U S Taxation – Auditor’s responsibility: U S Audit Vs Indian Audit, a lively comparison

Not a day passes without reference to fictitious accounts opened for diverting funds either for income tax purposes or laundering of funds. Interestingly, many of these accounts carry the solemn auditor’s fairness opinion on the financial statements. It was a meeting of Chartered Accountants, some of them must be leading, judging by the Toyotas, Hondas or BMWs parked at the gate of the conference. I was in attendance there. Sophisticatedly called “Transfer Pricing” one of the speakers made salient features of various ways of assessing the cost involved between two countries experts’ services, expert fees, boarding, lodging etc. and also casually concluded by mentioning some money to be paid to the tax authority to get the cases cleared. Wow! Since long our Chartered Accountants have become commission agents, a remark jokingly or seriously made by a government official in relation to demonetization drive and Chartered Accountants’ role in India.

This article takes up the role of an auditor in auditing the financial statements, both in India and U S A seriously and brings forth the actual mandates of regulatory authorities. Time to take up the role very serious, particularly, when some of the Chartered Accountants(CAs) had gone to prison and that too for a period of three years without any bail. This is not a joke!  Young CAs entering the profession need to read the instructions thoroughly and also repeatedly and follow the guidelines of regulatory authorities clearly before putting their signature on the financial statements as auditors.

Now the precious quotations from the Company Act, 2013 by Dr. Avtar Singh, eminently known as the authority on Company Act whose books have guided thousands of lawyers to lighten up their careers.

I have to quote from this Treatise on Company Law, sixteenth edition, 2015 and published by EBC Publishing(P) Ltd for further discussion:

S .143(9)

“Every auditor has to comply with auditing standards…

• Where an auditor has reason to believe that an offence involving fraud is being or has been committed against the company by an officer or employee, he has to report immediately the matter to the Central Government.
• His duty is not to confine himself merely to the task of verifying the arithmetical accuracy of the balance sheet, but to inquire into substantial accuracy. Thus, where an auditor failed to verify the cash balance claimed by the management and the actual cash in hand turned out to be much less than was shown in the books, he was guilty of neglect of duty.
• In matters of technical nature, ………the auditor may rely on a skilled person and was not held liable when he relied upon the manager of a cotton mill, unless there was suspicion of something wrong.
• Secondly, the auditor must exercise reasonable care and skill in the discharge of his duty. The auditor “is a watchdog, but not a bloodhound”.” He is not an insurer”. If the company owns securities, the auditor should see that they are in proper custody.
• If they approve of accounts showing false income, they will be liable for false income, they will be liable for the extra income tax that company had to pay, or for dividends paid on the basis of such accounts.
• Auditors are under no responsibility to persons other than shareholders unless they undertake any such duty under a contract with them, should they be misled by any error in the audited accounts.
• Penal provision [S.143(15)]. – If any auditor, cost accountant, or company secretary in practice does not comply with the provisions of sub-section (12), he is punishable with fine of not less than Rs.1,00,000 but extending up to Rs.25,00,000.
• Explaining the position of auditors, Mr. C Chakravarti of Calcutta High Court has said that a joint stock company carries on business with the capital provided by persons who buy its shares. The owners of the capital, are, however, not in direct control of its application which is left to the executives of the company………The Companies Act, therefore, provides for employment of an auditor who is the servant of the shareholders and whose duty is to examine the affairs of the company on their behalf at the end of a year and report to them what he found.
• That examination by an independent agency such as the auditor is practically the only safeguard which the shareholders have against the enterprise being carried on in an un-business-like way or their money being misapplied or misappropriated without their knowing anything about it.
• The act provides the safeguard in two forms. It makes the duty of the auditor to give an expression of opinion on certain specified matters of a vital character and makes him liable, along with the directors, for misfeasance, if he fails to perform his duties as required by law and the approved audit procedure.
• Standard of care and skill—Secondly, it has always been the law that the auditor must exercise reasonable care and skill in the discharge of his duty.
• Duty in connection with takeover—A three-point formula has been propounded by the Court of Appeal on the Auditor’s duty to the investing public. The court said that in determining the auditor’s duty of care to those relying on accounts audited by him, it must be shown that –
• It was foreseeable that persons relying on the accounts would suffer harm if the auditor was negligent.
• The auditor and the user of the accounts stood in a relationship of sufficient proximity.
• The circumstances made it just and reasonable to impose such a duty on the auditor.
• Liability for fraudulent misrepresentation – The liability for fraudulent misrepresentation was explained by Cardozo, Chief Justice, in these words: Accountants, may, however, be liable even where there is lacking deliberate or active fraud. A representation certified as true to the knowledge of the accountants when knowledge there is none, a reckless statement, or an opinion based on grounds so flimsy as to lead to the conclusion that there was no genuine belief in its truth, are all sufficient upon which to base liability. A refusal to see the obvious, a failure to investigate the doubtful if sufficiently gross, may furnish evidence leading to an inference of fraud.

