Is NFRA Being Undermined?

The Company Law Committee set up by the Ministry of Corporate Affairs has submitted its first report. The stated objective of the committee’s exercise is “to facilitate and promote ease of doing business and ease of living.” In a country that has myriad laws that are poorly drafted and often arbitrarily administered, freeing the citizen from prosecution for unintended lapses is a welcome step. Again, promoting ease of living by simplifying arduous compliance requirements should be a matter of joy. However, ease of living for one group of citizens should not result in making life grim for another group of citizens. This is what is likely if the committee’s thinking on debarment of audit firms becomes the basis for changing the Companies Act, 2013.

Section 132 (2) (c) of the Act (after the 2019 amendment) empowers the National Financial Reporting Authority to debar an auditor or an audit firm guilty of professional or other misconduct from being appointed as an auditor or internal auditor of any company or body corporate or performing any valuation for a minimum period of six months or a maximum period of ten years. The report states:

“The committee was of the opinion, that there may be cases, where only one or a few individuals/partners connected with such firm may be actually responsible for the fraud. In such cases, making the entire firm responsible for the actions of a few individuals may be disproportionate. The issue of vicarious liability of the firm was also considered and it was felt that heavy monetary penalties on the firm could be considered, instead, in such cases.” (paragraph 15.2)

The report adds:

“Therefore, the committee recommended that the debarment of a firm may be an exception rather than a rule. It should only take place in cases where the firm refuses to co-operate in the proceedings in question or if the higher management of the firm is involved in the fraud. Otherwise, debarment even in case of audit firm may be restricted to only those individuals/partners associated with the firm who were actually involved in the fraud.” (Paragraph 15.5)

Acknowledging that this was a complex issue, while the committee was of the view that there should be changes to the Companies Act, it left the issue open for the next phase of recommendations.

The Law And Practice Of Partnership

The recommendation to remove the power of the NFRA to debar audit firms needs deeper analysis. It strikes at the root of the well-established law that partners are jointly and severally liable for each other’s acts. The provisions of the Indian Partnership Act, 1932 (Sections 9, 10, 18, 19, 25, and 26, among others) are clear on this point. Specifically, Section 26 states that the firm is liable for the wrongful acts of a partner to the same extent as the partner.

Also, as a practical matter, when a company appoints a firm as the auditor, it clearly intends to hold the firm responsible for the audit. The audit report in such cases is signed by the partner for and on behalf of the firm. The partners share the profits from all the firm’s activities. Therefore, it would be disingenuous for a firm to pretend that when an audit is botched, it should have been only the signing partner’s fault. If this argument is conceded, audit firms will throw the guilty partner under the bus and carry on as if nothing happened.

The Centrality Of The Firm In An Audit

The committee’s implied view that it is the signing partner and not the firm which is responsible for audit quality is misconceived. The position under the auditing standards (e.g. SA 220 and SA 330) is that the firm lays down and administers quality control systems.

In the latter case, the firm can act against the delinquent partner under the Partnership Act but it is a matter between the firm and the partners.

Touching Faith In The ICAI’s Disciplinary Process

The argument that it is a matter of livelihood for the auditor seems emotional and lacks logic. If taking away the licence to practice would affect the livelihood of CAs, why should the ICAI have that power under the CAs Act? Bizarrely, the report says that “authorities (other than the ICAI) should take debarment decisions, even when provided for in relevant laws, in rare circumstances only, and should duly consider the doctrine of proportionality. In a usual course, debarment actions should be executed through the ICAI….” (paragraph 15.4) The reasoning behind the committee’s suggestion that the power to debar CAs should be taken away from the NCLT and the NFRA but should be with the ICAI is not articulated. Disciplinary powers were taken away from the ICAI because of its poor record. The committee’s recommendation will result in strengthening the ICAI to the point of handing to it a veto over the decisions of the NCLT and the NFRA and other authorities. Requiring an independent regulator to approach a trade association for taking action would be an international innovation.

Strengthen The NFRA

Since the NFRA came into existence last year, many more accounting scandals have surfaced, all involving staggering amounts with significant economy-wide ramifications.

In the past three years, the MCA has taken many initiatives to strengthen corporate governance. Setting up the NFRA is arguably the most important of them. It happened in the face of stiff opposition from the ICAI. By all accounts, the ICAI is still to swallow the truth that its regulation of the auditing industry has fallen far short of the public interest. The hidden message in the committee’s report is that the ICAI may be finally having its way in its stand-off with the MCA. If true, that would bring us back to where we were and all the gains made in auditor regulation would be squandered. I would be happy to be proved wrong.

R Narayanaswamy is Professor of Finance and Accounting at Indian Institute of Management, Bangalore.

The views expressed here are those of the author, and do not necessarily represent the views of BloombergQuint or its editorial team.