Limning Auditing Indian Auditors

Abstract

The boom of regulatory agencies is a common global phenomenon, and its basics are deeply rooted in national settings, leading to the setting up of specific regulators. Theoretically, auditors must demonstrate their professional prowess, skepticism, and analytical procedure, and effectively communicate audit outcomes to the stakeholders. Interestingly, the Indian audit profession is at its crossroads: constrained by scams and multiple regulators. Reform initiatives in the wake of corporate shenanigans compelled the creation of the National Financial Reporting Authority (NFRA) under Section 132 of the Companies Act, 2013. However, the accounting profession regulator, the Institute of Chartered Accountants of India (ICAI), alleges penetration of the former in its regulatory jurisdiction. Against this backdrop, adopting a descriptive approach, the current study attempts to unearth the factors leading to such face-offs for offering an amicable solution. The study concludes that the ICAI’s objections to treating the NFRA as a “super-regulator” cannot be supported. Consequently, the observation of the Committee on Experts constituted by the Supreme Court. Vesting investigating power in the NFRA could be a game changer in regulating auditors, audit firms, and audit networks. In light of the findings, the auditors could motivate to improve the audit quality substantially.

Keywords

NFRA ICAI audit reform Companies Act 2013 auditors

Introduction

Economic liberalization works on the premise that structural changes in the governance system are necessary to ensure the free play of market forces and the private sector (Faur, 2005). Such structural changes pave the way for increased growth of the regulators, whereas regulation reflects the direct interventions by the state agencies in the activities of a target population in the form of binding standards setting, monitoring, and sanctioning (Koop & Lodge, 2017); the scope of the regulators is fourfold, namely regulatory responsibilities, managerial autonomy, political independence, and accountability (Jordana et al., 2018). Post-1991 liberalized corporate India witnessed many newly created regulating agencies replacing the State’s direct control. The consequent depoliticizing of specific decision-making processes increased the number of regulators (Kapur & Khosla, 2019). However, the role of regulators is likely to be embedded in traditional politics and bureaucracy. Therefore, the performance is significantly varying across the regulators. Literature suggests that faulty design, opaque focus on market structure reforms, and inadequate understanding of the interaction between the market structure and the regulatory process caused this variability (Bhattacharya & Patel, 2005). Modern constitutional democracies thrive because the three pillars of democracy, that is, the legislative, executive, and judiciary, shape the modus operandi of the public institutions. Strangely, in the Indian context, judicial interventions shape public policy. One such prime instance is the creation of the National Financial Reporting Authority (NFRA). Under the Companies Act, 2013, as an independent regulator to oversee the Indian auditing profession and accounting standards, NFRA came into existence. However, it took a judicial intervention in the Supreme Court (SC) judgment on February 23, 2018, that the government formally set up the NFRA on October 1, 2018.

The Institute of Chartered Accountants of India (ICAI), the regulator of the Indian accounting profession, and the NFRA, the new audit regulator of the listed and large public companies, have been in a tug of war since the latter came into existence. The causes of such face-offs are multiple. The audit profession, in the recent past, experienced several regulators. Multiple bodies regulate auditors’ appointments, supervisions, and regulations; the ICAI, NFRA, the Ministry of Corporate Affairs, the Reserve Bank of India (RBI), and even the Securities and Exchange Board of India (SEBI). Notably, the Bombay High Court (HC), by dismissing two writ petitions (WP 5249 and 5256 of 2010) filed by two chartered accountant partnership firms on August 13, 2010, held that under Section 11 of the SEBI Act, 1992, SEBI, being a quasi-judicial authority, has the power to carry out investigations relevant to manipulation and fabrication of books of accounts of any listed company.¹ Furthermore, under the said Act, Section 11(4) empowers appropriate remedial measures, including debarring the chartered accountant (CAs) from auditing the books of accounts of any listed company. Interestingly, setting up the NFRA appears inevitable in retrospect, as the other regulators oversee specific categories of supervision (Mishra, 2021). The debate is whether the NFRA would only be an addition to the existing list of regulators or a “super-regulator.” The setting up of the NFRA in the wake of accounting shenanigans of the Infrastructure Leasing & Financial Services (IL&FS), Punjab National Bank, and other corporate scams for regulating the regulators by an independent body was an appropriate step. On the recommendation of the Report of the Standing Committee on Finance, the government created the NFRA under Section 132(1) of the Companies Act, 2013.

