3

Auditing the Auditors

 

 

3.01     Who audits audit? This question has vexed economists as well as corporate governance specialists. Simply put, the auditor performs a critical role in informing the shareholders of the true and fair picture of the state of financial and operational affairs of a company. However, the ability to play this role well depends upon the auditors knowledge, skills, independence, professional scepticism and integrity. It has been often argued that there are ought to be ais great  need to credibly regulate auditors effectivelyso as to ensure that they have properly discharged their fiduciary responsibilities.

 

3.02     In most countries, the regulatory role is carried out, to greater or lesser degree, by professional bodies representing certified public accountants. Whilst in some countries the regulator is a re are merely voluntary “non-statutory self self-regulating organisation, in some others they are creatures of a specific statutes. In IndiaHere, the Institute of Chartered Accountants of India (ICAI) has been set up under the Chartered Accountants Act, 1949, to examine and regulate the profession. Similarly, the Institute of Company Secretaries of India (ICSI) has been set up under the Company Secretaries Act, 1980, to regulate its members. Analogously, and  the cost accountants are regulated by the Institute of Cost and Works Accountants of India (ICWAI)Institute of Cost and Works Accountants of India (ICWAI) regulate the cost accountants. Indeed, these three professional organisations are statutory bodies created by acts of Parliament, and not mere self-regulating organisations.

 

3.03     Until recently, most countries felt no need for any kind of public oversight board acting as  to be an independent apex organisation to regulate the conduct of these fiduciary intermediaries. The US corporate scandals have changed all that. Spurred by the public spectacle of senior auditors claiming little knowledge of the financial skulduggery of top-level executives of Enron and Worldcom, shareholders and corporate governance specialists as well as peoplethe world at large have been are increasingly demanding the setting up of credible public oversight bodies.

 

3.04     The first such move has beenwas initiated by the SOX Act, which has legislated in favour of setting up the Public Company Accounting Oversight Board (PCAOB). Box 3.A synopsises the basic elements of the PCAOB. Its provisions are worth reading in some detail, for it is the most comprehensive legislative intermediation in the history of auditing.

 

3.05     At the time of writing, there are reports that the financial community in the US is up in arms against the severe provisions governing the PCAOB. In fact, expert commentators believe that the rules and regulations governing PCAOB will have to be modified to suit reality. Irrespective of what happens in the US, it is a fact that providing for the PCAOB has raised similar demands in other countries. And, the Committee has been entrusted in its terms of reference to examine this matter. 

 

Box 3.A: Public Company Accounting Oversight Board of the SOX Act

          Objective: To oversee the audit of listed companies in order to protect investors’ and public interest in matters relating to the preparation of audited financial statements.

          Status: A non-profit body corporate, and agency or establishment of the US government.

          Duties: (i) Register all audit firms, (ii) establish and/or adopt rules for auditing, quality control, ethics, independence and other standards relating to the preparation of audited financial reports, (iii) conduct periodic inspection of auditing firms, (iv) conduct investigations and disciplinary proceedings where justified and, if necessary impose appropriate sanctions and penalties, and (v) enforce compliance with the SOX Act, securities laws relating to preparation and issuing of audit reports and the rules of the SEC.

          Composition: Five full time members, who are prominent individuals of integrity, possess an understanding of financial disclosures and have a demonstrated commitment to the interests of investors and the public. While serving on the board, none of the members can be employed or be engaged in any other professional or business activity. Only two members out of five may be certified public accountants and if such a member is the chairperson, then s(he) cannot be practicing certified public accountant for at least five years prior to his or her appointment to the board.

          Powers: The board has powers to (i) sue, be sued, complain and defend, (ii) conduct its operations, maintain offices and exercise all other rights and powers authorised by the SOX Act, (iii) appoint employees, accountants, attorneys and others, define their duties and fix their compensation, and (iv) allocate, assess and collect support fees from registered public accounting firms.

          Registration: All public accounting firms have to register with the board within 180 days from the passing of the Act.

