Ethics in Financial Reporting &

Auditors’ Independence and Accountability

Rajnish Jindal
Asst. Professor
Symbiosis Law School, NOIDA
LESSON OUTLINE
The Role of Auditors in Corporate Governance
Auditor’s Responsibilities Under Companies Act 2013
Introduction
Ethics and values get short shrift in business in two ways; first, by the failure of the
management and second, by the failure of auditors. Auditors who are expected to be
the watchdogs of the organizations are often bought in by the managements through
some profitable assignments. This has led to the rise of the concept of corporate
governance which is about promoting corporate fairness, transparency and
accountability relating to the various participants of organizations. Recent unearthing
of the corporate frauds both in the developed countries and the developing and the
transitional economies revealed the fact that auditors had failed to do what they were
assigned to do. They involved themselves in unethical practices and failed to whistle-
blow when things went wrong in the organization. To have a check on the auditors’
role and to prevent them from the unethical practices, the Indian government and the
regulatory bodies elsewhere have come out with many regulations, re-establishing the
corporate accountability and reinforcing the investor confidence.
The Role of Auditors
The allegation that the annual reports presented by companies today lack truthfulness
and transparency need not be dealt with in great details here.
“Window-dressing, manipulation of profit and loss accounts, hedging and fudging of
unexplainable expenditures and resorting to continuous upward revaluation of assets
to conceal poor performance are malpractices companies resort to with the help of
the obliging auditing firms”.
The role of auditors who are expected to certify the veracity of accounts maintained
by companies for the benefit of all stakeholders of the company including fair and
transparent governance leaves a lot be desired. Instances are galore where the
obliging auditors have helped companies falsify accounts and in window-dressing for
small monetary gains.
Defining ‘Audit’
The Institute of Chartered Accountants of India (ICAI) has defined
audit as,
“...The independent examination of any entity, whether profit-oriented or
not and irrespective of its size or legal form, when such an examination is
conducted with a view to expressing an opinion thereon”.
In other words, auditing is the process by which a competent
independent person objectively obtains and evaluates evidence
regarding the assertions about an economic activity or event for the
purpose of forming an opinion about and reporting on the degree to
which the assertion conforms to an identical set of standards.
Types of Auditors
There are three types of auditors, namely,