The NFRA is entrusted with enforcing the Standards on Auditing (SA), ensuring audit quality, audit firm, and audit independence, and enhancing the stakeholders’ confidence in companies’ financial statements (FSs) and disclosure. The NFRA enjoys wide-ranging powers starting from investigations of the CAs and their firms, listed companies, large unlisted companies, and any other entity involving a substantial amount of public interest as notified by the central government. The Indian audit profession is in the limelight due to varied regulators’ interventions in the post-Satyam period, which has gained momentum in the past few years, especially after the debacles perpetrated in the IL&FS, Yes Bank, and Punjab National Bank. On January 10, 2018, the SEBI slapped a two-year ban on PricewaterhouseCoopers (PwC) from auditing listed companies for its alleged involvement in the Satyam Computers scam. Subsequently, the PwC challenged the SEBI’s debarment order in the Securities Appellate Tribunal, leading to a stay on September 9, 2018. Aggrieved by the said order, SEBI appealed before the SC, and on November 18, 2018, the SC passed an interim stay order. The NFRA, too, joined the case against the auditors of the IL&FS and Jaiprakash Associates. The NFRA reported that the initial appointment and the continuation of the auditor of the IL&FS Transportation Network were dehors the Rules and void as the auditors, with mala fide intentions, had understated the losses (Chitravanshi, 2021). Notably, the Comptroller and Auditor General of India also submitted an adverse report against select audit firms of the public sector undertakings (Levi, 2021).

Without citing exact reasons, on September 23, 2021, the RBI imposed a two-year ban on April 4, 2022, on Haribhakti & Co., the auditors of SREI Infrastructure Finance. The suppression of facts by the RBI created uncertainty and unprecedented tension among the auditors. However, an in-depth analysis of the audit report of the said company indicates a qualified audit report on its inability to continue as a going concern. The report suggests an emphasis on six matters and highlights four areas of critical audit matters (CAMs). Although complying with the Standards on Auditing (SA) 260 “Communication with those charged with Governance,” the auditors rightly communicated to the management indicating material weaknesses in the internal control system identified during the audit on a real-time basis but indeed become the scapegoats and paid a considerable price for the misdeeds of the management. SREI Infrastructure Finance was declared insolvent in compliance with the Corporate Insolvency Resolution Process under Insolvency and Bankruptcy Code, 2016, vide National Company Law Tribunal, Kolkata Bench Order dated October 8, 2021. The date of an effective ban by RBI, that is, April 2022, opens a window for further reprimanding the audit firm.

The notice of debarment has several implications. The RBI, on October 12, 2021, in compliance with Section 45MAA of the RBI Act, 1934, debarred the audit firm for two years from taking any audit assignment of the listed entities. The RBI further stated that the audit firm needs to comply with its specific direction of the statutory audit of a systematically crucial nonbanking finance company. RBI’s ban on the audit firm indicates that the ICAI failed on a real-time basis to prevent misdeeds. RBI’s suo moto intervention also shows that the ICAI still needs to prove its proactive role in protecting the company’s stakeholders. Interestingly, under the provisions of the ICAI Act, 1949, the ICAI is empowered to take punitive action only against the errant members but not against the audit firms. The Companies Act, 2013, inserted Chapter XIV containing 24 sections empowering the Registrar of the Companies to conduct inspection, inquiry, and investigation against erring companies. The Serious Frauds Investigation Office, a law enforcement agency, initiated action under Sections 211 and 212 and fraud charges framed following Section 447 of the Companies Act, 2013, against the errant auditors. Again, in exercising the powers conferred by Sections 139, 143, 147, and 148, read with Subsections (1) and (2) of Section 469 of the Companies Act, 2013, the government amends the Companies (Audit and Auditors) Rules, 2014, on March 24, 2021, putting the responsibility on the auditors. The said amendment stipulates that the auditors should disclose in Notes to Accounts that they have not invested or received funds to/from any other entity that the intermediary shall, whether directly or indirectly, lend or invest in other persons or entities identified in any manner or provide any guarantee, security, or the like on behalf of the ultimate beneficiaries. Such amendment enhances the auditors’ responsibilities, and the ICAI is the principal regulator entrusted to monitor compliance. As such, the RBI’s extreme step raises questions about no systematic failure; instead, a few errant auditors were involved in professional misconduct.

