Has The NFRA Achieved What The ICAI Couldn’t?
This week, India’s newest regulator in the financial sector marked its three-year anniversary.
On Oct. 1, 2018, the National Financial Regulatory Authority was tasked to oversee the audit and accounting quality of over 6,500 companies—5,300 listed, 1,000 unlisted, and insurance and banking companies. It was given a chairman, one full-time member and nine part-time members.
With a strength of 11 members, the regulator has issued four audit quality review reports and one accounting quality review report in the last three years.
R Sridharan, NFRA's chairman for the last three years, didn't respond to a request for an interview. But members of the audit fraternity BloombergQuint spoke with said these numbers do little justice to the impact the NFRA has made.
The regulator has made its presence felt. There’s consensus on that. The disagreements begin on how it has done so.
AQRRs: The Approach
The regulator has put out four audit quality review reports so far. Three of them are on statutory audits carried out by member firms of the Big Four.
IL&FS Financial Services Ltd.’s auditors for FY 2017-18: Deloitte Haskins and Sells LLP and KPMG’s network firm BSR and Associates.
IL&FS Transportation Networks Ltd.’s auditor for the same period: SRBC & Co LLP, a network firm of EY.
These three reports by the NFRA on them have one thing in common: questions around auditor independence.
The regulator stated that Deloitte, BSR and SRBC provided management services during the course of statutory audit engagement. For instance, it has pointed out, BSR earned Rs 9 crore through non-audit services to IL&FS Financial Services between 2017 and 2019. All three have contested this conclusion by the NFRA, saying the services provided by them are permitted under the law.
As per company law, a statutory auditor cannot provide "management services" to a company it audits.
Many people assume that through audit work, you can get consulting work, Nawshir Mirza, former audit partner and independent director pointed out.
It may have happened in a few instances, but companies pick consultants based on who is best and not hand out such assignments to auditors to make them happy.Nawshir Mirza, Independent Director
On this aspect, the NFRA has completely disregarded global precedents, market reality and guidance by the ICAI in the past, the audit head at a Big Four firm said on the condition of anonymity. And even if the regulator is taking a different approach, it needs to be reasonable.
The endgame can’t always be disciplinary action; it has to be a time-bound remediation plan. If someone is at 10 and the regulator’s starting point is 0, it’ll all end up in court which is where all AQRRs are heading, the person pointed out.
But former Deloitte India chairman, PR Ramesh said he can see where the regulator is coming from.
Typically, any new regulator would’ve spent its initial years in developing the profession, laying down standards, setting expectations. The authority would’ve inspected the audit profession and accounting practices of corporates after setting expectations, providing guidance and then come down heavily. To be fair, this regulator didn’t get time to do all this, given the enormity of the task at hand.PR Ramesh, Former Chairman, Deloitte India
But some of the interpretations of law and the positions it has taken may be considered extreme given that they were followed by the entire profession based on guidances and generally accepted practices worldwide.
And this is where the disagreements are the loudest—as recorded in the AQRRs and vocalised by the fraternity in conversations.
AQRRs: The Disagreements
For instance, the NFRA has concluded that Deloitte and BSR accepted the management’s stand to not disclose net-owned funds and capital-to-risk- assets ratio as negative—something that could’ve led to the cancellation of IFIN’S NBFC licence. They did not question the going-concern assumptions basis which the management had prepared financial reports, as per the AQRRs.
Similar conclusions have been made for EY’s network firm SRBC. That it did not discuss the susceptibility of the financial statements to material misstatement due to fraud, did not identify and assess revenue recognition and management override of controls as serious potential risks.
Mirza called it the benefit of hindsight and ignoring what could’ve been the situation at the relevant time, at least on some of the aspects.
I’m not suggesting that everything [at IL&FS] was okay. But there’s a big dose of vitriol in the way these reports have been written. There’s certain limitation on how much time you have, the amount of information you have—that hasn't been adequately respected. That said, I agree with the broad conclusion that the audits were unsatisfactory.Nawshir Mirza, Independent Director
Ramesh echoed that. He pointed out that an auditor of a listed company has less than 30 days to the year end to finish the audit whereas a regulator has unlimited time to scrutinise the audit file. The documentation and the decisions taken by the auditor have to be viewed in this context, he said.
