Towards Audited Financial Statements of Urban Local Bodies in India: Key Issues and Way Forward
CA. Ashok Rao & CA. K R Praveena
The authors are members of the Institute. They can be reached at eboard@icai.in
“In a recent development, audited financial statements have been made mandatory for urban local bodies (ULBs) across the country to access the 15th Central Finance Commission (CFC) grants. To circumvent capacity gaps in the present statutory audit arrangements (discussed later in this article), State governments are in a rush to get ULB financial statements audited by Chartered Accountants for complying with the grant conditions. This article attempts to highlight certain issues pertaining to the mandate of the financial statements audit and it’s scope, and attempts to offer recommendations for addressing the issues. Doing so will help in placing financial statements audit on a firm footing and contribute to better fiscal accountability of ULBs. Read on…”
Accrual Accounting in Urban Local Bodies (ULBs)
Although the transition to accrual accounting in ULBs began many years ago, the reforms never took off in the real sense. Even after almost two decades, in states where the transition is supposedly complete, the accrual accounting system is yet to fully stabilize.
The transition continues to be plagued by structural bottlenecks that include:
- Incomplete or piecemeal information for accounting;
- Underlying business processes not aligned with accrual accounting requirements;
- Low technical and functional capacities of accounts department personnel;
- Dysfunctional information technology (IT) and Enterprise Resource Planning (ERP) solutions; and
- A widespread lack of awareness amongst key municipal stakeholders on using financial statements for policy governance.
These chronic issues have fostered a regrettable tendency to fall back to the cash-based legacy system after the initial euphoria of the transition to accrual has died down.
“Although the transition to accrual accounting in ULBs began many years ago, the reforms never took off in the real sense. Even after almost two decades, in states where the transition is supposedly complete, the accrual accounting system is yet to fully stabilize.”
Audited Financial Statements to Access Grants
Successive Central Finance Commissions (CFCs) have highlighted these governance deficits and recommended ways to create better reward mechanisms for states to implement and sustain municipal accounting reforms. Several central urban renewal missions—such as the Jawaharlal Nehru National Urban Renewal Mission (JNNURM), the Urban Infrastructure Development Scheme for Small and Medium Towns (UIDSSMT), the Atal Mission for Rejuvenation and Urban Transformation (AMRUT), and the 14th CFC grants—have touched upon the subject of accrual accounting reforms in ULBs, either encouraging the transition as a soft reform or by directly linking it to performance grant eligibility.
The 15th Central Finance Commission (15th CFC) has gone a step further and made audited annual accounts an entry-level criterion for accessing basic municipal grants. The adoption of accrual accounting, which was expected to pick up in response to market forces and municipal bond issuances, is, unfortunately, now having to be forced by the federal government. Policymakers are hoping that this time around, fiscal conditionality will stir state governments and ULBs into decisive action.
Early Trends Look Promising, But Challenges Loom
The initial reaction to the 15th CFC recommendations offers genuine hope:
- The recommendations have been formally accepted by the Union Government.
- The Ministry of Finance has released comprehensive scheme operational guidelines.
- The Ministry of Housing and Urban Affairs (MoHUA) has published the official marking scheme and launched an online portal (www.cityfinance.in/fc_grant) for ULBs across India to upload their audited financial statements. The volume of uploaded statements is rising steadily.
- There is significant momentum at state government levels (anchored either in the state Urban Development Department or Directorate of Municipal Administration). Multiple states—including Karnataka, Odisha, and Himachal Pradesh—have floated Requests for Proposals (RFPs) inviting Chartered Accountant firms to audit ULB financial statements. Other states are scrambling to execute crash transition programs.
The Risk of a “Tick-in-the-Box” Exercise
Notwithstanding official proactiveness, there are alarming signals that the enthusiasm will degenerate into a mere “tick-in-the-box” compliance ritual. Barring a few exceptions, in most Indian states, financial statement audit is being positioned as an exercise completely distinct from the statutory external audit governed by municipal Acts.
Consequently, getting annual accounts audited is being reduced to the level of certifying Utilization Certificates (UC audit) for central schemes, where the auditor operates under a restricted mandate solely to unlock grant tranches. The authors analyze two fundamental structural issues underlying this crisis and propose systemic remedies.
Issue 1: Primary Audit Mandate and Legislative Fragmentation
A comparative review of state municipal statutes hosted on the MoHUA portal (www.cityfinance.in/municipal-law) reveals that statutory audit responsibility in most states is vested with the State Audit Department (alternatively designated as Local Fund Audit Department or Examiner of Local Funds). A few states, such as Bihar and Jharkhand, statutorily permit a Chartered Accountant appointed by the State Government to serve as the statutory auditor.
Under international standards (INTOSAI) and C&AG Auditing Standards, a financial audit culminates in attestation—expressing an opinion on whether financial statements are presented fairly and free from material misstatement. However, state audit departments in most states do not attest full financial statements because municipal corporation and Local Fund Audit Acts contain no such mandate. While Tamil Nadu’s Local Fund Audit Department certifies statements, and Karnataka statutes require CA firms to submit reports to the State Audit Department for reliance, most state audit departments face crushing handicaps:
- Audit arrears and backlogs spanning multiple financial years;
- Acute personnel shortages against an expanding roster of auditee institutions;
- Archaic manual audit processes; and
- Lack of internal competency to audit double-entry accrual financial statements (Balance Sheet, Income & Expenditure Statement, Cash Flow Statement, and detailed schedules as mandated by Para 7.95 of the 15th CFC Report).