The RBI took the harsh decision without considering the judicial observations. It is to be noted that the Hyderabad HC observed that any professional negligence by an errant auditor without mens rea (criminal intention or evil mind) would be tantamount to gross negligence,² and it is unclear whether RBI investigated any mens rea was present or not. Notably, in the matter of professional negligence of the advocates and medical practitioners, the SC held that there must be a presence of moral turpitude and professional negligence.³ The SC further observes that the directors of a company occupy a fiduciary position concerning the shareholders, and it is for the auditors to act in the interest of the shareholders. The auditors are to examine the books of accounts and disseminate the actual financial position to all the users of the FSs. The auditors are also expected to maintain a high standard of professional conduct. Regarding the powers of the Disciplinary Committee under Section 21 of the ICAI Act, 1949, recommending penalty/punishment to be imposed on any errant member of the ICAI, the SC held that the HC under Sections 21(5) and 21(6), after examining the material on record, must arrive at its conclusion about the misconduct if any attributed to the member of the institute (ICAI). The HC is entitled to impose any punishment/penalty, including a punishment other than the institute recommends.^4,5 The SC further observes that as per the ICAI Act, 1949, the Disciplinary Committee of the ICAI is a subordinate committee, and its conclusions are tentative and cannot be regarded as findings since the said Committee is not vested with the power to render any findings which per contra vests only with the institute.⁴

Audit Expectation Gap

The American Accounting Association defines “audit” as a systematic process of objectively verifiable evidence for asserting economic events and assessing the degree of correspondence amongst the assertions by establishing a criterion and communicating the results to the stakeholders. A critical analysis of the definition suggests that the auditors must demonstrate their professional prowess, skepticism, and analytical procedure in audit and should effectively communicate the audit outcome to the stakeholders. Literature posits that the underlying accounting information must be reliable and unbiased (Mautz & Sharaf, 1986). The shareholders expect auditors should give credence to the FSs. Despite the audit function’s significance, the auditors’ role is challenging to explain most acceptably, creating a perception gap between the auditors and the users of the FSs. This gap further exacerbated due to infamous corporate scams perpetrated by Enron, WorldCom, Satyam Computers, IL&FS, YES Bank, and others. In the audit literature, Liggio (1974) pioneered the term “audit expectation gap” (hereafter AEG), and its scope was subsequently extended by scholars having varied manifestations amongst the stakeholders (Stevenson, 2019). Initially, the AEG was limited to the users of the FSs and an auditor about the latter’s performance level during the audit function. With time’s widening scope, the AEG refers to the public expectation about the auditors, what they could achieve (Cohen Commission, 1978), and society’s expectations of them and their performance (Porter, 1993). Society’s confidence in the effectiveness of audits and auditors’ opinions are the cornerstones of the audit function. Any deviations from that place will likely disquiet society’s confidence and undermine the audit quality. Porter further classifies the AEG into ‘reasonable gap’ and “performance gap,” where the former refers to the difference between the public expectation about auditors’ achievements and reasonably what they achieve. In contrast, the latter is the difference between the public’s reasonable expectations about the auditors’ role and what they are perceived to achieve. The AEG also has multiple adverse consequences ranging from undermining the credibility of the audit firms and audit partners’ reputation losses and potential earnings losses (Sikka et al., 1998).

The public trust associated with any profession refers to the core of the profession. Any deficit could lead to credibility loss and the profession’s value erosion. Notably, the stakeholders referred to the corporate disasters as akin to audit failures, which substantially increased the litigation risk of the auditors. The AEG defines as the difference in opinions amongst the public, such as the users of the FSs and the auditors, about the latter’s duties and responsibilities and the information contained in the audit report (Monroe & Woodliff, 1993). Consequently, the users of the FSs set a high expectation that the audit has a broader scope and that the auditors could approve the management’s decisions after threadbare discussion, which would ensure that the books of accounts are free from material misstatements, which, in turn, would likely to attract new investments in the auditee firms. Furthermore, the users of the FSs erroneously assigned disproportionate responsibilities toward the auditors for adequacy of the FSs, primarily vested with the management, consequently widening the AEG (Chapman, 1992).