Now let us look at the responsibilities and functions of the independent Auditor from American regulatory point of view. (I shall express my views on both these standards, as an experienced auditor for guidance purposes at the end)

Let us directly go to the web site of PCAOB, Public Company Accounting Oversee Board as under:

https://pcaobus.org/About

The following information has been directly taken from above web site:

“Public Company Accounting Oversee Board(PCAOB) USA, is a nonprofit corporation established by Congress, USA, to oversee the audits of public companies in USA, in order to protect investors and the public interest by promoting informative, accurate, and independent audit reports. The PCAOB also oversees the audits of brokers and dealers, including compliance reports filed pursuant to federal securities laws, to promote investor protection.

The Sarbanes-Oxley Act of 2002, which created the PCAOB, required that auditors of U.S. public companies be subject to external and independent oversight for the first time in history. Previously, the profession was self-regulated.

The five members of the PCAOB Board, including the Chairman, are appointed to staggered five-year terms by the Securities and Exchange Commission, after consultation with the Chair of the Board of Governors of the Federal Reserve System and the Secretary of the Treasury.

The SEC has oversight authority over the PCAOB, including the approval of the Board’s rules, standards, and budget.

The Act, as amended by the Dodd-Frank Wall Street Reform and Consumer Protection Act, established funding for PCAOB activities, primarily through annual accounting support fees. These fees are assessed on public companies, based on their relative average monthly market capitalization, and on broker-dealers, based on their relative average quarterly tentative net capital.”

The responsibilities and functions of the Independent Auditor as explained under Auditing Standards(AS) 1001from the web site quoted above since it is essential to know the exact language used by regulatory authorities in USA to appreciate comparison with the meaningful  Indian explanations given earlier:

AS 1001

“.01 The objective of the ordinary audit of financial statements by the independent auditor is the expression of an opinion on the fairness with which they present, in all material respects, financial position, results of operations, and its cash flows in conformity with generally accepted accounting principles. The auditor’s report is the medium through which he expresses his opinion or, if circumstances require, disclaims an opinion. In either case, he states whether his audit has been made in accordance with the standards of the PCAOB. These standards require him to state whether, in his opinion, the financial statements are presented in conformity with generally accepted accounting principles and to identify those circumstances in which such principles have not been consistently observed in the preparation of the financial statements of the current period in relation to those of the preceding period.

Distinction Between Responsibilities of Auditor and Management

.02 The auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud. Because of the nature of audit evidence and the characteristics of fraud, the auditor is able to obtain reasonable, but not absolute, assurance that material misstatements are detected. The auditor has no responsibility to plan and perform the audit to obtain reasonable assurance that misstatements, whether caused by errors or fraud, that are not material to the financial statements are detected.

.03 The financial statements are management’s responsibility. The auditor’s responsibility is to express an opinion on the financial statements. Management is responsible for adopting sound accounting policies and for establishing and maintaining internal control that will, among other things, initiate, record, process, and report transactions (as well as events and conditions) consistent with management’s assertions embodied in the financial statements. The entity’s transactions and the related assets, liabilities, and equity are within the direct knowledge and control of management. The auditor’s knowledge of these matters and internal control is limited to that acquired through the audit. Thus, the fair presentation of financial statements in conformity with generally accepted accounting principles is an implicit and integral part of management’s responsibility. The independent auditor may make suggestions about the form or content of the financial statements or draft them, in whole or in part, based on information from management during the performance of the audit. However, the auditor’s responsibility for the financial statements he or she has audited is confined to the expression of his or her opinion on them.

Professional Qualifications

.04 The professional qualifications required of the independent auditor are those of a person with the education and experience to practice as such. They do not include those of a person trained for or qualified to engage in another profession or occupation. For example, the independent auditor, in observing the taking of a physical inventory, does not purport to act as an appraiser, a valuer, or an expert in materials. Similarly, although the independent auditor is informed in a general manner about matters of commercial law, he does not purport to act in the capacity of a lawyer and may appropriately rely upon the advice of attorneys in all matters of law.

.05 In the observance of the standards of the PCAOB, the independent auditor must exercise his judgment in determining which auditing procedures are necessary in the circumstances to afford a reasonable basis for his opinion. His judgment is required to be the informed judgment of a qualified professional person.

Detection of Fraud

[.06-.09] [Paragraphs deleted.]

Responsibility to the Profession

[10] [Paragraph deleted.]

11 The auditor should be aware of and consider auditing interpretations applicable to his or her audit. If the auditor does not apply the auditing guidance included in an applicable auditing interpretation, the auditor should be prepared to explain how he or she complied with the provisions of the auditing standard addressed by such auditing guidance.

Note: The term “auditing interpretations,” as used in this paragraph, refers to the publications entitled “Auditing Interpretation” issued by the American Institute of Certified Public Accountants’ Auditing Standards Board as in existence on April 16, 2003, and in effect.”

Let me offer my views on auditing in general which is equally applicable both in USA and India for auditors who undertake their tasks related to giving their opinion on financial statements.Copyright © 2002, American Institute of Certified Public Accountants, Inc.