          Auditing, quality control and independence standards and rules: The board shall establish by rule all auditing, attestation, quality control and ethics standards that need to be used by audit firms. These standards may be formulated either by adopting those of professional groups or by recommending new ones.

          Inspection of audit firms: The board shall have the powers to conduct a continuing programme of inspections of audit firms to assess their degree of compliance to its rules as well as those of the SEC. In general the board will annually inspect each audit firm that audits

      more than 100 companies, and once in three years those that  audit 100 or less companies.

           
Investigation and disciplinary proceedings
: The board has the powers to conduct investigations of any act by an auditing firm or its partners that may violate the provisions of SOX Act

      and other laws and rules. Non-cooperation with such investigations can result in suspension and revoking of the registration or licence of the audit firm. Moreover, the board has powers to initiate and conduct disciplinary proceedings against any registered audit firm.

          Sanctions: If the board finds that there have been violations, it is allowed to impose sanctions such as (i) temporary suspension, (ii) permanent suspension and revocation of licence, (iii) fines ranging from $50,000 to $100,000 for a natural person for each such violation, and between $2 million and $15 million for each violation committed by any other person.

          Extra-territorial jurisdiction: These provisions will apply to non-US auditing firms that prepare audited financial statements for US publicly listed companies. 

 

Should India have its Public Accounting Oversight Board?

3.06     The Committee took note of the Statement on Peer Review issued by the ICAI in March, 2002.  According to this statement, the ICAI has decided to aid professional firms in their quest for enhancement of quality of work through peer review, and have recognised that a professional should be always ready to show the quality of his work.

 

3.07     Quality has now come to be defined as the degree to which a set of inherent characteristics (distinguishing features) fulfils requirements, a requirement being the need or expectation that may be stated or generally implied, or obligatory.

 

3.08     The Committee, after some deliberation, came to the conclusion that while the ICAI statement on Peer Review is indeed a good one, it was time to think of a more independent and refined arrangement to ensure the quality of attestation services assignments performed by chartered accountants in relation to the technical standards prescribed for them.

 

3.09     The opinions expressed ofby those who met with the Committee were split along the middle: one set of people fervently advocated the setting up of an independent Public Accounting Oversight Board, while another — most notably, many chartered accountants, argued otherwise. We feel that it is important for the Committee to record both arguments before arriving at a conclusion.

 

3.10     Those who favoured an oversight board based their arguments on the perception of the efficacy and independence of ICAI. According to this school of thought, while the ICAI is legally empowered to carry out most of the regulatory, oversight and disciplinary functions outlined in the SOX Act (barring prosecution and levying of penalties), the public perception is that ICAI mechanisms are very slow and that the Institute seems to be loath to sufficientlyadequately discipline its errant members;. Ttherefore, it was argued, the need for a new, independent body to carry out such critical oversight functions.

 

3.11     Not surprisingly, many chartered accountants and spokespersons for ICAI believe otherwise. According to them, the Chartered Accountants Act, 1949, the regulations framed thereunder, and the organisational structure of ICAI enjoin the Institute to conduct all the necessary disciplining functions. The ICAI did agree that the procedures prescribed under the Chartered Accountants Act and its regulations tend to be slow, and favoured legislative amendments. They, however, contended that speeding up the process accompanied by changes suggested by them, should suffice to strengthen effective oversight over the disciplinary mechanism within the structure of ICAI. Hence, they felt that perhaps there was no need to create yet another legally mandated quasi-independent supervisory institution.

 

3.12     After considerable deliberation, the Committee came to the view that there was merit in theto ICAI argument. The reasons are as follows:

 

3.13    On balance, the Committee opted in favour of this view, and therefore rejected the idea of setting up yet another new regulatory oversight body. However, it also felt that the ICAI must now show more determination and speed — and so prove that it is an efficient body that can be always entrusted to provide transparent and expeditious auditing oversight in the interest of investors and the general public.