Literature reports worldwide regulators and standard setters are motivated to improve clarity in the audit process bringing substantial changes in the audit reports (Reid et al., 2019). Infamous bankruptcies of firms indicate increasing trends of corporate failures (Amankwah-Amoah & Wang, 2019), and audit reports are used as an early signal of such corporate failure (Muñoz-Izquierdo et al., 2019) as statutory auditors expected to report audit risk and material misstatements in audit reports. Increased business risks and uncertainty, more particularly going-concern issues and management misdeeds (Hategan et al., 2022), lead to significantly increased disclosed CAMs (Ecim et al., 2023; Kaka, 2021). The outbreak of the COVID-19 pandemic and its imposed restrictions like physical verification of records impede the gathering of sufficient audit evidence (Hegazy et al., 2022) and catalyzes adverse impact on audit quality and the auditor’s ability to identify and disclose CAMs (Albitar et al., 2021). Related literature further argues that the users of the FSs could be dissatisfied if the auditors fail to provide genuine financial information (Porter, 1993), and FSs’ users presume that the audit report is vague (Jayasena et al., 2019), albeit research contests the arguments of Porter (1993) as it does not consider the significance of accounting standards in the AEG study (Astolfi, 2021).

International research reports criminological studies of the past (Churchill & Nagy, 2021), which could guide in analyzing of current research problems (Lawrence, 2019). History significantly influences criminology studies as characterizing the present, and this focus differs the present-day research from crime histories, even though contested by scholars (Catello, 2022). Extent literature further documents that the reporting of suspicious economic crimes perpetrated by the board members is a mandatory duty of the Swedish auditors (Lindgren, 2002), as the auditors play a prominent role in detecting and preventing accounting shenanigans and fraud (Morales et al., 2014). Again, countries having weaker investor protection and law enforcement history report higher accounting scams and frauds, like China (Xu & Xu, 2020), in preference to countries with strict law enforcement practices in detecting and preventing fraud, for example, European countries (Cumming et al., 2018). Again, ‘corporate recidivism’ is more culpable of having a significant negative impact on society, firm’s reputation, market confidence, and the image of accounting professionals (Wang et al., 2023). But errant auditors are unlikely learnt any lessons, as evident from Indian corporate debacles such as IL&FS, Yes Bank, and Satyam Computers.

Literature documents that AEG emerges due to auditors’ ethical lapses, fraud detection, and prevention acumen (Davis et al., 2014). Apart from these, the common causes of the AEG attached higher expectations from the auditors in detecting frauds (Hooks, 1992), auditors’ efforts, skills, and the appropriate audit procedures applied in detecting fraud (Kamau, 2013) and even compromising with the relevant aspects of the audit independence endeavors (Alawi et al., 2018). Research reports that the gap widened with the enactment of the auditors’ acts, regulations, and duties (Fossung et al., 2020). Although the audit’s primary objective is to extend assurance service rather than detecting and preventing fraud, research concludes that the users of the FSs consider the latter (Chau & Yuen, 2011). CAMs are another area that requires the significant professional judgment of the auditors for appropriate assessment and gathering of audit evidence where challenges abound. Authors report that additional disclosures in the form of CAMs would accelerate the information content of the audit report (Christensen et al., 2014), which, in turn, could likely enhance the auditors’ liabilities (Deloitte 2013; Gimbar et al., 2016). However, a few scholars could not trace such precedence of enhanced auditors’ liabilities (Backof et al., 2022). The auditors are not likely to assert complete confidence about the fraud-proof records, considering that factors such as inherent limitations of audit evidence and uncertainties could adversely impact the audit reports. Notably, country-specific differences significantly influence audits, like assessing client risks and commensurable audit planning decisions. Consequently, such high expectations from the auditors create an AEG, that is, a discrepancy between the users of the FSs and auditors about the latter’s modus operandi. On the other hand, research further documents that the FSs’ preparers (management) are entrusted with implementing the internal control system and risk management rather than the statutory auditors (Lin et al., 2011).

Global Experience

Historically, the modern audit profession evolves organically and was primarily self-regulated. However, subsequent events widen the scope substantially, requiring states’ intervention in setting the tone for the present-day regulatory framework as evident globally (Watts & Zimmerman, 1981). The US experience indicates that it enacted the Securities and Exchange Act of 1933, after the Great Depression and the securities market crash of 1929, which mandates compulsory external audit certification of publicly listed companies’ FSs. Although the regulator of the American accounting profession, the American Institute of Certified Public Accountants, was allowed self-regulation, the Securities and Exchange Commission retains the authority to enforce discipline amongst the professionals. After the Enron saga, it introduced the Sarbanes Oxley Act of 2002. It constituted the United States Public Company Accounting Oversight Board (PCAOB) to oversee public companies’ auditors to protect the shareholders’ confidence. Considering the Enron saga, the UK government suo moto reviews the regulatory system of the auditors. It increases the monitoring of the listed companies through an independent audit regulator. Consequently, the Financial Reporting Council emerged as the unified, independent regulator for the statutory auditors entrusted with corporate reporting and governance. The civil liability of an errant auditor for professional negligence is etched in British law, albeit the Companies Act, 2006 limits the liability through limitation agreements between the auditee and auditors. The Audit Enforcement Procedure introduced by the Financial Reporting Council in 2016 oversees the compliance deviation of the standards of professional competence. Interestingly, the Work and Pensions Committee expresses deep concern over the monopoly of Big 4 audit firms, particularly after the collapse of the construction giant Carillion in 2018 (The COE Report, 2018).

