The Evolving Regulatory Climate & The Expectation Gap

Of late, the regulators have become far more demanding, and it has further enhanced the expectations gap without appreciating that so far, the Standards on Auditing expected the auditors to opine on truth and fairness of the financial statements rather than detection of frauds. But things have changed dramatically, primarily due to the increasing number of accounting scams causing huge losses to investors, lenders and other stakeholders. Needless to say, that the auditing profession is drawing flak from different quarters. Most of the times, it may be unjustified as well. Our endeavour is to highlight relevant issues / areas which need immediate attention.

The Past President of our institute ICAI, CA. (Dr.) Debashis Mitra recently said:

“Auditing is a serious business, stay away from it if you can’t meet expectation gap.”

This statement sums up the onerous task that the auditors have in their hands. Provision of class action suits as introduced by Section 245 of the Companies Act, 2013 has further made the lives of the auditors tougher.

Needless to say, that, auditing in today’s environment is significantly different from what we studied in our graduation / post-graduation and CA curriculum. We are all aware of the Kingston Cotton Mills case, wherein the Court of Appeal in England gave a landmark judgment on the role of the auditors and held the auditors to be watchful.

While talking of the auditing history, how can we forget about another landmark case of “McKesson & Robbins”, which happened in the US in the year 1939, which brought about a lot of foundational changes to auditing procedures and methods:

1. Attending physical verification of inventories;
2. Obtaining external confirmations;
3. Appointment of auditor to be made by shareholders;
4. Addressing auditor’s report to shareholders;
5. Mandating due diligence of client before accepting the assignment (i.e., Knowing Your Client - KYC);
6. Evaluating internal controls of the company.

It is difficult to believe that these procedures, which form the very basis of audit today, were not in existence prior to 1939.

From Watchdog to "Barking Dog": Expanded Whistleblowing Mandates

A question that we need to ask ourselves is, whether in today’s world, the position of an auditor being a watchdog holds good anymore. In our opinion, various stakeholders in the corporate and non-corporate world, including the regulators, expect the auditors to start playing a role much different from which is being played till date. They certainly expect the auditors to “Bark” to provide alarm signals at the right point of time.

• Section 143(12) of Companies Act, 2013: Requires an auditor to report to the Central Government any fraud and/or suspected fraudulent activity in a company which he comes across during the course of his audit.
• RBI Directives: Requires auditors to report any fraud observed in a branch or bank during the course of their audit. At times, the auditor may find it difficult to distinguish between a gross error and a fraud. In case of a dilemma, it would be desirable for the auditor to take a safer position for himself.
• Companies (Auditor’s Report) Order (CARO): Recent changes require auditors to enquire and answer on numerous matters: property plant and equipment, capital work in progress, investments, loans and advances, short-term funds diverted for long-term purposes, public issue moneys utilization, inventory data submitted to banks for working capital loans, and the ability of a company to meet current liabilities over the next 12 months. India is the only country in the world where auditors are mandated to report on such exhaustive operational matters.
• NOCLAR (Non-Compliance with Laws and Regulations): Code of Conduct amendments requiring auditors of Public Interest Entities (PIEs) to report on bribery, money laundering, tax evasion, and environmental protection violations make the audit function exceptionally onerous.

The Performance Gap: NFRA Audit Quality Reviews (AQRs)

Whereas one may argue that it may not be possible to do away with the expectation gap altogether, more worrisome is the performance gap in complying with Standards on Auditing (SAs), non-reporting of non-compliances with Accounting Standards (Ind AS), and deviations from ethical conduct.

In recent times, the National Financial Reporting Authority (NFRA) has undertaken Audit Quality Reviews (AQRs) and issued disciplinary orders regarding major corporate failures (including IL&FS, IFIN, ITNL, Jaiprakash Associates Ltd, SRS Ltd, Coffee Day Group). Major findings of NFRA include:

• Prohibited Non-Audit Services: Providing services barred by Section 144 of the Companies Act, 2013, directly impairing auditor independence.
• Non-compliance with SQC 1: Systemic failures in firm-level quality control policies.
• Lack of Professional Skepticism: Failing to challenge aggressive management judgments which artificially inflated profits:
  • Derivative valuations that inflated earnings
  • Reversal of contingency provisions to boost profits
  • Non-provision of impairment losses on investments
  • Incorrect computation of Capital Adequacy Ratio
  • Non-identification of the ever-greening of loans
• Governance Lapses: Non-communication of material non-adjustments to Those Charged With Governance (TCWG).
• Analytical & Going Concern Failures: Inadequate analytical review procedures and failure to evaluate adverse indicators regarding Going Concern.
• Gross Negligence in Provisions: Understatement of provisions for Trade Receivables and subsidiary investments, which masked huge corporate losses.
• Inappropriate Opinions: Using an Emphasis of Matter (EoM) paragraph instead of issuing a Modified / Qualified Opinion for doubtful debts.
• Audit Documentation Deficiencies: Tampering with audit files post-facto and failing to document planning, risk assessment, materiality, and audit evidence.
• Related Party Transactions (RPTs): Complete failure to exercise skepticism over promoter group transactions, allowing fraudulent fund diversion, non-verification of Arm’s Length Basis, and non-compliance with Ind AS 24 disclosures.
• Failure to Report under Section 143(12): Non-examination of massive asset impairments and doubtful debt spikes from a fraud angle.

“Going by the number of cases filed under Insolvency and Bankruptcy Code, the role of the auditors is bound to come under greater scrutiny.”

Prior to NFRA and continuing alongside it, ICAI’s Disciplinary Directorate has debarred members for varying terms and life, as well as reprimanded them. Furthermore, while the CA Act previously did not empower ICAI to penalize audit firms (only individual partners), ICAI’s demand for firm-level disciplinary powers post-Satyam was finally accepted by the government last year after a lapse of 12 years.

IBC Insolvencies & Scrutiny of Key Auditing Standards

Under the Insolvency and Bankruptcy Code (IBC), lenders are taking an average haircut of 70%. While some failures are commercial, in numerous cases, diversion of funds through related parties took place and went unreported, and auditors were found wanting in reporting on Going Concern status.

Crucial Standards Requiring Revisit & Guidance:

• SA 505 (External Confirmations): Section 143(9) mandates compliance with SAs. At times, financial statements carry the boilerplate note: “All party balances are subject to reconciliation and confirmation.” This is directly violative of SA 505. The reliance on vague “alternate procedures” requires urgent authoritative guidance from regulators. In future, mandatory disclosures of confirmed receivables, payables, and sample selection procedures should be included in audit reports to enhance transparency.
• SA 240 (Auditor’s Responsibilities Relating to Fraud): Requires a comprehensive overhaul to align with the aggressive realities of modern corporate fraud.
• SA 550 (Related Parties): Requires significant re-examination. Auditors struggle in the absence of comparable market rates to verify Arm’s Length pricing. Regulators need to examine whether high-value RPTs should be mandated on a tender basis rather than a nomination basis.
• Remote Auditing, Data Analytics & Crypto: The future belongs to remote, system-based auditing using automated data analytics tools across complete transaction populations. Furthermore, ICAI must issue detailed, specialized guidance on the audit of crypto assets.

Conclusions & Strategic Suggestions

“Regulators need to appreciate that an auditor is as good as the system allows him to be. All those who are regulating the profession must ensure the independence of the auditors.”

• The Regulatory Pendulum: In India, regulation has swung from under-regulation to extreme over-regulation, creating apprehension among new entrants.
• True Independence: Real auditor independence can only be achieved by fundamentally altering the auditor appointment mechanism away from management control.
• Accountability Hierarchy: Preparers of financial statements bear primary responsibility for fraud. Regulators must ensure that corporate preparers are prosecuted and adjudged guilty rather than punishing auditors in isolation.
• Natural Justice: The conduct of auditors should be adjudicated primarily by qualified accounting and auditing experts.
• ICAI and NFRA Collaboration: NFRA and ICAI must coordinate in tandem rather than functioning in watertight compartments. NFRA’s Audit Quality Reviews (AQRs) should serve as constructive, time-bound rectification guidance rather than merely punitive exercises.

“The future of the auditing profession will belong to those who would be able to handle the audits through a system on remote basis.”

Despite heavy criticism, immense faith is reposed in auditors. Stakeholders expect that when all around are committing wrongs, the auditor standing at the end of the tunnel will act as a vigilant “Chowkidaar” protecting public interest. We must take a resolute pledge to never allow that faith to be shaken under any circumstances.

---

Authors may be reached at: eboard@icai.in