 

3.14     If not a new public oversight board, then what? The Committee considered two major steps. First, recommending legislative and organisational support for the setting up of independent Quality Review Boards to strengthen and extendreform the peer review system   within the ICAI. Secondly, recommending significantly enhanced and expeditious disciplinary action within the framework of the Chartered Accountants Act, 1949 to bring errant auditors to book . The former is discussed in section 3.2, while the latter is examined in section 3.3 below.

 

Independent Quality Review Boards

3.15     Before recommending the setting up of independent Quality Review Boards (QRBs), it should be stated that tThe Committee examined the ICAI’s recently introduced system of peer review of audit firms, which is going to be operational from 1 April 2003. While ICAI’s Peer Review Statement seems to be an adequate, self-contained document that addresses most of the issues regarding ‘who audits the auditors’, it is still necessary to recommend a process of quality review that is publicly perceived to be independent and expeditious. The committee noted that such a system has already been established in Sri Lanka recently.  The committee recommends setting up of independent QRBs — one each for the ICAI, the ICSI and the ICWAI.

 

Recommendation 3.1: Setting up of independent Quality Review Board

          There should be established, with appropriate legislative support, three independent Quality Review Boards (QRB), one each for the ICAI, the ICSI and ICWAI, to periodically examine and review the quality of audit, secretarial and cost accounting firms, and pass judgement and comments on the quality and sufficiency of systems, infrastructure and practices.

          In the interest of realism, the QRBs should, for the initial five years, focus their audit quality reviews to the audit firms, which have conducted the audit for the top 150 listed companies, ranked according to market capitalisation as on 31 March. This should give investors the comfort that the audited financial and secretarial reports of all important listed companies are being reviewed. Depending upon the record of success of such reviews, the DCA may subsequently consider altering the sample size or criterion.

          Composition of ICAI’s QRB: The board shall consist of 11 members, including the chairman. The chairman shall be nominated by the DCA, in consultation with, but not necessarily from, the ICAI. Five members of the board, excluding the chairman, shall be nominated by the DCA who will be people of eminence, professional reputation and integrity including, but not limited to, nominees of the Comptroller and Auditor- General of India, RBI, SEBI, members or office-bearers of the Bombay Stock Exchange or the National Stock Exchange, the three apex trade and industry associations (CII, FICCI and ASSOCHAM), reputed educational and research

      institutions, bankers, economists, former public officials and business executives. The remaining five members of the Board will be nominated by the Council of the ICAI.[1]

          Composition of ICSI’s QRB: A five-member board, including the chairman. The chairman shall be nominated by the DCA, in consultation with, but not necessarily from, the ICSI. Two  members, excluding the chairman, shall be nominated by the DCA, who will have the same attributes suggested for ICAI’s QRB above. The remaining two members will be nominated by the Council of the ICSI.

          Composition of ICWAI’s QRB: A five-member board, including the chairman. The chairman shall be nominated by the DCA, in consultation with, but not necessarily from, the ICWAI. Two  members, excluding the chairman, shall be nominated by the DCA, who will have the same attributes suggested for ICAI’s QRB above. The remaining two members will be nominated by the Council of the ICWAI.

          Funding: Each of these QRBs will be funded by their respective institutes in a manner that each sees fit.will enable it to discharge its functions adequately.

          Appellate forum: In the instance of a dispute between the findings of the QRBs and reviewees, the matter should be referred to an appropriate appellate forum. This appellate forum should be the same as that suggested for disciplinary matters, which is discussed in Recommendation 3.2 below.

          DCA should adopt transparent procedures while nominating people of eminence to the QRBs

 

 

Disciplinary Action foragainst Professional Misconduct

3.16     The areasubject of disciplinary mechanism requires careful consideration. Spurred by revelations of significant audit failures in the US, there have been reports in the Indian media expressing concern over the alleged lack of disciplinary action on auditors who have failed to perform their duties. It has also been stated by many who interacted with the Committee that the ICAI has been unable to adjudicate disciplinary cases within reasonable time. Similar concerns have been expressed for the other two Institutes, even though they have much fewer disciplinary cases.