The audit legislation in the European Union has twin components—a directive and a regulation where the former encompasses a series of requirements governing statutory audits and amends the existing Statutory Audit Directive of 2006. On the other hand, the latter includes additional requirements about the statutory audits of the public interest entities, mandatory audit firm rotation, and prohibition of extending nonaudit services (in short NASs). The Australian audit profession is governed by a regulatory framework comprising legislation, standards, regulatory and professional bodies, and disciplinary boards. The Corporations Act, 2001 (Corporations Act) has comprehensive legislative requirements for financial reporting and auditing public companies. The Act mandates compliance with the accounting and auditing standards. It creates and delegates powers of those standards to the Australian Accounting Standards Board and Australian Auditing and Assurance Standards Board, respectively. Furthermore, large companies must furnish audited FSs to the Australian Securities and Investments Commission.

In the Asian context, China regulates the auditing profession significantly. Promulgating laws on Chinese foreign equity joint ventures made a mandatory provision for auditing the FSs by Certified Public Accountants. In 1988, the Chinese Institute of Certified Public Accountants was formed under the aegis of the Ministry of Finance. Following the global practice, in 2001, the Chinese Securities Regulatory Commission mandated that companies seeking listing shares should compulsorily get their FSs audited by foreign accounting firms. The current accounting profession regulators include the Ministry of Finance, the Chinese Securities Regulatory Commission, and the Chinese Institute of Certified Public Accountants. The audit regulations guide Singapore’s registered public accountancy professionals, which would mandatorily adhere to the Code of Professional Conduct and Ethics, update their skills through continued professional education, and inspect their performance under the Practice Monitoring Programme. It expects that the registered public accountants should adhere to the Code of Professional Conduct and Ethics, keep themselves technically up to date through continuing professional education and inspect their audit work. The Accounting and Corporate Regulatory Authority’s Practice Monitoring Programme, a statutory body under the Ministry of Finance, consistently monitors the accounting professionals’ quality against the Singapore Standards on Quality Control. In Bangladesh, anecdotal evidence suggests a history of self-regulation of the accounting profession until the Enron debacle. In tune with its global peers, it radically shifted from self-regulation to independent regulation. The said independent regulation clears the path for the state’s interventions, such as debarring NASs by the audit firms, capping on audit tenures, and enhancing the role of the Audit Committee in appointments and remunerations of the auditors. Enacting the Companies Act of 1994, it mandates that the FSs of all companies must be audited only by the professionals of the Institute of Chartered Accountants of Bangladesh.

Regulating Indian Auditors

The corporate governance reforms in India started its journey after the Asian crisis of 1997–1998. Admittedly, the Asian crisis could be a lesson for establishing stringent and vibrant corporate governance mechanisms, but corporate India could not implement the same. After that the government likely realizes its mistake and subsequently constituted several committees to suggest the modalities and other regulatory changes for implementing the corporate governance mechanism. The Committees formed include the Confederation of Indian Industry Code of Desirable Corporate Governance (1998), Kumar Mangalam Birla Committee (2000), Naresh Chandra Committee (2002), N. R. Narayana Murthy Committee (2003), and J. J. Irani Committee (2005). The government, by and large, accepted the recommendations of the committees. The Satyam scam of 2009 and the enactment of the Companies Act, 2013, introduced significant changes in the auditing profession. Earlier, the Enron debacle galvanized the corporate governance mechanism globally. Considering this, the government constituted a high-level committee chaired by Mr Naresh Chandra on Corporate Audit and Governance, which comprehensively assessed the aspects of the governance highlighted in the Enron failure. Apart from this, the Study Group Report of the ICAI, the J. J. Irani-headed Expert Committee Report on Company Law indicates different conflicts of interest and auditors’ liabilities. The policy reform initiatives highlight the need for shifting from self-regulation to independent oversight, significant capping on the NASs, and the cut-throat competition domestic audit firms face from their global peers. Notably, Section 210A of the erstwhile Companies Act, 1956, empowers the National Advisory Committee on Accounting Standards to formulate corporate India’s accounting standards, albeit the ICAI was vested with setting the auditing standards. Subsequently, the said Committee was renamed the National Advisory Committee on Accounting and Auditing Standards to incorporate the auditing standards. The Committee is empowered to act as a quasi-regulator to monitor the corporate audit quality.

