps

5. Key Questions Audit Committees Should Ask Auditors

To enforce active governance, Audit Committees should engage in structured dialogue with auditors using these illustrative questions:

Before Annual Audit / Planning Stage

During Post-Audit Review Meeting

6. The Way Forward

In an environment of complex accounting standards (such as hedge accounting and fair valuation), regulators like SEBI must revise the definition of "financial literacy". Regulators should enforce mandatory financial reporting courses and assessments for Audit Committee members.

Entities should adopt the ICAI "Technical Guide on the Functioning of Audit Committee & its Review Checklist", regularly evaluating skill matrices, diversity, tenure, and ongoing financial education programs.

Conclusion

While auditors remain accountable under SAs and codes of ethics, penalizing only auditors when financial statements fail is insufficient. Primary responsibility for financial statements rests with management, while Audit Committees serve as the primary line of defense. Regulators must conduct reality checks to ensure Audit Committees function in true spirit. Effective two-way communication under SA 260(R) between auditors and TCWG is essential to uphold public trust in corporate governance.

References