Simply put, an auditor has to be sceptic, neither excited about successful completion of the audit by framing a very good opinion of the client or diffident about prospects.

Yes, as an experienced banker, an auditor, and later a CPA from U.S.A. I have given many practical examples for readers’ consideration:

• Assertions are representations by management, explicit or otherwise, that are seen from the financial statements. These are based on American Institute of Certified Public Accountants prescribed instructions.
• Transactions and events (Statements of Income and Cash Flows) – Occurrence, completeness, accuracy, cutoff, and classification.
• Account balances (Balance Sheet) – Existence, rights and obligations, completeness and valuation and allocation.
• Presentation and Disclosure (Notes) – Occurrence and rights and obligations, completeness, classification and understanding and accuracy and valuation.

Some actual application of above in real life situations:

• Standard audit plan for sales and receivables – Completeness. Do the sales and receivables contain all recordable transactions for the period?
• Accuracy – Have the amounts been recorded appropriately?
• Valuation and allocation – Are accounts receivable measured in accordance with the applicable accounting standards, e.g., Ind AS at net realizable value (gross accounts receivable – allowance for un-collection accounts)
• Similar comparison can be done for existence, cutoff, rights and obligations, occurrence, classification and understandability.
• Similar audit plans can be drawn for substantive checking of cash, substantive checking of accounts payable and purchases, substantive checking of inventory, substantive testing of property, plant and equipment, substantive testing of investments, substantive testing of non-current debts, audit of payrolls and substantive testing of equity.

My mind rolls over an instant happened with me as a senior bank manager and my the then chairman regarding audit of the checking account of his daughter. I had the guts, tenacity or stupidity to write to him about the irregularities and request for removal since his address was given in the account opening form of the account holder. He just called me for a meeting. Most of his personal staff was trembling since my transfer would be certain for having committed the sin of removal of irregularities with the top most man of the bank, however genuine the case may be, in their views.

The actual happening was entirely different and rather, I had a rousing reception from my CMD who happily offered his help to remove the irregularities. Well, you may wonder whether similar senior manager or CMD of banks do exist today? Why not?

But I shall narrate another involving my younger brother who is a brilliant chartered accountant and his experiences with Mr. J R D Tata, the legendary industrialist of our times. Who can forget his unfailing love for professionals and the growth of modern India?

My brother informed me that he raised some audit objections about validating the closing inventory of one of the leading mills of Tata Oil Mills Ltd. I was told that the legendary industrialist not only called him but also agreed with the judgement of my younger brother and appreciated his professional ethics and courage in fulfillment of his duties.

I have met many brilliant bankers/industrialists/Chartered Accountants who travel extra miles to fulfill their legal/professional obligations without fear or favor.

A small audit test for you before concluding the reading of the article:

• How do you audit the cash holding/investments/stocks hypothecated in a bank?
• You are the top most man of the trading hall of the bank for purchase of forward dealing of currencies and you are expected to audit the day’s dealings of the dealers working under you. One dealer has input some value for purchase of a foreign currency while incorporates another value for sale of the same. How do you audit?
• You are a manager of a big Hindu temple and at year end closing and auditing of accounts, the auditor wants to audit the financial statements of the temple and enquires your suggestion about gold holdings/jewelries/gold or silver vessels kept in the lockers. Does he need physical verification of all items? How does the temple ensure correct counting of cash or other offerings from the Hun dial or massive cash boxes kept at the entrance? Can the priest just count and inform the authorities the daily collections?
• What is the standard procedure to understand the operations of IT companies and what is the audit plans of accounting firms?
• Can we say auditing standards change with the size of the companies and Can I agree with too big to fail in auditing? You may recollect many big companies who even restated their financial statements recently abroad raising a storm of protests and bewilderment among the investing public or big investment firms?

Conclusion

It was my accidental reading of the plans of income tax authorities to take action against the auditors who could have given their clean audit reports for those Limited Companies who seemed to have indulged in benami transactions and also identified by Income Tax authorities during massive operations taken recently to unearth benami transactions or laundering of ill-gotten wealth. Many of these account holders showed no mercy to the accounting standards or auditing plans evolved over centuries to safeguard all stake holders.

 Now is the time to educate our brilliant Chartered Accountants/Cost Accountants/Company Secretaries or other professionals involved in auditing of companies the current rules and regulations of governing authorities of India and U.S.A. I do not think I have done full justice to auditing standards by this article since audit has been in vogue since time immemorial and has evolved immeasurably over time.

 Let more brilliant and young auditors take the reins to face the uncertain future with hope and better technology.

Reference

• Company Law by Mr Avtar Singh, sixteenth edition, published by Eastern Book Company, Lucknow. Mr Avtar Singh is a legal authority over the subject and thousands of legal students/lawyers have enlightened their lives by his books.
• Web site of   Public Company Accounting Oversee Board(PCAOB), USA
• https://pcaobus.org/About