To oversee the extent to which Sections 25 and 29 of the Chartered Accountants Act, 1949, may be enforceable in letter and spirit, the SC, on February 23, 2018, ordered the government to constitute a three-member Committee of Experts (CoE).⁶ The SC observes that the Statutory Code of Conduct for the practicing CAs requires a thorough revision to regulate the multinational accounting firms and implement appropriate discipline. The SC further held that the expert Committee could examine the need for appropriate legislation in line with the Sarbanes Oxley Act, 2002, of the United States and others to oversee the auditing profession in India. Consequently, the Companies Act, 2013, paved the way for the implementation of the NFRA. Earlier in 2016, the Company Law Committee emphasized requiring an independent regulating body to oversee the auditing function. Accordingly, the government constituted the NFRA in October 2018. Section 132 of the Companies Act, 2013, entrusts wide-ranging powers to the NFRA, such as recommending the government frame the accounting standards and monitor its compliance and service quality of the accounting profession. NFRA is empowered to investigate any professional misconduct committed by CA and the audit firms. It could impose punishment ranging from a monetary penalty to debarment from practice by any individual member and/or audit firm or both for a period of 6 months to 10 years. Furthermore, the Standing Committee on Finance, in its 21st report, recommends the requirement of an independent audit regulator for improving the audit quality of corporate India.

The Debate

The debate on the need to set the NFRA even after being accorded the statutory status continues. The Companies Law Committee was entrusted to recommend relevant amendments to the Companies Act, 2013. In 2016, considering the gravity of the issue, the ICAI raised its objections to the constitution of the NFRA itself. The Companies Law Committee observes that the auditors perform a significant role. However, in the wake of infamous scams, an independent regulator must monitor the audit profession, as observed in the major developed and developing economies. Accordingly, the provision for the prohibition of extending NASs by the auditors in the Companies Act, 2013, in line with the Sarbanes Oxley Act, 2002, of the United States, is probably an appropriate step to ensure audit independence and to improve the audit quality. Section 144 of the Companies Act, 2013, has a provision to impose a ban on the NASs; the government also empowers to add more of those services. The CoE recommends expanding the scope of the section considering the exposed corporate debacles perpetrated during the last couple of years. The Committee further observes that the NFRA is unlikely to create any inconsistency between the Companies Act, 2013, and the Chartered Accountants Act, 1949; instead, it addresses self-regulation problems. Literature affirms the growing acceptance of independent audit regulators for boosting investors’ confidence and bringing transparency and accountability to the auditing profession (Simnett & Smith, 2005). Notably, auditees and audit partners investigated by other regulators (Juric et al., 2018; Leng et al., 2011), and the Indian auditors are unlikely an exception. Interestingly, in the United States, the PCAOB has a history of preferring a punitive regulatory approach to penalize errant auditors (Westermann et al., 2019). Surprisingly, the auditors prefer such an approach (Ege et al., 2020). Albeit the NFRA is empowered to impose punitive actions, the ICAI’s objections about the NFRA’s scope and modus operandi raise serious repercussions amongst the auditors.

