Ayushi Agarwal
Introduction
In order to understand the reason why auditors and audit firms are the first target in any financial fraud, it is first important to know what auditing really is.
Audit is defined as “an independent examination of financial information of an entity whether profit making or not, and irrespective of its size or legal form, when such an examination is conducted with the view to expressing an opinion thereon.”
Hence, from the above, it can be seen that the auditors’ responsibility is to give his opinion on the Financial Statements alone. The opinions along with their meaning are as follows:
- Unmodified Opinion: it is an opinion when the financial statements are prepared in all material respects and in accordance with the financial reporting framework.
- Modified Opinion:
- Qualified Opinion: when the auditor concludes that there are material misstatements but the same is not pervasive.
- Adverse Opinion: when the conclusion arrived at is that the misstatements are both material and pervasive.
- Disclaimer of Opinion: the disclaimer is given when the auditor is unable to obtain sufficient appropriate audit evidence and that the effect of the same could be material and pervasive.
Hence, from the above, it can be seen that an auditor only needs to make sure that the Financial Statements are prepared in accordance with the relevant Accounting Standards and that there are no irregularities in the making of the Financial Statements.
It is also a known fact, that the making of the Financials are the responsibility of the Board of Directors and the company. The Auditors duty begins only after the Books of Accounts as at the end of the Financial Year are prepared and submitted to them for the audit process.
As is popularly known, that an auditor is a watchdog and not a blood hound. Hence, given the basic structure of the role of an auditor, it can be seen that an auditor’s role is limited, however there exists a grey area as to how they are responsible for the irregularity conducted, despite them not conducting an introspected review of the Financial Statements. Most financial frauds, often have a paper trail, and hence, the duty of the auditor becomes more difficult, since he is not aware of the true facts that exist behind the scene of this after-thought paper trail.
This risk element involved in the professional conduct of an auditor, makes the practice of conducting audits in India has become a highly onerous and risky profession. In addition to the risks, there are various stringent civil and criminal liabilities. Auditors are the first people to be held accountable for any and every financial scam in a company. In cases of debarment of audit firms, there is no provision which limits the debarment to just the individuals who were actually involved in the wrongdoing. There may be cases where only a few individuals are actually responsible for the fraud, however, Section 140(5) of the Companies Act, 2013 has the power to disproportionately make the entire firm responsible. While it is completely unacceptable for defaulting auditors to escape even the slightest liability, it is henceforth argued that a penalisation as harsh as debarment of the entire firm should only be used in the rarest of rare cases where the conduct of audit firms has been exceptionally reckless, negligent, or fraudulent. This argument further gets backing in light of the multiple other penalties with respect to auditors which already exist in the Companies Act, 2013, thereby making the exercise of the second proviso to S.140(5) unwarranted in cases of individual defaulting creditors.
Legal Framework
Chapter X of the Companies Act, 2013 contains provisions regulating audit and auditors of companies. Among other things, this chapter deals with the appointment, removal, disqualifications and resignations of company auditors. The second proviso to S.140(5) of the Companies Act, 2013 states that if a final order is passed against any such firm or individual, he shall be debarred from being appointed as the auditor of any company for a period of five years. This means that under the existing legal framework in India, audit firms are not always immune from disbarment even for the action of only some of their auditors. Nonetheless, auditors in India are liable jointly and severally, and are faced with class action suits under multiple laws and regulations.Firstly, S.140(5) allows the Company to change its auditors. Secondly, along with a debarment, S.140(5) also mentions liability under S.447 of the Companies Act, 2013 which deals with fraud and provides imprisonment for upto ten years. This indicates that two different forms of debarment of a company auditor are prescribed under the same provision which prevents him from practicing his profession. The National Financial Reporting Authority (NFRA) is empowered to separately regulate auditing standards under S.132 of the Companies Act, 2013. In light of such different provisions governing professional misconduct and fraud, the second proviso to S.140(5) seems rather an extraordinary and unnecessary provision that acts as a death note with double jeopardy for the company auditor.
