Auditors more accountable, need to be more independent under new company law

Seeking greater transparency and corporate responsibility, the Companies Act, 2013 (“New Companies Act”) has changed the role of auditors in companies.

Discussions about the role of auditors took center stage in the United States after a number of corporate scandals — the best documented of them being the Enron scandal, which sounded the death knell for its auditor, Arthur Andersen. Reacting to this scandal, the United States passed the Sarbanes Oxley Act, 2002 (“Sarbanes Act”).

This law established a separate body for the independent oversight of public company audits. This ended more than hundred years of self-regulation of the public company audit profession. The Sarbanes Act also prescribed that all audit committees (in listed companies) be independent of the management. This independent audit committee, rather than the management, would be directly responsible for the oversight of the external auditor. Additionally, audit firms were prohibited from providing certain non-audit services to the companies they audit.

All these provisions — ensuring that auditors are independent, free from all external influences, and solely responsible for doing their job efficiently — stem from the basic motive of increasing their accountability. Since its notification, the Sarbanes Act has been both critiqued and applauded.

In India, the Satyam scandal brought to the fore the inadequacies in the regulatory scrutiny of accounting. It is shocking that B. Ramalinga Raju could stand before the company’s board and admit that he had falsified accounts for “several years” to stave off a takeover, when a reputed accounting firm such as Price Waterhouse India (“PWC”) had been auditing their accounts for several years. While PWC claimed that they had received adequate evidence from Satyam and had carried out audits in accordance with applicable Indian auditing standards, the scandal begged the question whether it could have been averted if there had been stricter regulatory scrutiny of auditors. The following questions were also asked: Should a company be forced to rotate its auditors? Should there be a greater liability on auditors to deter such scandals? Let us now see whether the New Companies Act provides any answers.

Auditor’s term                                                          

Under the Companies Act, 1956 (“1956 Act”), an auditor was appointed at the annual general meeting, for a term of one year. Under Section 139 of the New Companies Act, an auditor will be appointed at the first annual general meeting and will hold office till the end of the sixth annual general meeting, though its appointment will be ratified at every AGM.

Mandatory rotation

The New Companies Act (Section 139(2)) read with the draft rules provide for the mandatory rotation of auditors. Individual auditors will be compulsorily rotated every five years and the audit firm will be rotated every ten years in all companies except one-person companies and small companies. This step was inserted to ensure that auditors do not increase their familiarity and reduce their independence by continuing to audit a company for an unlimited period of time. One questions however, whether such stringent requirements are needed in private companies.

A more basic question is whether the rotation of auditors really results in independence? The Standing Committee on Finance reviewing the Companies Bill was sure that rotation does in fact lead to independence. On the other hand, some feel that companies do not have much choice in relation to auditors, and that such rotation may lead to cartelisation among large audit firms. Another argument is that the rotation policy discourages small and medium-size audit firms from investing in technology and training because of the uncertainty of securing another client of the same size operating in the same industry, given that there are only a few large players operating in a particular industry. Arguments from both the sides appear to have some strength.

Cooling period

A cooling period of five years is also prescribed (Proviso to Section 139(2)) before the reappointment of auditors who complete one term. The same company cannot reappoint such auditors or audit firms for the next five years after completion of one term.

Non-audit services

Similar to the Sarbanes Act, the New Companies Act in Section 144 lists a few services that a company’s auditor cannot provide, directly or indirectly, to the company and its holding and subsidiary companies. The intent is to ensure that the auditor avoids any conflict of interest arising from the provision of other services such as accounting and book keeping, internal audit, management, and actuarial and, investment advisory services.

Tribunal’s power to remove auditors

While no separate regulatory body has been set up to regulate auditors, the National Company Law Tribunal (“Tribunal”) has (in addition to the company itself) the power to order the removal of auditors. The Tribunal under Section 140(5) can order a company to remove its auditor, if it believes the auditor has acted in a fraudulent manner, or abetted or colluded in any fraud.

Reporting fraud

The New Companies Act also enhances the accountability of auditors. It does so by placing on auditors, the onus of reporting fraud noticed by them, during the performance of their duties (Please see the draft rules).

(Deepa Mookerjee is part of the faculty on myLaw.net.)