The CoE recommends that the NFRA be empowered to impose civil liability and pecuniary penalties on the Indian audit firms who work in partnership/networking with the multinational accounting firms for any audit failure if they adopt faulty audit methodologies. In contrast, the ICAI refers that the Council established a Disciplinary Directorate to investigate the CAs guilty of professional misconduct under Clause (7) of Part I of the Second Schedule read with Sections 21 and 22 of the Chartered Accountants Act, 1949. Interestingly, the Andhra HC in June 2016 also affirmed the recommendation of the Disciplinary Directorate to suspend a CA from practicing for three years who was found guilty of professional misconduct.⁷ Earlier, the Andhra HC imposed severe punishment than the one recommended by the Council.⁸ As far as the legal liability on audit failure is concerned, it occurs due to a breach of duties or fraudulent behavior, for unlawful gains earned by the auditors, and for compensation required to be paid by the auditors to the direct victims for an audit failure or fraud. Literature reports that auditors sued for audit failures due to accounting gimmicks such as understated assets and incomes, including fictitious assets, overstated liabilities, and expenses (Lennox & Li, 2020). In the past couple of years, en masse, resignations of Indian auditors indicate multiple audit risks, including engagement risks like litigation risk (Ghosh & Tang, 2015). However, such litigation risk likely catalyzes the objective of achieving higher audit quality (DeFond & Zhang, 2014). Again, the Indian judicial fora inconsistently define professional negligence in determining the auditor’s liability (Ram Mohan & Raj, 2020). Any professional negligence without any men’s rea could be tantamount to gross negligence,⁵ albeit contested.^9–11 The SC observes that for furnishing a false certificate by an auditor, a mere reprimand by the ICAI is an inadequate punishment.¹² Moreover, the Calcutta and Bombay HCs suggest the debarment of an auditor from the profession for a certain period.¹³ The HCs, in some cases, also observe that the auditors’ breach of duties was not due to gross negligence but rather a failure to exercise due diligence, which could be tantamount to professional misconduct.^14,15

Literature on auditors’ liabilities highlights different aspects. It concedes that the auditors comprehensively able to address the enhanced risks emanates from the changing economic conditions (Doogar et al., 2015) but contested (Sikka, 2009). Post the global financial crisis of 2009, the United States Public Company Accounting Oversight Board cautious the auditors about any attempt to compromise the rigor of the audit quality (Goelzer, 2010). It further indicates the supremacy of the independent regulator over and above self-regulation by the accounting profession. The intervention of the independent regulator likely was justified, say in Oman, where, since 2000, the number of audit litigations increased to 32,000, out of which 2,250 cases were against the Big 4 audit firms (Al Qadasi & Abidin, 2018). Against this backdrop, the research attempts to assay the association between audit quality and audit litigation, indicating mixed outcomes (Gajevszky, 2014; Khurana & Raman, 2004). Extant literature suggests that the Generally Accepted Accounting Principles avoidance in preparing FSs often compels the auditors for accounting restatements which, in turn, triggers lawsuits (Palmrose & Scholz, 2004). Literature argues that an auditor’s past litigation experience could certainly caution her to avoid the recurrence of a lawsuits. Interestingly, anecdotal research documents mixed evidence about the issuance of modified audit opinions and auditors’ risk of being sued (Kaplan & Williams, 2013). Consequently, it also documents that the audit quality will likely improve following litigations against the auditors (Lennox & Li, 2014).

Anecdotal evidence further reports that increased litigation cost catalyzes auditors’ mass resignation (MacDonald, 1997), and the Indian audit profession witnesses the stepping down of the auditors in the middle of the audit (ET Editorial, 2019). Auditors’ resignations are likely to trigger investigations by the NFRA, albeit based on the Uday Kotak Committee recommendations and in compliance with the SEBI (Listing Obligations and Disclosure Requirements) Regulations, the auditors of the listed companies must explain the reasons for their resignations within 24 hours. Again, under Section 140(2) of the Companies Act, 2013, an auditor must furnish a Statement of Resignation as provided in the Rules to the Registrar within 30 days from the date of his resignation. The reasons behind such en masse exit likely range from information asymmetry about the company’s core activities, revenues, tax observations, preoccupations, health issues, and even to “mutual exits” (Upadhyay & Sultana, 2018). Admittedly, NFRA’s investigation would unearth the underlying reasons. However, in his limited review report, the auditor should reveal the confronted management-imposed challenges in gathering sufficient and appropriate audit evidence, if any, and to what extent the lack of those could significantly impact the FSs. Moreover, as the ICAI not challenged the SEBI Regulations, which could substantially minimize the independent investigation, the errant auditors could investigate for any professional misconduct under the provisions of the ICAI Act itself.