 

3.17     Under the current legal framework, failure on the part of auditors regarding their civil and/or criminal acts or omissions are dealt with under the respective laws. Auditors are  also liable under the common law of the country. But law proceeds in ponderous ways. And the hallmark of any reputed profession, especially one discharging key fiduciary obligations, is the code of ethics that it imposes on its members, and  the mechanism for reviewing and punishing professional misconduct. In fact, The Chartered Accountants Act, Company Secretaries Act and the Cost and Works Accountants Act do provide for athe framework for taking disciplinary action against the erring members.

 

3.18     As far as chartered accountants are concerned, section 21 of the Chartered Accountants Act provides for disciplinary action against a member of the ICAI for professional and/or other misconduct; while regulations framed under the aAct defines  the framework and procedures by which the disciplinary proceedings must be conducted. The existing mechanism is quite elaborate. However, procedures that were framed in the past have not been able to cope with the changed scenario, which must deal with complex businesses and over 70,000 practicing members.

 

3.19     Not surprisingly, there have been professional as well as public concerns aboutover  the time taken in the disposal of disciplinary proceedings.[2] The existing system suffers from the following limitations :

 

3.20     Indeed, a note from the ICAI has itself highlighted the problems which occur at each stage of the process. These require some elaboration.

 

3.21     The Committee believes that such delays just have to be avoided. The confidence of the investing public, especially small investors, cannot be nurtured unless disciplinary cases are dealt with more expeditiously and transparently.

 

3.22     The Committee has been given to understand that in its various representations to government, the ICAI has suggested changes in the processprocedure. Some of these changes are:

        Merging the two existing two schedules of the Chartered Accountants Act, that describe professional misconduct, into a composite schedule, and clear categorisation of offences. According to ICAI, this ought to help focus on cases having larger public interest and also relate the quantum of punishment to the gravity of offence.

 

3.23     While the Committee appreciated the changes suggested by the ICAI, it felt that the need of the hour was something more. Shareholders, investors and other stakeholders of companies rely on the audited financial statements for making investments and other major decisions. The auditing profession, therefore, needs to respond to the confidence reposed in them, and has to be seen to be responsive.

 

3.24      Moreover, in most instances, disciplining the auditors need not be a matter requiring consideration of High Courts. For one, there are significant delays whenever a case is recommended by ICAI to the High Court. For another, the High Courts have enough on their plate to be further burdened by ICAI cases. Hence, there is a need not only to have more expeditious disciplinary processes within the ICAI, but also to have a quasi-judicial appellate body outside the High Courts to hear most of the appeals.

 

3.25     The existing disciplinary cases fall under two specific categories: ‘complaint’ and ‘information’ cases. While this categorisation may continue, the procedures to be followed need significant changes not only to overcome the bottlenecks but also to ensure effective and expeditious delivery of justice. Accordingly, the Committee has recommended an entirely new disciplinary procedure which, while keeping the process within the framework of the ICAI and The Chartered Accountants Act, will bring about greater  speed whileand ensuring independence and fair play.

 

3.26     After considering the matter at some length, the Committee arrived at the conclusion that the right to appeal to the High Court or making certain penalties subject to confirmation by the High Court was not strictly necessary.  The Committee noted that such a provision was not there in the Advocates Act. Given the nature of cases involved, it would be more appropriate to establish a high-powered Appellate Body comprising two senior chartered accountants, two eminent persons having qualifications similar to the ones prescribed for independent members of the Disciplinary Committee but of a higher standard and experience and a Presiding Officer who should be a retired Judge of the Supreme Court or a retired Chief Justice of High Court.

 

Recommendation 3.2: Proposed disciplinary mechanism for auditors

        Classification of offences and merging of schedules: At present there are two schedules of offences and misconduct — with the second schedule requiring action by High Courts. These two schedules need to be merged, so that the Council is empowered to award all types of punishment for all types of offences. Further, offences need to be categorised according to the severity of misconduct, so that processes can be designed, and punishments awarded, according to the severity of the offence.