The Role of an Auditor
In Trisure India v. A.F. Ferguson, the Court ruled that the mere role of an auditor is to employ reasonable care and skill and the auditor is not required to begin with the suspicion of trying to detect a fraud, unless some information has reached which excites suspicion in a professional man of reasonable competence. At this juncture, it is important to note that frauds are normally perpetrated through an ingenious design of those individuals who are part of the internal management. Thus, a presumption of innocence applies to auditors since they are supposed to be gatekeepers and are not privy to every action of the management. An auditor’s negligence in performing his duty must attract penalties but not so much so that the entire audit firm is debarred for five years altogether. While an auditor provides assurance on financial statements, he does not insure the related financial risks of all stakeholders.
The Bombay High Court’s Ruling in the Deloitee Haskins Case
In N.Sampath Ganesh v. U.O.I., the auditor companies; Deloitee Haskins & Sells Ltd. and BSR & Co. challenged the constitutionality of S.140(5) for to its ability to debar the two companies from auditing for a period of five years. Although the Bombay High Court did not finally debar the auditor firms since the auditors had already resigned, it upheld the constitutionality of the section. The Court laid down that if the auditors had already rescued themselves, they do not attract penalty under S.140(5). However, if they challenge the subjective satisfaction of the Tribunal and raise grounds of defence, harsher treatment of debarment gets attracted. This reasoning by the Court seems more like a threat than a caution which places a burden on the auditor to rescue himself, before the NCLT passes a final order of debarment under S.140(5).
From the hearings and the order passed, it could be seen that for the Serious Fraud Investigation Office (SFIO) and the Ministry of Corporate Affairs (MCA) to unearth the scam and put it before the court, it took an investigation report of almost 40,000 pages, running into multiple volumes, and this was just for one group company of the IL&FS group, which was IL&FS Financial Services (IFIN). This additionally shows the complex nature of financial frauds. In the case of IL&FS, it required 90 days of investigation followed by a complex report to show the entire scam, whereas, an auditor is not supposed to investigate, and only supposed to audit, thereby making him not liable at all technically for the doings of the company.
Conclusion
The need of the hour calls for a more nuanced approach under which no defaulting auditor is allowed to escape liability while also ensuring at the same time that an entire firm does not suffer due to the actions of some of its auditors. The Company Law Committee formed under the MCA has acknowledged the lacunae of Section 140(5) and made far reaching recommendations to address the same in its November 2019 report. It has suggested that the debarment be limited to only guilty auditors and the corresponding firms be let off with a hefty fine, if required. For professionals, the right to practise is a core requirement for exercising their livelihood. Thus, so far as debarment of audit firms is concerned, it must be predicted on larger principles such as the due process of law, innocent until proven guilty and the doctrine of proportionality. Before imposing excessive criminal liabilities on individual auditors, the degree of personal involvement of the auditor must be investigated. Debarment should be considered as a serious punishment, more like an exception instead of a rule The concerned authorities must remain judicious and pragmatic while imposing liability upon auditors and audit firms.
Reference
1Ashok Haldia, ‘India needs to take a judicious view while banning audit firms’ (Mint, 25 December 2019) <https://www.livemint.com/opinion/columns/india-needs-to-take-a-judicious-view-while-banning-audit-firms11577213253127.html> accessed 20 June 2022.
2 Shubham Nahata, ‘Debarment of Company Auditor: A Cursory Death Note’ (IndiaCorpLaw, 26 April 2020) <https://indiacorplaw.in/2020/04/debarment-of-company-auditor-a-cursory-death-note.html> accessed 19 June 2022.
3 (1986) 3 Comp LJ 132(Bom).
4 2019 SCC OnLine Bom 1887.
5 The Ministry of Corporate Affairs, Report of the Company Law Committee, November 2019 at 57.
Indian Corporate & Finance Law Review 