The Way Forward

The CoE indicates the presence of multiple competing self-regulated organizations (SROs), such as the ICAI, for accessing the benefits under one independent regulator, as evident from the United Kingdom and the newly launched Indian insolvency profession, for implementing in the Indian audit profession. It observes that leading economies such as the United Kingdom and the United States shifted toward independent audit regulatory regimes. In the globalization era, India should quickly follow global trends. Again, the NFRA should be operationally independent of any external political influence and free from the conflict of interest. Moreover, exercising its powers and carrying out its functions should be independent of the audit professionals. The UK model entrusts the Financial Reporting Council to regulate the auditors of public companies and delegates powers to regulate the auditors of private companies to the SROs. The NFRA could discharge the role of the Financial Reporting Council. The Securities and Exchange Commission and PCAOB regulate auditors of US public companies. The regulations of auditors of private companies lie with a few professional bodies. Interestingly, in both models, the independent regulators are entrusted to impose penalties on those SROs for professional misconduct or deviations in complying with the regulations. Accordingly, under the Companies Act, 2013, the NFRA should regulate only the auditors of the listed and public companies beyond a specific threshold limit. In contrast, the ICAI being an SRO under the framework of the Chartered Accountants Act, 1949, should regulate the auditors of private companies and those of public companies falling below the threshold limits. The allegations labeled by the ICAI against the constitution of the NFRA for encroaching in its jurisdiction are not tenable since, under the provisions of the Companies Act 2013, the NFRA would regulate the statutory auditors of the listed and public companies beyond a specific threshold limit. On the other hand, the ICAI regulates the entire accountancy profession under the Chartered Accountants Act of 1949. The power vested with the NFRA under Section 132 of the Companies Act, 2013, was essential for creating sufficient deterrence at the audit firm level for addressing the most critical shortcomings of the Chartered Accountants Act, 1949. Admittedly, the ICAI’s objections of treating the NFRA as a “super-regulator” cannot be supported as Section 132 allows the petitioner to file to the Appellate Tribunal challenging the NFRA’s orders. In corollary, the observation of the CoE supporting the creation of the NFRA, considering the current audit environment and the lessons learned from the infamous accounting scams, is an appropriate decision.

Reverting to the audit literature indicates that multinational accounting firms resist any attempt to regulate them (Malsch & Gendron, 2009). Resistance to change has a positive impact since many audit firms are compelled to quit the US audit market due to enhanced regulation by the PCAOB (Abernathy et al., 2013). Albeit, the benefits and limitations of the Board’s inspection processes were also reported (Hermanson et al., 2007; Offermanns & Peek, 2011). The US auditors’ litigation risks significantly increased as the PCAOB imposed monetary penalties and other sanctions on the audit firms (Houston & Stefaniak, 2013). However, in the Indian audit environment, instances of auditors’ resignations are not related to the NFRA’s imposition of punishments (Upadhyay & Sultana, 2018). The regulation of statutory audits offers immense benefits to society, capital markets, and the general public, which, in turn, could enhance the public interest significantly (Baker et al., 2014). Moreover, the government must monitor the self-regulated audit profession for improved audit quality and to rebuild public confidence in the statutory audit (Maroun & Atkins, 2014). It argues that the NFRA would be referred to as what is globally known as the “Independent Audit Regulator” (IAR).

After the collapse of Enron in the United States, there is a global consensus to bring about fundamental reform in the accounting and auditing profession for regulating the SROs such as the ICAI (Sridharan, 2020). Admittedly, the International Forum for IARs (IFIAR) drafts 7 core principles for promoting effective independent audits worldwide by overriding any other forum member(s) objective to serve the public interest and improve investors’ protection and audit quality significantly. In other words, the creation of the NFRA will likely monitor the accounting and audit works of the ICAI. The CoE reports similar observations supporting the constitution of the NFRA, and the ICAI’s versions are likely to be refuted regarding the improved audit quality and public interest at large. As the Indian audit profession is self-regulated, the ICAI probably takes this contradictory standpoint. Undoubtedly, the ICAI plays a dual role. First, it should regulate its members and impose disciplinary actions for professional negligence to retain public confidence. Again, the ICAI is committed to promote the profession at a competing level alongside other professions. However, the continued opposition to forming the NFRA defers critical reform in the audit profession. Only in March 2018 could the government implement the decision, even though Section 132 of the Companies Act, 2013, empowers the NFRA to regulate the profession and improve the audit quality to match global standards. Eventually, the current study concludes that after addressing the teething problems, the NFRA would comprehensively counter the challenges of the auditors, audit firms, and audit networks, and the Indian audit profession would attain new heights.

Footnotes

Declaration of Conflicting of Interests

The author declared no potential conflicts of interest with respect to the research, authorship and/or publication of this article.

Disclosure Statement

The author declares that the study has been carried out exclusively for academic purposes, without any financial aid from any funders. The contents are free from plagiarism, no conflict of interest (CoI), and all other usual disclaimers apply. Moreover, acknowledgement does not apply to the current study.

Funding

The author received no financial support for the research, authorship and/or publication of this article.

Notes

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