        Prosecution Directorate: An independent permanent directorate within the structure of ICAI shall be created, which shall act as the Prosecution Directorate. This office will exclusively deal with all disciplinary cases and, hence, expedite the process of enquiry and decision-making by fully devoting its time and energy towards processing these cases. The office should be headed by a person of the level of Director, and should be one with a legal background and conversant with the provisions of The Chartered Accountants Act and its regulations. He and his office shall be independent of the electoral process of ICAI. Suitable regulations need to be framed to uphold the independence of this office. The Prosecution Directorate shall have the same powers as are vested in a civil court under the Code of Civil Procedure, 1908, regarding (i) the discovery and production of any document; and (ii) receiving evidence on affidavit.

Procedure for dealing with complaint cases

1.       The complaints received in the appropriate form, manner, and complete in all respects, shall be registered by the Prosecution Directorate, and sent to the member or firm within 15 days of registration of such a complaint.

2.       Depending on the category of the complaint, the Prosecution Directorate shall ask for and obtain necessary documents such as written statements, rejoinders, comments, and other evidence from the complainant as well as the respondent. The time frame for this should be, under normal circumstances, no more than 60 days. Not submitting such documents within the prescribed time shall be treated as an offence, risking the initiation of additional obstruction of justice proceedings.

3.       On receipt of the relevant documents, the complaint, along with the views, if any, of the Prosecution Directorate, will be placed before the Disciplinary Committee. This has to be done within 20 days of receiving all relevant accompanying documents.

Procedure for dealing with information cases

1.       Information received shall be examined by the Prosecution Directorate. After forming his views, the Director of the Prosecution Directorate will place the matter before the Secretary of ICAI.

2.       If the Secretary agrees with the view expressed by the Director, then the information case will be placed before the Disciplinary Committee.

3.       In the event of the Secretary differing with the views of the Director, the matter would be placed before the President of ICAI and, thereafter, it would be discussed at a meeting between the President, Secretary and the Director. If in this meeting, it is decided to refer the matter to the Disciplinary Committee, then reference be made accordingly. Upon such referral, the Prosecution Directorate shall argue the case before the Disciplinary Committee. If, however, the Secretary and President of ICAI decide that the information should be filed and closed, then the Director of the Prosecution Directorate will have the choice to either follow the majority opinion, or dissent and refer such a case to the Disciplinary Committee, with his as well as the Secretary’s and President’s opinion. In such instances, however, the President shall not function as the Presiding Officer of the Disciplinary Committee.  Further, if the Director Prosecution does not feel that a reference to the Disciplinary Committee is warranted, the Institute would still be free to take such cases to the Committee if it feels there is a need to do so. 

4.       After registering the ‘information’ case, the procedure outlined for the complaint case may be followed mutatis mutandis. 

Disciplinary Committee

Ÿ         Enquiries in relation to misconduct of members shall be held by the Disciplinary Committee. To expedite decision-making, the Council of ICAI shall be empowered to constitute one or more bench of the Disciplinary Committees in cities where there are regional headquarters of ICAI.

Ÿ         Composition: Each bench should consist of five members. The President or the Vice-President of ICAI will be the Presiding Officer. However, in information cases put before the Committee by the Prosecution Director after disagreeing with the views of the President and the Secretary, the President shall not act as the Presiding Officer. In such cases, the Vice-President will perform this role. Two of the other four members will be nominees of ICAI’s Council, while the remaining two will be nominees of the DCA viz. people of eminence, professional reputation and integrity such as, retired judges, bankers, professionals, educationists, economists, business executives, former members of regulatory authorities and former public officials. As far as practicable, members of the Disciplinary Committee should be from the regions other than the one in which it is being constituted.

It needs to be stated that in terms of the existing requirement, a nominee of the Central Government is required to be nominated to the Disciplinary Committee. Until very recently, such a nominee was an official of the DCA. However, DCA officials have rarely had the time to attend the meetings of the Disciplinary Committee. Hence, the Committee recommends that, given their pre-occupation in the department, paucity of time, a sitting government official should not be nominated to the Disciplinary Committees.