The Dual-Audit Anomaly:
To meet grant deadlines, state Urban Development Departments engage CA firms to conduct parallel financial audits. These audited statements unlock 15th CFC grants and are promptly shelved. Months or years later, the State Audit Department conducts its statutory audit. This has resulted in bizarre situations where ULBs possess two divergent sets of audited financial statements for the identical financial year—one by the CA firm and another by the state audit department—undermining legal sanctity.
Three Policy Pathways to Harmonize Audit Mandates:
- Statutory Recognition of CA Firms as Primary Auditors: Amend state municipal Acts to formally recognize CA firms appointed by the State Government as primary statutory auditors (emulating the Bihar and Jharkhand model). This eliminates duplicative state audit department inspections and dramatically alleviates the acute workload of overwhelmed state audit departments.
- Empower State Audit Departments with Outsourcing Frameworks: Retain the state audit department as the primary statutory auditor, statutorily incorporate financial statement certification into its mandate, and institute a transparent mechanism enabling the department to outsource audit field work to empaneled CA firms (resembling the model in Odisha).
- Legislative Delineation of Complementary Roles: Statutorily delineate the precise division of labor between the CA financial statement auditor and the primary state auditor, explicitly defining how the primary auditor places formal reliance on the CA’s attestation (as successfully practiced in Karnataka).
Issue 2: Divergent Scope of Audit – Propriety vs. True and Fair View
The traditional “audit of accounts” practiced by state audit departments is dominated by compliance and propriety auditing (evaluating observance of financial rules, procurement codes, sanctions, and anti-waste standards) via 100% voucher verification, often certifying only the closing cash balance. This heavy emphasis exists because ULBs completely lack independent internal audit departments.
In contrast, a financial statement audit by Chartered Accountants delivers an opinion on the “true and fair” view of financial affairs. CA audits employ risk-based statistical sampling rather than 100% transaction checking, scrutinizing compliance and internal controls primarily to assess audit risk and certify the complete set of financial statements.
“An audit of financial statements is understood by CAs as an opinion on the true and fair representation of the auditee’s financial affairs. Although compliance and propriety aspects are important considerations, these are not the primary focus of a financial statements audit.”
Legitimate Administrative Concerns Regarding CA Audits:
- Omission of Propriety Lapses: Procurement violations, non-adherence to delegation of powers, and service irregularities may not be captured in financial statement audits if they do not lead to material accounting misstatements.
- Public Funds Risk: Since public money is involved, sample-based audits might omit irregular transactions that fall below materiality thresholds.
- Perceived Dilution of Public Accountability: The administrative perception that government audit departments possess higher public accountability compared to private CA firms.
“Given the involvement of public money, a sample-based audit may omit to catch irregular transactions when they fall below the sampling threshold, and therefore, a more detailed audit is called for.”
Four Systemic Solutions to Reconcile Scope and Accountability:
a) Institutionalize Independent Internal Audit:
Compliance and propriety belong legitimately to internal audit. Larger ULBs should establish dedicated internal audit wings, while smaller ULBs can adopt a cost-effective state-level pooled internal audit framework. The external primary auditor can then evaluate internal audit controls rather than checking 100% of transactions.
b) Leverage Automated Pre-Audit and Concurrent Audit:
Pre-audit (scrutinizing payment vouchers prior to release) or concurrent audit provides near-100% transaction coverage. With ongoing municipal digitalization, these checks can be automated into financial management software, drastically curtailing error rates and compliance costs.
c) Statutory Accountability and C&AG Empanelment:
Chartered Accountants are legally bound by ICAI Auditing Standards, the Code of Ethics, and rigorous disciplinary mechanisms. Mandating empanelment with the Comptroller & Auditor General of India (C&AG) as a prerequisite for ULB audit tenders provides institutional assurance over auditor competence and ethical accountability.
d) Formulation of Standard Terms of Reference (ToR):
Just as the C&AG formulated standard ToRs with the World Bank and Asian Development Bank for externally aided projects, a joint initiative by the C&AG, ICAI, and MoHUA should formulate national standard Terms of Reference for ULB financial audits. These ToRs should standardize scope, computerized audit methods, format of opinion, and auditor capacity-building.
“The Comptroller and Auditor General of India (C&AG), working with the World Bank and the Asian Development Bank, has formulated standard terms of reference for the audit of externally aided projects.”
Conclusion and Policy Recommendations
The 15th Central Finance Commission has set the ball rolling towards institutionalizing accrual accounting reforms in ULBs across India. It is now up to the MoHUA and state governments to ensure that quick-fix workarounds do not proliferate merely to satisfy grant disbursement conditions while leaving structural gaps unresolved.
A sustainable national architecture requires the collaborative synergy of State Audit Departments (as statutory auditors), the ICAI (as the regulatory authority of the accounting and auditing profession), and the C&AG of India (as the Supreme Audit Institution).
Crucially, the 15th CFC has provided a strategic window of opportunity by relaxing eligibility criteria for FY 2021-22 and FY 2022-23, requiring only 25% of ULBs in a state to submit audited annual accounts. This transitional cushion must be utilized to amend statutes, harmonize audit mandates, institute pooled internal audits, and establish standard ToRs. Doing so will ensure ULB financial audits transcend grant-seeking rituals and establish genuine municipal fiscal accountability.