The regulator, too, has the difficult task of maintaining a fine balance between evaluating the work done by the auditor at the point in time and avoiding hindsight. This is not easy for one cannot ignore corporate collapse and rationalise by stating there were no visible signals.PR Ramesh, Former Chairman, Deloitte India
So the appeal to the regulator is to appreciate the difference between error of judgment and gross negligence, he said.
Ramesh explained his point by using NFRA's approach on "going concern assumptions" as an example.
Debts falling due, company not making enough cash, loss of major customers, litigation resulting in significant outgo, skewed debt-equity ratio...are all indicators that the going concern status needs to be questioned.
In such an event, the auditor will ask the management if there’s doubt whether the company will survive the next year. So projections—cash flow, revenue, etc.—for the next one year are looked at. They could be supplemented by management plans to raise capital via commercial borrowing, etc.
There are assumptions in all of this—not everything is even verifiable. The going-concern test has to be for the next one year. It is about projecting the future and an auditor is not a soothsayer. This is where the auditor has a challenge when he is under scrutiny.PR Ramesh, Former Chairman, Deloitte India
R Narayanaswamy disagreed.
The NFRA has taken certain positions based on its interpretation of network affiliation, management representation, going concern, management services, independence, documentation, professional scepticism and so on, the chair of the NFRA's Technical Advisory Committee and former IIM-Bangalore professor said.
Until now, we have only seen banalities and bromides in discussions on auditing such as how auditors build the nation. In contrast, the NFRA has given us a forensic analysis of what goes on in the name of auditing in this country.R Narayanaswamy, Chair - TAC, NFRA
All that the NFRA has done is to remind the auditors of their public interest responsibility in applying the standards and the law, he said. "The feral reaction of the audit community is a measure of its lax application of standards in the absence of questioning by anyone all along."
It’s not just the big boys that the regulator has scrutinised.
The NFRA has also found lapses in the audit carried out by Rajendra K Goel & Co. of Jaiprakash Associates Ltd.:
Not issuing an adverse opinion on certain transactions, for instance overstatement of profits.
Gross negligence, lack of due diligence in not ascertaining why JAL was made party to insolvency petition filed against Jaypee Infratech Ltd.
Too many 'emphasis of matter' paragraphs.
Failure to ascertain going concern assumption.
The Regulator’s Future
Since the NFRA has come in, there’s been visible change.
Grant Thornton, Deloitte and PW India have said they won’t provide non-audit services to audit clients. Audit fees are going up. Auditors are getting more selective about accepting clients. Quite a few have resigned because of disagreement with managements.
Mirza shared an anecdotal view.
A lot of companies who were basking, not because of the robustness of their accounts but because of the big names that audit them, can no longer be complacent. Investors are no longer sure that if there’s a big auditor, the management is clean.
“Such companies are finding it difficult to get the large auditors. Dubious clients are only being accepted as long as the large auditors are convinced those running it will be able to manage the authorities.” – Nawshir Mirza, independent director
So they are now going to second and third-tier auditors—that’s where the regulator needs to pay attention now, he added.
For that, the NFRA needs to be protected from regulatory capture, all experts BloombergQuint spoke with said.
The ICAI is implacably opposed to the NFRA. It wants the NFRA to go, Narayanaswamy said.
Pointing to the notification on the NFRA's constitution, he said, it was astonishing to see three part-time members drawn from the ICAI’s elected council. Later, two practicing accountants were added.
The Competition Commission of India has only full-time members. TRAI has no telcos, SEBI has no brokers, IRDAI has no insurers on its board. Politicians are not on the Election Commission of India.R Narayanaswamy, Chair- TAC, NFRA
And finally, the NFRA should have administrative, financial and functional autonomy. This is not possible as long as it remains part of the Ministry of Corporate Affairs, he said.
As for how the regulator would view auditors going forward, its chairman of three years summarised it in a speech last year.
That the auditor is a watchdog and not a bloodhound is a misconception.