It is pointed out that for each stage in the process, strict time lines should be prescribed.  This is especially important in respect of scrutiny of information cases.

Ÿ         Quorum: Three of the five members.

Ÿ         Tenure: Co-terminus with the duration of the ICAI Council.

Ÿ         Functions: The Disciplinary Committees shall hear the complaint and information cases referred by the Prosecution Directorate and record their decisions and conclusions in a report. This report shall also record the punishment to be awarded, if any, to the member, which can

Ÿ          constitute (i) reprimand, (ii) removing the name of the member either permanently or for such a period as thought fit, (iii) monetary penalty, and/or (iv) a combination of any two.

Council

Ÿ         Any report submitted by the Disciplinary Committee should normally be considered by the Council within 45 days from the date of the report. It shall be the duty of the Council of ICAI to act upon the decisions of the Disciplinary Committee. While performing such a duty, the Council can: 

1.       Endorse the decisions of the Disciplinary Committee, and implement them.

2.       Refer any case back to the Disciplinary Committee for further enquiry, when it finds   that certain issues need further enquiry. However, in doing so, the Council will have to frame the specific issues.

3.       Direct the Prosecution Directorate to place the case before the Appellate Body, in the event of the Council deciding to appeal against the decisions of the Disciplinary Committee.

Appellate Body

Ÿ         Headquartered in New Delhi, the Appellate Body shall consist of a Presiding Officer and four other members. The Presiding Officer shall be a retired judge of the Supreme Court or a retired Chief Justice of a High Court. Two members shall be Past Presidents of ICAI, nominated by the Council. The remaining two shall be persons of eminence nominated by the DCA (but excluding any officer of the Department or member of the Council). The quorum shall be three.

Publication of decisions of the Disciplinary Committee

        Due publicity shall be given by the Prosecution Directorate about the punishment ultimately awarded, through periodicals, newsletters, website and any other means considered appropriate. However, no decision taken by the Disciplinary Committee be published unless and until the punishment is endorsed and implemented by the Council.

Funding

1.       Appellate Body: Required funding arrangements should be made by the Central Government. This is essential for ensuring independence, and on the ground that the High Court stage can be said to have been always funded by the Government. 

2.       Disciplinary Committee: The expenses shall be borne by ICAI’s Council, which shall also fix the emoluments, sitting fees, allowances, and other expenses of the members. 

3.       Prosecution Directorate: All expenses will be borne by the Council of ICAI.

4.      Every complaint, other than a complaint made  by or on behalf of the Central or any State Government shall be accompanied by a fee Rs.5,000, which will be returned as soon as the

Disciplinary Committee recommends that case is not frivolous. Fees not refunded for frivolous cases will be used to partly defray the cost of investigation.

 

3.27      Independent disciplinary mechanisms may be designed on similar lines in respect of Company Secretaries and Cost Accountants. The Committee believes that the mechanism outlined above is realistic and should work, given adequate funding and determination. This should bring to bear a transparent and expeditious disciplinary procedure that could contribute to enhancing the prestige and public trust that the Institutes have today.



[1] In the interest of independence, it was suggested to the Committee that professionals should not be members of the QRB at all. However, the job of QRB is not that of inspection or review of audit. Rather, it is to ensure that standards, procedures and practices that are required to be met or followed, are indeed being met and followed. This is a technical area, the absence of professionals from which would tell upon the quality of the QRB itself. Therefore, the Committee has suggested a structure that has them on the QRB, but the majority of the Board is made up of eminent persons from other fields.

[2] During the last five years, 613 complaints were received by ICAI, of which 454 were disposed of— a disposal rate of 74 per cent. The remaining 26 per cent are pending at different stages, including at the High Courts. During the same period, the Council of ICAI has awarded or recommended punishment up to five years in 72 cases. Barring very few exceptions, the recommendations of the ICAI on the punishment to be awarded to have been invariably endorsed by the High Courts.