(1) internal auditors,

(2) independent auditors, and
(3) government auditors
Internal auditors
Internal auditors are employed by the organization for which they
perform audits. Their responsibilities vary and may include financial
statement audits, compliance audits and operational audits. They may
assist the external auditors in completing the financial statement audit
or perform audits for use by management within the entity. Internal
auditors must have no operating involvement in the activities they audit.
An organisation may have a small or very large internal audit staff. They
cannot be independent as long as the employer-employee relationship
exists. Independence is often accomplished by giving the highest ranking
person in internal auditing the status of vice president and having that
person report directly to a committee of the board of directors.
Independent auditors
Independent auditors are usually referred to as CPA (Certified Public
Accountants) firms. The opinion of an independent auditor about the
financial statements makes the statements more credible to such
users as the investors, the bankers, the labour unions, the
government agencies and the general public.
Government auditors
Government auditors work in various local, state and federal or
central government agencies performing financial, compliance and
operational audits. Local and state governments, for example, employ
auditors to verify whether businesses collect and remit sales taxes
and excise duties as required by law.
Auditor’s Responsibilities in CA2013
Auditor is an important independent functionary in a company to
look after the affairs of the company from the outsider point of view.
This office has to play a key role in corporate governance. To improve
the quality of corporate governance in India the new Company Act
2013 has prescribed several new measures.
The basic approach of the new Companies Act with regards to the
role of auditor is ‘Auditor should not listen to management advice
during the finalization of accounts and it should be purely
independent finalization and financial statement should reflect true
and fair view of the business. Otherwise the auditor will be held
responsible’.
Appointment and Reappointment
Chapter X of the Companies Act 2013 deals with the role and the functions of
auditors of a company. As per section 139, the first auditor has to be
appointed in a Board Meeting within 30 days of registration of the company
or else within 90 days in an EGM. Further the Act says that “Every company
shall, at the first annual general meeting, appoint an individual or a firm as
an auditor who shall hold office from the conclusion of that meeting till the
conclusion of its sixth annual general meeting and thereafter till the
conclusion of every sixth meeting”.
Auditor already appointed by the board can be appointed by the
shareholders at the first annual general meeting. The company shall place the
matter relating to such appointment for ratification by members at every
annual general meeting.
Appointment and Reappointment
Written consent along with a certificate is required to be given by the
proposed appointee. Certificate shall also indicate whether the
auditor satisfies the criteria provided in S. 141 & Rule 4 of (Audit &
Auditors) Rules, 2014. No audit firm having common partners or
partners whose tenure has expired immediately preceding financial
year shall be appointed as auditor of the same company for a period
of five years. It means though auditor is appointed at AGM but he can
conduct the audit for a particular financial year. The company has to
inform the auditor and file form ADT-1 for the appointment with the
Registrar within 15 days of the meeting in which the auditor is
appointed.
Terms of Appointment
Listed company or a company belonging to such class or classes
of companies as may be prescribed in S.139(2) & Rule 5 of
Companies (Audit & Auditors) Rules, 2014 shall not appoint or
re-appoint:
An individual as auditor for more than one term of 5 consecutive
years and an audit firm as auditor for more than two terms of five
consecutive years.
Provided that:
An individual auditor who has completed his term shall not be eligible for
reappointment in the same company for the next 5 years. Similarly, an audit
firms which has completed its terms shall not be eligible for reappointment
in the same company for 5 years. 3 years transition period shall be given to
comply with this requirement. However, according to the rules, period of 5
years will be calculated from retrospective effect.
For the purposes of S.139, the classes of companies shall mean the following
classes of companies excluding one person companies and small companies
which include all unlisted public companies having paid up capital of Rs. 10
crore, all private limited companies having paid up share capital of Rs. 20
crore, all companies having paid up share capital of below threshold limit
mentioned in (a) and (b) above, but having public borrowings from financial
institutions, banks or public deposits of Rs. 50 crores or more.
A retiring auditor may be re-appointed at an annual general
meeting, if he is not disqualified for re-appointment, or has
not given the company a notice in writing of his unwillingness
to be re-appointed. Where at an annual general meeting, no
auditor is appointed or re-appointed, the existing auditor shall
continue to be the auditor of the company. In case of death,
casual vacancy is to be filled by the board of directors within
30 days. He shall hold office till the conclusion of the next
AGM.
Auditor’s Responsibilities
Appointment and reappointment of auditor.
Mandatory rotation of auditor.
Powers and duties of auditors.
Auditor not to render certain services.
Auditor’s liability in case of unlawful acts.
Disclosures.
Liabilities relating to contents of the prospectus under Section 35 of the Company Act,
2013
Duties and responsibilities in case of material misstatement.
Liability in case of material misstatement.
Punishment for contravention.
Prosecution by NFRA (National Financial Reporting Authority) under section 132
Mandatory Rotation of Auditor
Compulsory rotation of auditors by the listed companies and the
classes of companies is prescribed:
 Audit firm including LLP – not more than 2 terms of 5
consecutive years.
 Individual auditor – not more than 1 term of 5 consecutive years.
 During the cooling period ( of 5 years) even any audit firm having
one or more common partners with the audit firm being rotated
is not eligible to be appointed auditor of the same company.
Powers and Duties of Auditors
The following powers and duties have been prescribed for auditors in the
new Companies Act to ensure compliance of all auditing standards:
1. Consolidation of accounts exercises your right to access to the records of all
its subsidiaries, if required.
2. Ensure you have sought the desired information. Keep all backups,
preferably, certified copies.
3. The auditor’s report shall state any qualifications, reservation or adverse
remark relating to the maintenance of accounts and other matters connected
therewith.
4. The auditor’s report is to state whether company has adequate internal
financial controls systems in place and operating effectiveness of such controls.
Powers and Duties of Auditors
5. If an auditor of a company, in the course of the performance of his
duties as auditor, has reason to believe that an offence involving
fraud is being or has been committed against the company by the
officers or the employees of the company, he shall immediately
report the matter to the Central government immediately but not
later than thirty days of his knowledge or information, with a copy to
the audit committee or in case, the company has not constituted an
audit committee, to the board.
6. If the auditor does not report the fraud committed or being
committed, he shall be punishable with fine which shall be not less
than Rs. 1 lakhs but may extend to Rs. 25 lakhs.
Auditor Not to Render Certain Services
An auditor appointed under this Act shall not directly or indirectly provide any of the following
‘other services’ to auditee-company or its holding company or subsidiary company:
 Accounting and book keeping services
 Internal audit
 Design and implementation of any financial information system
 Actuarial services
 Investment advisory services
 Investment banking services
 Rendering of outsourced financial services
 Management services

Any other services as may be prescribed is not clear whether the restriction will apply to rendering
of non-audit services by the auditor to its network firms wherever located to the auditee’s holding
company or subsidiary located outside India. Further, the Act does not define the terms such as
investment advisory services and management services which are subject to varying interpretation.
Auditor’s Liability in Case of Unlawful Acts
The auditor’s basic responsibility is to report whether in his opinion the
accounts show a true and fair view and in discharging his responsibility in a
fair manner. The general thinking with regards to unlawful acts or default by
the clients appears to be that the auditor should not ‘aid or abet’ but he is
not under any legal obligation to disclose the offence. The Institute of
Chartered Accountants of India has considered the role of a chartered
accountant in relation to taxation frauds by the assessee and has made the
following major recommendations:
A professional accountant should keep in mind the provisions of section 126 of
the Evidence Act whereby a barrister, an attorney or vakil is barred from
disclosing any information made to him the course of and for the purpose of his
employment.
Disclosures
If the fraud relates to the past years when the Chartered Accountant did not
represent the client, the client should be advised to make a disclosure. The
accountant should also be careful that the past disclosure should not affect
the current tax matters. In case of fraud relating to the accounts examined by
the accountant himself, he should advise the client to make a complete
disclosure. In case, client refuses to do so, the accountant should inform him
that he is entitled to dissociate himself from the case and he would make a
report to the authorities that the accounts prepared and examined by him
are unreliable on account of certain information obtained later. In case of
suppression in current accounts the clients should be asked to make a full
disclosure. If he refuses to do so, the accountant should make a complete
reservation in his report and should not assciate himself with the return.
Liabilities of the Auditor
The question of liability of an auditor for unlawful acts or frauds by
the clients should be considered in the light of broad parameters
given above. However, it appears that if an auditor is aware of any
unlawful act has been committed by the client with respect to the
accounts audited by him and the unlawfulness is not rectified by
proper disclosure, the auditor owes a duty to make the suitable
report if he does not do it, he may be held liable.
Liabilities Relating to Contents of the Prospectus
Under Section 35 of the Company’s Act
Where the person has subscribed, the securities of a company acting on any
statement included, or the inclusion or the omission of any matter, in the prospectus
is misleading and he has sustained any loss or damage as a consequence thereof, the
company and every person who is a director; has authorized himself to be named
and is named in the prospectus as a director of the company; is a promoter; is an
expert referred in section 26(5), (AUDITOR is Covered) shall without prejudice to any
punishment to which any person may be liable under the section 36, liable to pay
the compensation to every person who has sustained such loss or damage.
Notwithstanding anything contained in this section, where it is proved that
prospectus has been issued with an intent to defraud the applicants for the
securities of a company or any other fraudulent purposes, every person, (including
auditor) referred to in the subsection (1) shall be personally responsible, without any
limitation or liability, for all or any of the losses.
Liability in Case of Material Mis-statement
Misstatement in financial information can arise from fraud or error. The term
FRAUD refers to the ‘INTENTIONAL ACT’ by one or more individuals amongst the
management, those charged with governance.
Fraud involving one or more members of management those charged with
governance is referred to as MANAGEMENT FRAUD. The primary responsibility
for the prevention and detection of fraud rests with those charged with
governance and management of the entity.
Further, an audit conducted in accordance with the standards on auditing
generally accepted in India, is designed to provide reasonable assurance that
financial statements taken as a whole are free from material misstatement
whether caused by fraud or error. The fact that an audit is carried out may act as
a deterrent, but the auditor is not and cannot be held responsible for the
prevention of error and fraud.
Liability in Case of Material Mis-statement
The auditor is concerned with fraudulent acts that cause a material
misstatement in the financial statements.
An auditor does not guarantee that all material misstatement will be detected
because of such factors, as the use of judgment, the use of testing, the
inherent limitations of internal control and the fact that much of the evidence
available to the auditor is persuasive rather than conclusive in nature.
Certain levels of management may be in a position to override control
procedures designed to prevent similar frauds by other employees. Auditor’s
opinion on the financial statements is based on the concept of obtaining
reasonable assurance. Hence in an audit the auditor does not guarantee that
material misstatements will be detected.
Punishment for Contravention
If any of the provisions of S.139 to S.146 is contravened, the company shall be
punishable with a fine which shall not be less than Rs. 25000 but which may
extend to Rs. 5 lakhs and every officer of the company who is in default shall
be punishable with imprisonment for a term which may extend to one year or
with a fine which shall not be less than Rs. 10000 but which may extend to
Rs. 1 lakhs or with both.
If the contravention by the auditor is willful or with intention to deceive the
company or its shareholders or creditors or tax authorities, he shall be
punishable with imprisonment for a term which may extend to 1 year and
with fine not less than Rs. l lakhs but extend to Rs. 25 lakhs
The auditor who has been convicted shall refund the remuneration and pay
for damages to company or the statutory bodies.
Prosecution by NFRA (National Financial Reporting
Authority) U/s 132
NFRA may investigate either suo motu or on a reference made to it by the Central
government on matters of professional or other misconduct committed by any
member or firm of chartered accountants, registered under the Chartered
Accountants Act, 1949. If professional or other misconduct is proved, NFRA has the
power to make order for:
 imposing penalty of (i) not less than one lakh rupees, but which may extend to five
times of the fees received, in case of individuals; and (ii) not less than ten lakh rupees,
but which may extend to ten times of the fee received, in case of firms;
 debarring the member or the firm from engaging himself or itself from practice as
member of the Institute of Chartered Accountant of India referred to in clause (e) of
sub-section (1) of section 2 of the Chartered Accountants Act, 1949 for a minimum
period of six months or for such higher period not exceeding ten years as may be
decided by the National Financial Reporting Authority.
Thanks…..